The recent fall in equities represents a belated recognition by the markets that the global economy has been much weaker than consensus economic forecasts indicated earlier in the year. Unlike last summer, when the same thing happened, the markets have also begun to recognise that policy makers have little ammunition left in the locker to combat the downturn.
The political will needed to ease fiscal policy, even temporarily, has evaporated on both sides of the Atlantic. And monetary policy has been hamstrung by the rise in inflation, which has clearly changed the thinking of the Fed. So where is the escape route?
Lower inflation would help a great deal. In the US, headline CPI inflation rose rapidly in Q1 and Q2, mostly because of the rise in commodity prices. It was this rise in inflation which squeezed household incomes and consumption, and that in turn was the main proximate cause of the recent weakness of GDP growth. If oil prices simply stop rising from now on (they do not have to fall), the headline rate of inflation will decline, and the growth rates of consumption and GDP should bounce back.
JP Morgan calculates that the rise in oil prices subtracted 3.5 percentage points from the growth in real retail sales in the developed economies in the first half of 2010. The potential disappearance of that drag constitutes the main hope of a partial recovery in growth in the next few months.
However, when it comes to possible support from monetary policy, a fall in headline inflation will not be enough. The rise in core inflation (ie the headline rate excluding food and energy prices) has been worrying the central banks, especially the Fed. If this rise persists, there is no chance of any further easing in Fed policy, even if economic activity remains in the doldrums.
There has been some debate about the cause of the increase in core inflation this year. The hawks at the Fed and elsewhere believe it indicates the economy has less spare capacity than had been previously thought, and they fear that core inflation will rise further unless monetary policy is tightened soon. In contrast, the Fed doves (and others like Paul Krugman) think the underlying trend in core inflation will stay very low because there is still a wide margin of spare capacity in the US economy. They attribute the recent rise in the core rate to temporary pass-through effects from higher energy prices, and the firming in the residential rental market. If the doves are right, then core inflation will soon start to subside, and the attitude of the Fed towards monetary policy might change.
So what does the evidence show? Fortunately, in the past couple of months, there have been some clear, though still very early, indications that the doves will be proved right. There has been no improvement yet in the 12 month rates of change, but there has been a tentative fall in the 1 month rates of change, which peaked in April or May, depending on the series used. The first graph shows the figures for the core CPI and core PCE, which are the simplest series to use for this purpose:
These trimmed mean series are calculated by leaving out all of the outliers on either side of the inflation data, which is to say the items which have risen most rapidly in price, and those which have risen least rapidly. Many economists, including a large number at the Fed, believe that these trimmed mean series provide the best immediate information on the behaviour of the broad mass of prices in the economy at any given time. So the improvement in these series is significant.
If core inflation does indeed continue to decline in the next few months, it will tell us some important things about the true state of the US economy. It will suggest that the chronic medium term problem with the economy remains one of a shortage of demand. Superimposed on this fundamental picture, there was clearly an adverse supply shock in the first half of 2011, which temporarily dominated the picture. Monetary policy was forced to respond to the supply shock for quite a while, but this would no longer be the case if the supply shock goes away.
Those who fear that there has been a massive (and implausible) deterioration in structural unemployment, or a large (and even more implausible) loss of entrepreneurial energy in response to excessive regulation, would have to accept that the evidence has not gone in their favour. The basic shortage at present would be one of demand, not of supply potential (though low investment rates may also be damaging the latter from a longer term perspective).
A shortage of demand is not proving easy to solve, any more than it did in Japan in the last 20 years. It seems extremely hard to form a consensus among economists that this is indeed the most urgent problem facing the US, and even harder to reach agreement on what to do about it.
But one thing is certain: a demand side problem is easier to solve than a supply side problem. And that is why it is important to see core inflation falling further in the remainder of this year.