Saturday, October 11, 2014

The Fed’s 2% Inflation Target: The Ultimate Keynesian Con Job

By David Stockman

The old adage that if something is repeated often enough it is soon assumed to be true couldn’t be more apt with respect to the Fed’s 2% inflation target. Today Bloomberg has a piece that does exactly that, describing how“Federal Reserve officials are hunting for new tactics to raise price increases to their target”  because “inflation is descending toward the danger zone”.

In fact, the September meeting notes cited several officials who worried that “inflation might persist below” the committees target for “quite some time.” Accordingly, the Bloomberg author, Craig Torres, pulled out his editorial pen and offered his opinion as if it were objectively obvious:
The Fed needs a clear strategy for getting the inflation rate higher after falling short of its 2 percent target for 28 consecutive months.
Well, now. Twenty-eight straight months of misses. Let’s see, even using the Fed’s
systematically understated measure of inflation, the PCE deflator ex-food and energy, consumers’ savings and paychecks have lost 3.3% of their purchasing power during the last 28 months.

Apparently, had they instead suffered a 4.7% loss of purchasing power (2% inflation for 2.33 years) everything would be copasetic. Instead of remaining in a funk, as has been evident since it unexpectedly snowed last winter, they would have been spending up a storm. Presumably the US economy would have long ago hurtled through that pesky “escape velocity” barrier.

Isn’t it amazing that over the relatively brief period in question that shrinking the purchasing power of the dollar by 4.7%% versus 3.3% could make such a profound difference. Or maybe not.

But don’t expect the “journalists” at Bloomberg to even ask. Like their “competitors” at the WSJ and Reuters, they are about as mainstream, lazy and intellectually sloppy as they come. In this case, it is not likely that a writer who cites two ex-central bank true believers as his main source—-former Fed governor and macro-model peddler, Larry Meyer, and former Bank of England policy committee member and current Keynesian snake oil salesman, Adam Posner—-would trouble himself with proof that a 2% annual gain on the CPI is a proven economic elixir.

No, the 2% inflation mantra has been repeated so early and often by Fed speakers, their court economists and the Wall Street stock peddlers known as “strategists” that it appears to amount to the monetary equivalent of the Pythagorean theorem.  Even then, the literalist presentation of the matter in the attached story sets a new standard for credulity.

Supposedly, if inflation is a tad on the weak side, or even remotely veers off in the direction of the dreaded “deflation” zone, consumers will sit on their wallets waiting for prices to fall further. Soon you are sliding down the slippery slope into the maws of a deflationary malaise, and then Great Depression 2.0. So Bloomberg even found a consumer to illustrate this point.

It was a rather prosperously proportioned lady in an appliance store who would apparently be put out of a buying mood if prices were not increasing with sufficient vigor. And Bloomberg even included that proposition in the caption, lest any reader miss the point:

 Consumers anticipating falling prices may postpone discretionary purchases. This can combine to create a vicious circle of less spending and further downward pressure on prices.

So it must be true. Its right there in the (online) papers.

For the life of me, therefore, I can’t figure out how the Apple shoppers pictured below are still even functioning. Prices of their favorite i-Gadgets have been falling for years—but here they are lined up an Apple Store as far as the eye can see fixing to spend up a storm.

Ok, digital age products are different. I get that. Not only do their prices drop consistently, and sometimes even plunge precipitously, but they also give you huge increases in function and quality. So what’s involved, apparently, is some kind of consumer addiction to getting more bang for the buck in this allegedly idiosyncratic corner of the marketplace.

Unfortunately, that doesn’t explain the graph below which is distinctly not new age, but the BLS wholesale price index for all finished consumer goods less food. Year-in-and-year-out since Alan Greenspan’s arrival at the Fed in August 1987, it has risen at relatively consistent annual rate—- averaging 2.4% over the 27 year period as a whole. The occasional minor dips in the rate of increase have absolutely no correlation with consumer spending rates over the period.

The only serious dip is during 2008-2009 when the oil price plunged from $150 per barrel to less than $40, and took the whole index with it. But consumer spending skidded during that period due to the fact that jobs and incomes were plunging owing to the Great Recession—- not because oil prices were crashing from speculative peaks that were undone by the laws of supply and demand.

