Thursday, February 21, 2008

Kudlow 101: Bank Credit & Inflation

Economist Martin Feldstein made the case in yesterday’s Wall Street Journal ("Our Economic Dilemma") that credit is contracting throughout the banking system. As a result, Mr. Feldstein contends that a recession is all but inevitable. I beg to differ.

My friend, economics professor Mark Perry from the University of Michigan business school (and author of the great Carpe Diem blog site) provides us with the following charts to challenge Mr. Feldstein’s thesis.

First up, commercial & industrial loans:

This is through the end of 2007. As you’ll see, business loans are still rising.

Next up, consumer loans:

Again, still rising.

Finally: real estate loans:

Check that out. Even real estate loans are still rising. They’re not rising much, but they are still rising.

Even though big pockets of problems still exist out there, I do not share Mr. Feldstein’s credit contraction scenario. People are still getting loans.

Moving on to inflation. The big problem yesterday was a lousy CPI report.

The overall inflation rate went up to 4.3 percent, last twelve months. The core inflation rate is 2.5 percent. As you can see by this chart, core inflation is in line with the last ten years. Although, it’s still a little high for the Fed’s tastes.

I did some statistical testing of various inflation models. Now, to be sure, I don’t think anyone has really cornered the market on inflation forecasting. (Or for that matter, any forecasting.) But let me just share with you some statistical results.

If you use just the price of gold -- which has had a heck of a run, shooting up over $900 bucks -- with an 8-quarter lead, gold is predicting 5.7 percent inflation in 2008. That’s the highest. If you use the old, Milton Friedman, narrow money supply M1, with an 8-quarter lead, the inflation rate comes to a modest 2.2 percent. This is headline inflation. And therefore way down from today’s 4.3 percent report. On the other hand, if you use the 5-year Spot TIPS inflation model, the so-called inflation spread that the Fed looks at, the inflation rate by the middle of the year would be 2.2 percent.

Now, if you take all them together, you get 3.4 percent as an average. But if you exclude gold, it’s actually only about 2.2 percent. That may be a little high, but still nothing to worry about.