The estimable Martin Feldstein put the wood to the Fed in a recent op-ed and in so doing hit the nail directly on the head. He essentially called foul ball on the whole inflation targeting regime and the magic 2.00% goalpost in part due to the measuring stick challenge.
A fundamental problem with an explicit inflation target is the difficulty of knowing if it has been hit.
That problem is plainly evident in the chart below. You could very easily make the argument that goods prices are beyond the Fed’s reach because they are set in the world markets and by the marginal cost of labor in China and the EM.
Therefore the more domestically driven CPI index for services such as housing, medical care, education, transportation, recreation etc. is the most relevant yardstick. Alas, if there is something magic about 2.00%, why then, mission accomplished!
On a five-year basis, services inflation is up at 2.2% annually, and during the past year, it has heated up to 3.2%.
Then again, if the Fed were not comprised of power-hungry apparatchiks looking for any excuse to intrude in the financial markets and dominate their hourly behavior, it might well recognize the merit of what we have termed “CPI Using Market Rent” (box).
That’s because the regular CPI gives a 25% weighting to the OER (owners equivalent rent), which is more than a little squirrely.The BLS actually asks a tiny sample of homeowners what they would charge per month if they were to rent out their castle.
They have no clue! So the BLS plugs some survey questionnaire noise into an algorithm and calls it 25% of the entire damn index!
To improve upon this nonsense, we just swapped out the OER in the chart above and replaced it with an asking rent index that a private vendor provides to real clients in the housing rental business. The results get us exactly to the title of Feldstein’s post called “Ending the Fed’s Inflation Fixation”.
After all, can any adult really believe that there is any significant difference between 2.0% and 1.9% on a five-year trend basis? Or even that 1.6% is a significant “miss” that adversely impacts an $18 trillion economy during a year where the global collapse of oil and commodities has clearly temporarily depressed the overall CPI index?
So why is it that the Fed insists on the PCE deflator less food and energy to measure its inflation policy target. Is it technically or theoretically superior to the dozens of alternative measures available, including the internet based Billion Prices Project index, which is based on scrapping massive numbers of high-frequency transaction prices from the internet each day?
Not in the slightest. Bernanke and his disciples and successors embraced the PCE less food and energy deflator solely because at least in recent years it has been the shortest inflation measuring stick around. It’s about staying in the game, period.
These people are all about justifying a regime of financial market domination that is a complete historical anomaly and a wellspring of price falsification, malinvestment, rampant speculation and dangerous trolling for yield. And the smoking gun, in fact, is the data scrapped from the billions of actual transactions prices which course through cyberspace daily.
The chart below shows that consumer inflation has long been running above 2.0% in the real world of transactions. The light orange line plunged below the 2% marker only when global crude oil dropped from $100 per barrel to $40.
Folks, that’s not undershooting the target from below. That reflects, in fact, just the opposite.
Namely, that the world’s central banks have enabled so much cheap, uneconomic credit in recent years that massive excess energy and commodity investments have generated a condition of chronic over-supply, and therefore deflationary commodity price trends. So the temporary plunge in consumer prices is yesterday’s monetary policy errors at work, not a reason for central banks to keep interest rates lashed to the zero bound today.
Indeed, the rank intellectual dishonesty of the Fed’s “2 percenters” is even more dramatically demonstrated below. The level of the overall consumer inflation index, regardless of which one you choose, is a function of its components. That is, the overall index value is a weighted average statistical derivative.
Yet the two driving forces on the CPI since inflation targeting was officially adopted in 2012 have been medical care services and consumer energy products like gasoline and heating oil.
As it happened, during the 48 month period ending in April 2016, the medical services component rose by 2.9% per annum while energy has dropped by 7.7% per year. Neither of these component changes is driven by some Keynesian either called “aggregate demand” in the domestic economy, or anything else the central bank can remotely influence or manipulate.
Instead, energy prices are driven by long-cycle supply, demand and capacity balances and short-cycle inventory movements in the $80 trillion global GDP; and medical prices are driven by third party payer machinations in the nation’s $3 trillion bureaucracy-encrusted medical care delivery system.
Indeed, throw in the BLS’s phony OER component with these two items and you have 40% of the weight in the CPI and only slightly less in the PCE deflator. Given this, is it even remotely rational to believe that the deliberations and interventions of the FOMC have anything to do with the second decimal place outcome on the overall CPI of 1.19% annually during the last four years?
You might conclude that our monetary politburo consists of feckless and befuddled academics and apparatchiks who are tilting at inflation windmills, but you would be mainly wrong.
The truth is, these are power-hungry bureaucrats who have usurped their charter in a manner so brazen and excessive as to be fairly described as a coup d etat. There is absolutely nothing in the elastic and aspirational language of the Humphrey-Hawkins Act that requires this kind of fanatical pursuit of 2.00% inflation or a 4.99% U-3 rate, either.
And that gets us to the even more important point in Feldstein’s post regarding the real function of the Fed with respect to inflation. That is, its true inflation mandate is not about two decimal point undershooting from below on a monthly basis; it’s being vigilant about a break-out of inflation to the upside on a trend basis.
With a margin of error that large, it makes no sense to focus monetary policy on trying to hit a precise inflation target. The problem that consumers care about and that should be the subject of Fed policy is avoiding a return to the rapidly rising inflation that took measured inflation from less than 2% in 1965 to 5% in 1970 and to more than 12% in 1980.
Although we cannot know the true rate of inflation at any time, we can see if the measured inflation rate starts rising rapidly. If that happens, it would be a sign that true inflation is also rising because of excess demand in product and labor markets. That would be an indication that the Fed should be tightening monetary policy.
Here’s the thing. Feldstein has been at this game since the late 1960s and knows a thing or two about how economies work and what central banks can and cannot do with their primitive tools of money market pegging, yield curve management and wealth effects pumping and puts.
What they can’t do is micromanage the GDP or fine-tune the short-term rate of wage, price, production and job gains on domestic ledgers that are rooted in an integrated global economic and financial system. Attempting to do so, will only result in more price falsification in the financial markets and inflation of financial asset values. As Feldstein argued,
…….but interest rates remain excessively low and are still driving investors and lenders to take unsound risks to reach for yield, leading to a serious mispricing of assets. The S&P 500 price-earnings ratio is more than 50% above its historic average. Commercial real estate is priced as if low bond yields will last forever. Banks and other lenders are lending to lower quality borrowers and making loans with fewer conditions.
When interest rates return to normal there will be substantial losses to investors, lenders and borrowers. The adverse impact on the overall economy could be very serious.
That’s right, but “serious” is not the word for it.
What is coming down the pike is the Mother Of All Financial Meltdowns. And this time, it will be evident to the world as to who is responsible for the resulting carnage.
Reprinted with permission from David Stockman’s Contra Corner.