What is embodied in the above chart is actually the “stuff” sold at Wal-Mart outside of the food department—where presumably people need to eat whether prices are rising or falling.

As it happened, Wal-Mart’s slogan was not “everyday rising prices” but “everyday low prices”. During the 27 years pictured above, it is absolutely certain that Wal-Mart’s average prices did not grow anything close to the 2.4% CAGR embedded in the BLS index. Yet its domestic sales nevertheless soared by orders of magnitude more than the growth of consumer spending during the same period.

walmart ap

In fact, nominal PCE grew at an annual rate of 5% during the period or by only two-fifths of Wal-Mart’s 12+% CAGR. That is, as a result of scouring the earth for the lowest prices available, its market share of the American consumer’s wallet rose dramatically. Low and often falling prices did not drive consumers away; it attracted them in droves.

The Wal-Mart saga alone knocks the 2% inflation story into a cocked hat. The latter is a complete myth made of whole cloth.

Indeed, the very idea that the hard-pressed main street consumers of America—-most of whom have virtually no discretionary income to spend after the basics anyway— will go on a buyer’s strike if they don’t get enough inflation is just plain ludicrous.

That Keynesian central bankers peddle this nostrum with a straight face is amazing in itself, but it is at least understandable because it gives them a reason to keep the printing presses humming. That journalists like Mr. Torres at Bloomberg repeat it with no questions asked is even more remarkable. It proves that the impending replacement of financial journalists with robo-writers may not be so bad after all. It won’t make any real difference.

By Craig Torres at Bloomberg News
Federal Reserve officials are hunting for new tactics to raise price increases to their target as slowing global growth, cheaper commodities and flat wages sound warnings that inflation is descending toward the danger zone.
The Fed needs a clear strategy for getting the inflation rate higher after falling short of its 2 percent target for 28 consecutive months.
Now, as longer-run inflation expectations erode in financial markets, the Federal Open Market Committee is shifting its focus toward prices after putting its main emphasis on jobs for months. Several officials worried that “inflation might persist below” the committee’s target for “quite some time,” minutes from the Sept. 16-17 meeting said.
Too-low inflation “is getting to be a real issue again,” said former Fed GovernorLaurence Meyer. With inflation at 1.5 percent according to the Fed’s preferred index, Meyer said FOMC policy makers aren’t likely to raise interest rates, even if the economy approaches full employment, defined as a jobless rate of 5.2 percent to 5.5 percent. Unemployment was 5.9 percent last month.
“The timing of the first rate hike is all about inflation,” said Meyer, now a senior managing director at Macroeconomic Advisers LLC in Washington.

Photographer: Ty Wright/BloombergConsumers anticipating falling prices may postpone discretionary purchases. This can combine to create a vicious circle of less spending and further downward pressure on prices.
Policy makers including regional Fed Presidents William Dudley of New York, Charles Evans of Chicago and Narayana Kocherlakota of Minneapolis have in recent days all mentioned below-target inflation as a risk that weighs against raising interest rates too soon.

Vicious Circle

An inflation rate approaching zero is bad for the economy because of its impact on behavior by businesses and consumers. Companies’ inability to raise prices hurts profits, and they rarely compensate by cutting wages, so they fire workers instead. Consumers anticipating falling prices may postpone discretionary purchases. This can combine to create a vicious circle of less spending and further downward pressure on prices.
Prices fell 1.2 percent for the 12 months ending in July 2009, when the economy had just exited the recession, according to the inflation measure the Fed uses, the personal consumption expenditures price index. Unemployment that month was 9.5 percent. Since Fed officials first published their inflation target in January 2012, the index has averaged 1.5 percent.
“It is a reflection of a lousy recovery,” said Adam Posen, a former member of the Bank of England’s Monetary Policy Committee who now leads the Peterson Institute for International Economics in Washington.
Former Federal Reserve Governor Laurence Meyer said too-low inflation is getting to be a real issue again. Close
Former Federal Reserve Governor Laurence Meyer said too-low inflation is getting to be a real issue again.
“As we are seeing in the euro area, and as we saw in Japan, if you let it go on for too long it becomes a lock-in, it reinforces a bad outcome,” he said.

