Inflation As Mouse Not Being Chased

Here is a graph that shows the fall of core PCE inflation from its peak in 1981 to the present. (link to quarterly data)

Inflation has fallen with a stable swoop downwards. We are currently at about the 0.1 mark on the x-axis showing a core PCE of 1.6% on the y-axis.

The graph implies that inflation is a long way from returning back to the conditions when inflation was high. So the x-axis must tell a story of inflation. What is on the x-axis? Let's look at its equation...= Profit per unit of real gross value added of nonfinancial corporate business: Corporate profits after tax with IVA and CCAdj (unit profits from current production) - (60%*Fed rate +40%*10-year treasury rate)

The equation basically takes the real after-tax profit rate and subtracts a measure of the nominal rate which blends short-term rates with long-term rates.

When nominal rates are high, we would expect inflation to be high too. Why? Well, when inflation goes high, nominal rates go high to control inflation. But there is more to the story. Nominal rates can float inflation upwards, or knock it down depending on how strong nominal rates rise.

Model of Inflation & Nominal Rates (Cat & Mouse Chase)

Here is the model for the graph. The up sloping red diagonal line is the real cost boundary. Corporations want to be to the right of this red line. Then their after-tax profits are positive and the economy can grow or stabilize. But to the left of this red line, corporations are forced to contract from negative after-tax profit rates.

Net Profit rate = real profit rate - nominal rate + inflation

If corporations can keep prices rising ahead of nominal rates, then they can deal with profit rates being squeezed. But if the central bank does not like rising inflation, nominal rates will get aggressive and can force net profit rates negative. This happened in the Volcker recession. As soon as Volcker jacked up the Fed rate, the data points were pushed to the right of the red diagonal line and the recession ensued, which brought down inflation.

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Edward Lambert 3 years ago Author's comment

In the second to last paragraph, I meant to say... "... if corporate taxes are slashed NEXT year."