The Fed’s Focus on Low Inflation Is Destroying the Economy

John Mauldin |

The Federal Reserve prefers to use core PCE rather than core CPI. The Cleveland Fed has a very good basic explanation of the differences between the two indexes (quoting from their site):

What accounts for the difference between the two measures? Both indexes calculate the price level by pricing a basket of goods. If the price of the basket goes up, the price index goes up. But the baskets aren’t the same, and it turns out that the biggest differences between the CPI and PCE arise from the differences in their baskets.

The first difference is sometimes called the weight effect. In calculating an index number, which is a sort of average, some prices get a heavier weight than others. People spend more on some items than others, so they are a larger part of the basket and thus get more weight in the index. For example, spending is affected more if the price of gasoline rises than if the price of limes goes up. The two indexes have different estimates of the appropriate basket. The CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.

Another aspect of the baskets that leads to differences is referred to as coverage or scope. The CPI only covers out-of-pocket expenditures on goods and services purchased. It excludes other expenditures that are not paid for directly, for example, medical care paid for by employer-provided insurance, Medicare, and Medicaid. These are, however, included in the PCE.

Finally, the indexes differ in how they account for changes in the basket. This is referred to as the formula effect, because the indexes themselves are calculated using different formulae. The details can get quite complicated, but the gist of the matter is that the PCE tries to account for substitution between goods when one good gets more expensive. Thus, if the price of bread goes up, people buy less bread; and the PCE uses a new basket of goods that accounts for people buying less bread. The CPI uses the same basket as before (again, roughly—the details get complicated).

You can make the argument that the PCE is biased toward returning lower inflation numbers. But that tendency is almost beside the point.

Both measures are honest attempts to understand what inflation is and how it affects us. Neither index necessarily reflects the inflation that you are personally experiencing, or the inflation of your particular area or region. And similar differences pertain to every country in the world.

But in most countries, inflation affects the bottom 50% more than it does the top 50% by income. Because there are certain necessities of life that must be purchased, and because many of those goods and services (such as housing and health care) have higher-than-average inflation, the bottom half suffers a much higher inflation rate than the overall national average.

And yet, a national inflation policy geared to the lower 50% would aggressively skew monetary policy in a negative fashion.

Tell me again why 12 people sitting around a table should set interest rates based on data they don’t understand, in a market that is way too complex? More loans are based on LIBOR than anything else. And we trust a rather complicated market process, which can be somewhat manipulated, to set the price of LIBOR.

Manipulating interest rates in the broader market would be far more difficult and would lead to interest rates that are more reflective of what is going on in the marketplace. Just saying…

The Consequences of Disinflation Fixation

In theory, we want “price stability,” which means no inflation or deflation. When Greenspan was asked, when he was chairman of the Fed, what is meant by price stability, he answered “zero.”

None of this 2% inflation target. “Price stability” is the obsession of central bankers everywhere, and in some places it is their legal mandate. They currently like having just a little inflation but not too much.

The Fed wants 2% and can’t even deliver that, if you define inflation by CPI or PCE. People think that 2% is coming. Maybe so.

However, maybe we should all think about this issue differently. Last week, I ran an article by my good friend William White, former Bank for International Settlements chief economist and now with the OECD. Bill is my favorite central banker in the world.

White says central banks rightly responded to 1970s inflation by clamping down hard, but then failed to adjust when conditions changed. That oversight led directly to some of today’s problems.

From the late 1980s onward, low inflation was largely due to positive supply-side shocks— such as the Baby Boomer-fueled expansion of the labor force and the integration of many emerging countries into the global trading system. These forces boosted growth while lowering inflation. And monetary policy, far from restricting demand, was generally focused on preventing below-target inflation.

As we now know, that led to a period of easy monetary conditions, which, together with financial deregulation and technological developments, sowed the seeds of the 2007 financial crisis and the ensuing recession. The fundamental analytical error then—as it still is today—was a failure to distinguish between alternative sources of disinflation.

The end of the Great Moderation should have disabused policymakers of their belief that low inflation guarantees future economic stability. If anything, the opposite has been true. Having doubled down on their inflation targets, central banks have had to rely on an unprecedented array of untested policy instruments to achieve their goals.

The fixation on keeping inflation low, according to White, has driven up global debt ratios, squeezed lender margins, and forced lending activity into an opaque shadow banking sector. All these effects raise systemic risks that will probably bite us eventually.

Here’s Bill again, with a thought-provoking point I’ve formatted in bold.

These developments constitute a threat not just to financial stability, but also to the workings of the real economy. Moreover, one could argue that easy money itself has contributed to the unexpectedly strong disinflationary forces seen in recent years. Owing to easy financing and regulatory forbearance, aggregate supply has risen as “zombie” companies have proliferated. Meanwhile, aggregate demand has been restrained by the debt headwinds—yet another result of easy monetary conditions.

This insight isn’t intuitive to many economists. Easy credit—as the Fed gave us for the last decade— should raise inflation, not reduce it. Bill says no; it allows zombie companies to survive and overproduce, while putting consumers in so much debt that their spending gets constrained.

So, it pushes inflation down instead of up.

Blind Monetary Policy

Wrap your head around all of this. It answers some riddles that otherwise make little sense. But it also highlights the difficulty of formulating sane policy.

Yes, it’s important to let zombie companies die. Creative destruction and all that. But real people work for the zombies, earning real money that lets them buy goods and services and keep the economy moving. So what do you do? None of the choices are painless.

Too often, we simply redistribute the pain to those least able to bear it, who are understandably unhappy. Hence the present social and political tensions. They all trace back to economics.

Is data boring?

Yes. It’s often wrong and misleading, too. But ignoring it to fly by the seat of our pants isn’t the right response, either. We need much better understanding and application of all these numbers, and I see very few economists trying to deliver either. That’s the core problem.

Suffice it to say that using data that is fundamentally flawed as a “guide” to monetary policy creates the rather strange outcomes that we see. I get extraordinarily angry when central banks and big government proponents argue that it is capitalism and free markets, rather than manipulation and inappropriate regulation, that are the problem.

The monetary policymakers never see themselves as the problem. This blind spot reminds me of one of my favorite Paul Simon quotes: “A man hears what he wants to hear and disregards the rest.”

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