Lost Decade

Japan’s lost decade of the 1990s came after the Bank of Japan raised interest rates in 1989. That was followed by the collapse of a real-estate bubble and falling consumer prices.
Fed officials now have two problems, and both are growing in urgency.
First, events in global markets and economies exert further downward pressure on U.S. prices. West Texas Intermediate oil is down more than 20 percent from this year’s June peak; wages were flat in September, according to Labor Department figures, and the Fed’s trade-weighted dollar index is up 4.5 percent year-to-date.
A stronger dollar makes it cheaper for Americans to pay for imported goods. A 10 percent increase in the dollar versus currencies of major trading partners could trim inflation by a quarter percentage point, said Michael Hanson, U.S. senior economist at Bank of America Merrill Lynch in New York.
A second problem is that Fed policy makers have failed to communicate a plan to hit their inflation target, said Diane Swonk, chief economist at Mesirow Financial Holdings Inc. in Chicago.

Policy Goals

The 2 percent inflation objective first appeared in a January 2012 statement on longer-run policy goals, and has been restated each January since. The statements say nothing about tactics for returning inflation to 2 percent over the medium term.
What’s more, since January 2012, every one of Fed officials’ central tendency forecasts, which toss out the three highest and three lowest estimates, has projected the top end of the range for inflation for the two years ahead at 2 percent or less.
Swonk said the forecasts are suggesting to market participants that 2 percent is an inflation ceiling, even though Janet Yellen, as vice chair in 2012, said the target “must be treated as a central tendency around which inflation fluctuates.”
Yellen’s “message isn’t getting through,” Swonk said. “They have stated it frequently, but it is not in their forecasts.”

Market Expectations

Market measures of inflation expectations have deteriorated since the Fed’s Sept. 16-17 meeting, when policy makers signaled their intent to raise rates at a slightly faster pace in 2015.
Inflation starting five years from now is expected to average 2.14 percent a year on the consumer price index, down from the 2.38 percent projected just before the September meeting, according to yield differences on Treasury Inflation Protected Securities and nominal Treasuries.
“If the evidence continues to look the way it looks now, you will see stronger language and stronger steps” from the FOMC, said Jon Faust, director of the Center for Financial Economics at Johns Hopkins University in Baltimore, who served as a special adviser to the Fed board earlier this year.

More Commentary

“I don’t think the committee to a person is happy with inflation of 1.5 percent,” Hanson said. “We will get a little more commentary from Fed officials that says, ‘We need to see more signs of inflation going back up’” before raising interest rates.
As Fed officials prepared their policy goals statement in January, some wanted an explicit signal that inflation remaining “persistently below” the target was as undesirable as remaining above it, according to meeting minutes. After becoming Fed chair this year, Yellen appointed a subcommittee to study Fed communications. Fed spokesman Doug Tillett said he was “not in a position to confirm what the subcommittee is or is not working on.”

Symmetric Goal

Both Evans and Kocherlakota said the Fed needs to reaffirm that the 2 percent goal is symmetric, that is, the Fed will take action to keep inflation from going too far below the target as well as too far above it.
“Although the FOMC has a 2 percent inflation objective over the long run, it has not specified any time frame for achieving that objective,” Kocherlakota said in an Oct. 7 speech in Rapid City, South Dakota.
One concrete step the FOMC could take would be to announce a two-year deadline for returning inflation to the goal, he said.
Evans told reporters Oct. 8 that the committee needs to constantly assert that the target is symmetric, and policy makers shouldn’t worry about overshooting 2 percent slightly.
“When we try to thread the needle and try to bring it in just at 2 percent, and not overshoot, that means that there’s some risk that we’re not actually going to get there,” Evans told reporters in Plymouth, Wisconsin. “If we were to allow inflation to stay at 1.5 percent for an extended period of time when our target is 2 percent — that would be a remarkably negative hit to our credibility.”

David Stockman was the Director of the Office of Management and Budget during part of the Reagan Administration, from 1981 to 1985. He is the author of The Great Deformation: The Corruption of Capitaism in America and The Triumph of Politics: Why the Reagan Revolution Failed.

 The above originally appeared at David Stockman's Contra Corner and is reprinted with permission. 

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