The Power of Ideas

It’s Official, Fed Banishes Inflation from the Vernacular

In his appearance before Congress yesterday, the Chairman of the Federal Reserve made clear that the only concern of the Central Bank at this point in time is the abysmal state of the economy.  Inflation, which over the last five years has been an annoyance requiring lip-service, has had its’ status further degraded.  It is officially irrelevant.

That is unfortunate. First, one of the reasons we are having economic problems to this degree is inflation.  Skyrocketing prices of fuel, energy, food and other items are forcing Americans to reallocate expenditures, lowering real growth.  Debt burdens have risen commensurately, and are reflected in skyrocketing default rates on mortgages and other consumer debt.  Of course, the Federal Reserve has essentially eliminated such “non-core” items from their policy deliberations.  This is laughable.  Next time you fill your gas tank, try telling your gas station attendant that he can only charge $1.99 per gallon because the Fed Chairman says the cost of a non-core item like gasoline does not count.

Furthermore, in speeches before Congress over the last few years, Mr. Bernanke has repeatedly hewn to model-based prognostications that slower growth would reduce price pressures.  These models have been wrong.  Reported GDP in 6 of the last 12 quarters has been under 2.5%; 8 have seen GDP under 3.1%.  During this same period, commodity prices have exploded. As measured by the CRB, commodity prices have risen at a 10% compounded rate over this period.  Using the overall CPI, prices have increased at a compounded rate of 3.5%.  (I do not know anyone who actually believes this is an accurate measure of personal cost increases).  The Fed has tried to assure us that current price increases are tolerable so long as inflation expectations remain “contained”.  When sentiment and reality are in conflict, following sentiment can be a dangerous game.  In any event, these forward indicators are also in the red-zone.

Perhaps most importantly, inflationary pressures are offsetting the impact of monetary easing.  Commodity prices have been exploding raising the cost of basic necessities.  The depreciating value of the dollar is likely to further hurt consumers by raising the cost of imported goods.

It is clear that the Central Bank has taken its eye off the ball and we are paying for this dearly.  Inflation is not the only effect we are feeling.  In large part, the disaster in the real estate and financial industries, including the sub-prime disaster, can be tied to overly-accommodative monetary policy.  This includes the process of normalizing rates employed by Mr. Greenspan.  (I refer to his approach as infinitesimal incrementalism).

What is perhaps most unfortunate is that the Fed has actually drifted from its mandate.  Section 2A of the Federal Reserve Act, as amended, provides that: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  There is no GDP target granted to the Fed by statute.  They are mandated to achieve “maximum employment”.  While there is obviously linkage, GDP growth and employment are not always coincident.  This has been clear in recent years, as the unemployment rate has stayed near multi-year lows even with sub-par GDP growth.  In the last year, this rate has drifted up only modestly to 5%.

This shift in emphasis, implemented by former Fed Chairman Greenspan, has given the Fed more flexibility to identify and react to growth risks and ignore inflation issues.  There are obviously periods when the markets, economists and consumers (politicians and voters too) have believed this to be the right approach.  (The relatively small number of market participants who have voiced opposition to this approach (generally referred to as “bond vigilantes”, a group in which I include myself) have generally been marginalized.)  We are paying the price.  The Fed was given independence and a prescribed mandate to stay above the fray.  They were given the rare privilege of focusing on longer term economic trends and trajectories.  This was embedded in the dual objectives maximal employment and stable prices.  Unfortunately, the Fed has allowed “mandate creep” to subvert these objectives.  Because of this we are facing an unstable economic environment with, being polite, sub-optimal policy prescriptions.  The sad thing is that there is no accountability.


February 28, 2008 - Posted by | Economics, Finance, General Interest, Markets, Politics


  1. no, the cpi is not accurate. it does not include energy, housing (just rent), or food!! its rigged.

    March 8, 2004

    Comment by Jesse | February 28, 2008

  2. Inflation is a problem, one that I for one thought would slink away as the economy slowed. It hasn’t. There are two questions that we need to ask ourselves, the first being is whether the Federal Reserve’s forceasts of inflation slowing with a slowing economy are right and owed an extra amount of time to come to fruition. I think a plausible reason to believe that this might be the case is the existence of a broader network of trade links, links that will take longer to transmit a U.S. slowdown to the rest of the world. I think the existence of intra-Asia trade, where peripheral countries provide inputs to China as component goods to that country’s final products is one example of this. Another is the large exportation of capital goods from Western Europe, notably Germany, being sold to China and the other large emerging economies. Once the emerging economies realize there is slack in demand for their output, their own demand for both capital and expendable inputs will decrease, which ought to slow the growth in prices globally. The question remains how long we give this theory.

    I think the second question that we need to ask ourselves before laying blame on the Fed is to how much of the current inflationary spurt can be attributable to the (admittedly horrendous) conduct of monetary policy in this country. The primary issue, as I see it, is the dramatic weakening of the dollar, in which almost all commodities, not just petrocommodities, are priced. Surely the Fed ought to be held accountable for some of the weakenss in the greenback, and not just because of monetary policy, but because of its failings as a banking regulator for the last decade. Anyone literate enough to open a newspaper is aware of this country’s reliance on foreign capital to finance the twin deficits. Allowing the banking system to run amuck, where lenders and borrowers ostensibly can point the blame at one another for the collapse in the housing market is not a way to assure foreign investors of the sanctity of their dollar based investments. The dollar therefore must weaken to draw new investors to finance the deficit. Surely the existence of these deficits and structural imbalances in the financing scheme of the global economy is not something strictly to be shouldered by the Fed. Rather, imbalances, and therefore inflation, is every bit as much the fault of the US Treasury, and the Bank of Japan and the People’s Bank of China, which have created a de facto dollar block and letting the Fed’s loose monetary policy germinate through an economic block which was growing ever faster than the U.S., to which the policy itself was ill-suited.

    The Fed is in a big pickle, though not one exclusively of its own making!

    Comment by Paul | March 2, 2008

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: