Taxes – Divide, Confuse and Conquer

Better than reruns of Two and a Half Men are the nightly television news reports of our government’s dealing with deficits and debt.  As you know, the government deficit is defined as the difference between government revenues and government spending. The Federal government deficit according to the CBO was $1.29 trillion in 2010 and will be $1.48 trillion this year.  According to the CBO’s baseline estimates it will bottom at $610 billion in 2018 and then start rising again. As a result of all these deficits the privately held debt of the nation will rise from 62% of GDP in 2010 to about 76% by 2019. Our government, therefore,  is presently discussing plans for reducing the deficit for this year, plans for next year, and, of course, what to do about these deficits through at least 2019.

I wrote several postings in the last months about government spending but have shied away from taxation. Why? I am not sure. It might be because I just paid my annual tax payment and I feel poor. Or it might be because I am just like Albert Einstein who once said, “The hardest thing in the world to understand is the income tax.” Or Ben Franklin who said, “In this world, nothing can be said to be certain except death and taxes.” And finally Mark Train said, “I shall never use profanity except in discussing housing rent and taxes.”  Damn, why get into something that Einstein can’t understand and that reminds you of death?

Anyway, it was either this or going shopping with Betty. This one post does little to solve the issue of using tax revenues to resolve the current and future government budgeting mess. But what I have tried to do is get my arms around Roseanne Barr, err I mean get my arms around some of the many issues that make the tax debate so complicated. You see, complication is the power tool of government.  The more complicated the topic is and the more they can discuss all its ramifications, the more they can dither and do nothing about it. 

You will see below a list of many tried and true (old) aspects that relate to taxation. Hopefully you will come away from this list with a realization of how these folks in Washington are trying to evade real decisions. This list is a minefield of special interest bombs that are sure to keep the enemy from the real fighting. If debts and deficits are the number one issue it is hard to imagine (forecast) progress. It is time to demote some of these issues – at least for a while – so we can work on our biggest worry – how to reduce debt and deficits before our economy implodes. I argue below that much of the work should be devoted to the spending side while admitting that longer-term issues probably cannot totally avoid some revenue increases. 

Taxes are part of the calculation of the government budget balance, where balance equals government taxes (T) minus government spending (G)

Balance = T – G.

If G is greater than T, Balance is negative or what we call a deficit. The 2010 budget deficit was as follows:

      -$1.294 trillion = $2.162 - $3.456

A higher T with G held constant, would create a smaller government deficit. So increasing T makes mathematical sense as one discusses policies. Of course, reducing G also makes sense. But this post is about T so let’s work on that.

Federal tax revenues equaled $2.162 trillion in 2010. In 2007 T had reached a high of $2.568 but then the recession came and tax revenues fell to a low of $2.105 trillion in 2009 before starting to climb again in 2010. It may take until 2012 before tax revenues recover again and get back to their value in 2007. The baseline CBO estimate for 2013 has T at about $3.1 trillion. Baseline estimates do not incorporate any changes from the 2010 revenue laws. So T is expected to recover quite a bit even without any policy changes in 2011 or beyond. From where they were in 2010, without any change in policy they will increase by about a trillion dollars or by almost 50% in three years.

Federal tax revenues come from several sources. In 2010 the breakdown for the full $2.162 billion Federal T was as follows below. Notice that what we call our Social Security Taxes are almost as large as all individual income taxes.

                           Individual Income Taxes                $ 899 billion

                           Corporate Income taxes                    191

                           Social Insurance Taxes                      819

                           Other Revenues                                 207

When discussing a nation’s tax revenue it is incomplete to leave out the state and local governments.  In 2010, State and Local government units collected taxes of approximately $1.425 trillion making national T equal to $3.588 trillion. State and Local T was about the same in 2010 as it was in 2007 – meaning that the recession had a less proportional impact on state and local revenues. State and Local governments get their revenues from sales taxes, property taxes, individual and corporate income taxes, and various licenses and fees. Total government revenue was about 25% of GDP in 2010. It averaged 28% from 1990 to 2007.

It is important to note that tax revenues can change without any change in policy. That is, both tax revenues and government spending are automatically impacted by changes in the economy. Congress could be on vacation in a Holiday Inn Express in Illinois – a state proven to be a very popular place for state legislators – and the deficit could change in leaps and bounds simply because evil super villains caused the economy to contract and that automatically reduces tax revenues and increases government spending. Of course if super heroes in tight pants somehow cause the economy to grow rapidly, the tax revenues would gush and spending would dip – leading to an automatic surplus. We use the following fancy words to describe these automatic changes as cyclical.

Change in deficit = cyclical (automatic) change in deficit + cyclically adjusted (policy) change in deficit

The policy induced changes in taxes or spending are referred to as “cyclically-adjusted.” So when you read that the cyclically adjusted deficit got bigger, you know it was because the government enacted laws to change taxes or spending.  For example in 2010, removing the dip in the economy tax revenues (without automatic stabilizers) would have been $2.454 trillion. That compares to the $2.162 of actual T – implying that the negative state of the economy automatically decreased T by $292 billion dollars. As the economy recovers, that amount of taxation should return automatically without any policy.

Taxes can be defined as the rate of taxation multiplied by the tax base.  In a definitional sense, we raise taxes either by raising the tax rate and/or the tax base. It sounds easy to raise taxes by increasing the tax rate. It sounds like a bunch of fun if you raise the tax on other people like the neighbor who doesn’t trim his trees properly and lets his leaves fall on your lawn when you would be rather drinking mint juleps than raking leaves. The challenge is that the tax base does not stay constant as you are raising the tax rate.

Tax rates have a behavioral aspect. If you raise tax rates as a means to increase tax revenue, it is believed that the higher rates could create disincentives to produce within the taxing district. As a result a rise in the tax rate could reduce the tax base. If the latter is large enough we could get the self-defeating result that a rise in tax rates causes tax revenues to decline. Or looked at in reverse, a reduction in the tax rate that increases the tax base enough might cause tax revenues to rise. As a result of this discussion (assuming you are still awake) much of the debate about how to raise tax revenue involves beliefs or estimates of the behavioral impacts of changes in tax rates. How much does a change in tax rate impact the tax base? This is highly complicated and therefore controversial. We can argue about this until the cows come home (where did the cows go? Vegas? Asolo?).

Tax revenues are part of the process of paying for government spending.  While we might have different opinions about how large the government should be or how much it should spend, most of us agree that local, state, and federal governments have legitimate and constitutional bases for spending. The real question involves how much is enough. Federal government spending averaged approximately 20% of GDP from 1990 to 2007. It was about 24% of GDP in 2010. If taxes are levied to pay for government, then tax revenues should be the same percent of the economy.  So part of the solution for T is that we decide about G. As you know, this is not an easy one either.

Part of the spending story relates to the longer-term adequacy of taxes to meet the needs of an aging population. This focuses our attention on Medicare, Medicaid, and Social Security. Some politicians pretend that we can somehow separate these programs from the rest with little lock boxes with Al Gore’s picture on them. Others stand with arms crossed on their heaving chests and tell us we cannot jeopardize the future of our senior citizens.  It looks more like opera than government! The only thing that matters for the short-term or the long-term is the amount of tax revenues to collect relative to the government spending. 

Some people believe that tax increases will never reduce government deficits. They believe that an increase in taxes simply makes it more possible for governments to spend more. While an increase in tax revenues reduces government deficits by definition, another behavioral implication is that this increase in T gives government higher incentive to spend more.” Bertha, you just spent your whole month’s allowance in the first week.”” Dad, please give me a loan of next month’s allowance.”  “Of course, honey, because I love you more than Mom.” Right!

Taxes are also used for income redistribution. Most countries use higher tax rates on the rich to help lower income persons, who have lower or zero tax rates; or who receive transfer payment from the government.  Each time a government decides to raise taxes there is an inevitable debate about how much of the tax increase ought to be levied against the rich, the middle class, and the poor.

One report from the Tax Foundation http://www.taxfoundation.org/blog/show/27134.html  that used one set of data to show that the US actually has a very progressive tax system – meaning that when we compare ourselves to other nations, our rich pay the largest share of taxes absolutely and relative to income. In other words, the top 10% of the income earners in the USA pay a higher share of Federal government taxes than the comparable set of rich folks in Sweden, Finland, Canada, Australia, Germany and many more. This report shows one side of the argument. Others question specifics of such a report. Still others might acknowledge its truth and still lament that something must be done to stop an apparent movement of income and wealth from the poorest to the richest citizens.

Jeffrey Sachs  http://www.ft.com/cms/s/0/8836f284-592a-11e0-b9f6-00144feab49a.html   decries cuts to austerity programs that hurt low income families and tax cuts that largely benefits the rich. While he acknowledges that some attention needs to be paid to the spending side, he emphasizes that taxes need to be raised – especially on the rich. Recent news about GE’s tax situation in 2010 just added fuel to that fire.

Taxes are used to promote other economic ends….this is where the word loophole comes in. A loophole is a tax regulation that allows someone to avoid a tax that others pay. If a company locates a new factory in your town they may not have to pay local taxes for several years. If you pay interest on the mortgage on your primary residence you are allowed to reduce your tax payment by writing off your mortgage interest against your taxable income. When you receive a tax loophole you plainly see the incentive effect it creates – the positive impact it has on you and the economy. When others receive a loophole and you don’t, you often see it as a drain on the government’s taxes and a waste of taxpayer money. So loopholes are very controversial. 

The government could raise a lot more revenue if it closed all loopholes. But such a closing would have negative impacts on policies to attract new companies, would make housing more expensive, and more.  Accordingly any tax changes that close loopholes will set off a chorus of howling guaranteed to stall progress

Taxes are used for short-term stimulus or stabilization. Whether it was an extension of the Bush tax cuts or Obama-inspired tax changes, it is clear that much was done to offset a recession. One would think that it is not controversial to remove these tax changes once the recovery set in. But the questions continue. Will removing tax cuts some two years after the beginning of the recovery risk damage to a fragile economy? I doubt it but many leaders are wringing their hands (that must hurt) daily (in in front of numerous cameras) to show their support and kinship with working people.

My take from all this is that taxes are abnormally low right now because of a combination of cyclical effects from the recession as well as legislated changes in policy as part of a short-term stimulus package. As the economy improves, tax revenues will increase automatically. As we move into a more stable expansion period legislation can remove tax changes designed for short-run stimulation. Thus, one can “vote for” higher tax revenues simply based on these two elements which shouldn’t be highly controversial. Second, taxes are low compared to extrapolations of government spending in the near-term and long-run. This is where it gets sticky. 

But this is where one needs to create some priorities about government spending. To me the main issue now is the financial health of the country. Because that is my first concern, I think the main focus ought to be on a believable plan to attack future deficits. To do that means most of the focus has to be on the spending side. Raising taxes for this purpose is not going to be very effective since spending always seems to adjust to revenues.  But it might entail some tax increases.  It will be easy to scream about every impact on distribution of income, on legitimate uses of government spending, on the old versus the young, etc. But if we let all those issues distract us from the central one – then we very seriously risk being the generation of people who let government turn us into a second class nation.

The Fed meets a Fork on the Road to Oz. But is it an illusion?

These days the Fed sounds discombobulated. One Fed official says that we have to start thinking about withdrawing monetary stimulus and the next day another Fed official worries publicly that the economy is still too weak to contemplate raising interest rates above 0.25%. Bernanke always claimed that he would know when to withdraw the stimulus – and he would! Darn right! Like Bernanke I always know when to have my last JD of the evening but on occasion I sometimes have another one or two more as a night cap. It would be rude to not offer a night cap to good friends. Bernanke may have the same problem and the recent lack of unanimity of Fed officials underscores the real problem he has. In this post I try to do two things. First, explain why he will continue to have a challenge with the night cap thing and second, why there are good ways around this dilemma that involve mostly fiscal policy. But excuse me for a moment, as I can’t seem to find my JD.

That’s better. Now where was I? Night caps and Fed policy. Expansionary policy and government entitlements have a lot in common. Once you let the cat out of the bag it wants to stay out of the bag. You give a borrower a low interest rates and he will sacrifice two goats and a short child (this is Indiana the home of John Wooden) to keep those rates low. How unfair to raise interest rates just when the average family decides it wants to expand its family room to house its Best Buy nineteen surround sound speakers and 70 inch 3-D Samsung TV set. Imagine all the companies basing their expansion plans on a low cost of capital who might be forced to defer these investments because the Fed raised rates to 1%! Do you think for a second that once the Fed leaks more than a faint rumor of monetary tightening that Bernanke won’t hear a deafening moan and cry of why it is still TOO SOON to reverse monetary thrust?

Larry Dear – it is 11 pm and it is time for us to go home. But Honey Dear – there is still some onion dip residue on the corner of the coffee table and the host says we should stay and talk more about the pros and cons of using Coyote piss to control deer feeding in our backyard. It would be impolite to leave while some of the lights are still on. You might think I am crazy but this is what you are already hearing. The recession was over 7 quarters ago. 7 Quarters? If I remember my math correctly that is almost two years ago that we started the recovery. Consumer spending grew by more than 4% in the fourth quarter of 2010. And yet, the Fed is following through with another $600 billion in monetary stimulus. Geez, I’d hate to see Bernanke with a bottle of JD. Charles Evans, President of the Federal Reserve Bank of Chicago said on March 28, 2011

“Despite recent improvements to the outlook, we are not yet at that point” when “a change in the stance of monetary policy will be necessary,” Evans said today in the text of a speech in Columbia, South Carolina. “Slow progress” in lowering unemployment “and underlying inflation trends that are too low lead me to conclude that substantial policy accommodation continues to be appropriate.”

Geez Chuck, please tell me when it is time to shut the lights out. One analyst says that unemployment will not reach former lows until 2019. Are you going to wait until then? Everyone sees shoots of inflation popping up here and there. Are you going to wait until it is spreading like a wildfire to get out your hose? Please tell us if you can – how high does inflation have to be before you think it needs your attention? For how many months must it ravage us before you deem it a national problem? If inflation does start rising while the unemployment rate is still 9% or higher, then my buckaroo, what are you going to do then?

And this brings us to the fork in the road and my second point. It is well-known and pretty much correct that when the unemployment rate is high and the inflation rate begins to rise, this creates a VERY DIFFICULT TRADEOFF for the Fed. Remember that the Fed has one tool and this tool can only be applied to AD in one way at a point in time. If unemployment is the main problem today then it uses monetary policy to expand demand output, and employment – knowing that the negative consequence might be higher inflation. Instead, if inflation is public enemy #1 on another day the Fed will use its policy to reduce AD with resulting lower inflation – knowing that the negative consequence of slower growth might be higher unemployment.

So this is what we mean by the fork in the road. The Fed is at or very close to this fork when unemployment is still above 9% and the inflation rate is starting to rise. Toto (a dog) wants Dorothy to take the right fork and the Scarecrow (no brain) prefers the left direction. Dorothy has been traveling a long time and would just like to get to Oz where she can take off those tight shoes and have a very cold, shaken not stirred very dry Bombay Sapphire martini.

It turns out (and I am taking substantial liberties in this paragraph that could land me in real trouble with little people) that either one of those two paths is riddled with munchkins or evil witches or Joe Biden. Either path will get you to Oz but either path also has its negatives. But there is another path – a less popular one advocated by Macroman (no heart) that offers a clear and safe path to Oz. This path has no tradeoffs. This path decreases BOTH inflation and unemployment. The Scarecrow shouts that this is impossible. Toto pees on the Scarecrow’s stalky toes in concurrence. We pan our cameras to a scene with many dancers and singers – the refrain something like “we’re off to see the Wizard, and the Phillips Curve says there must be a tradeoff….” Or something like that.

But Macroman glides in on a broom and explains the glories of a shifting Phillips Curve – or more simply some brief words about why it is possible to reduce both inflation and unemployment. The Fed is in a fix. They say that they will refrain away from monetary expansion but they have already backed themselves into a no-win corner that offers very negative consequences in the short-run – either too much inflation or too much unemployment.

There is no better time to think about policies designed to reduce both inflation and unemployment together. These policies go to the heart of the business equation which says that reducing business costs and raising business productivity allows for simultaneously higher output, higher employment and lower inflation. Wow – is that really possible? It seems crazy because our policy makers are so stuck on the single horse we call AD that they cannot easily see or easily explain other policy alternatives. It may also reflect the fact that many of our legislators never took a course in microeconomics. Do you need a course in micro to graduate from law school? Sorry, all this Oz stuff (ie JD) is making me a little crazy.

By the way, these kinds of policies aimed at business costs and productivity are not novel or new. Virtually every transforming nation that moved from a centrally planned production system to a market driven economy legislated and implemented a host of policies aimed at strengthening business competitiveness. I won’t go through a list of things the US could do – at least not in this posting – but it takes very little imagination to understand these things. (1) Permanent increases in employment and prices come from firms. (2) Some government regulations and taxes may unnecessarily impose costs on business, and (3) constrain attempts to be more productive. I will let the politicians decide which of these things could be quickly evaluated and legislated.

My message is simple. Monetary policy officials are already too late to do what is necessary. They are still at the punch bowl. Monetary policy presently offers only bad choices with well known negative tradeoffs and consequences. There are other policies designed especially for these kinds of times and the Fed has no control over them. It would be better if the spotlight shifted from the Fed back to our government. The tools are there and they need to use them.

The Fed Fails to Understand Supply and Demand

Several Fed leaders keep expressing concern about letting go of QE2 and monetary stimulus too soon. One worried that the economy was too fragile to stand an end to QE2. Another said specifically that rising interest rates would put us in a double-dip recession.

Let’s understand a few things. First, banks are sitting on tons of money and not lending it out. Mostly they are buying government bonds. Reversing QE2 means taking that money out of the system that is doing nothing but sitting there. It is like taking away half of your kid’s score of candy on Halloween night. The kid is not going to eat three large grocery sacks of candy. Taking it away does nothing. Second, would an increase in the Fed funds rate from basically zero to 1 or 2 percent really cause tsunami-like ripples in the financial system? Please. You guys gotta be kidding me.  Third, what is this talk about a fragile economy? Check it out. We are growing at 3+% and the recession was over almost two years ago. If the recovery was a golden retriever, the new born puppy would weigh 80 pounds in 2 years. Sure, the economy is not growing fast enough. Sure the economy has some soft spots. But please – 0% interest rates for another year!  Admit it, you are hooked on stimulus and you just can’t get off.

But a bigger point is that these leaders simply are confused and have not learned their lessons of supply and demand. I apologize if I have to use highly technical terms like supply and demand, but I will try to make this as painless as possible. (Go drink two ounces of your favorite alcoholic beverage to prepare for this.)  Now you are ready. 


Here is the key point. It is true that if the Fed made a clear signal that they were going to raise interest rates in the future, some long-term rates might begin to rise by 100 basis points or more. It is also true that higher interest rates might increase the cost of borrowing and might induce some households and business to NOT borrow. If businesses and households do not borrow then they don’t spend and this threatens spending and output and employment. Okay – I get all that. But the truth is that borrowing and spending is not very high anyway. Why? Because both borrowers and lenders are worried about the future. As I said above, banks are sitting on tons of cash and they are NOT LENDING IT because they are worried they won’t be repaid. They are worried it won’t be repaid because these goofy Fed (and Treasury) people keep telling them how weak the economy is.

The problem is what we sometimes called a supply-constrained disequilibrium in the credit market. We don’t have a demand (for loans) problem – we have a supply problem since bankers don’t want to lend out the money. Imagine that Fed and Treasury folks started emphasizing the glass half-full -- i.e.focusing on all the good or positive parts of the economy and the bankers and borrowers became more optimistic about the future. With stronger confidence a credit supply response might be faster and more elastic than a demand increase. In terms of basic supply and demand what you have is a situation in which a renewed confidence causes supply to increase more than the demand – and a fall in the price of credit. If demand increases but supply increases even more – then prices fall! Here is the interpretation in a nutshell in terms of banking and loans:

o   The Fed stops QE because the economy has shown strength

o   Bankers decide to make more loans

o   Spenders borrow more money

o   Interest rates on business and consumer loans fall though in time will begin to rise back to normal historical averages

o   Higher spending leads to more output and employment

But the Fed is afraid to do this right now. They focus on the negative and they spread hand-wringing concern about weakness in the economy. It is no wonder a tightening of money would scare people and lead to a bad result. Your little kid is afraid to learn to swim. Why? Every time he gets near the pool his parents hover and make sure he knows how dangerous it is. The kid won't get near the water..  Some Fed officials need a good dunking in the pool. Only then will the pool party begin. 

The Fed, food, fuel, and foolishness

     True or False? Ben Bernanke called up my local grocer and asked that he reduce the price of T-Bone Steaks.

     True or False? Ben Bernanke doesn’t understand inflation?

I am writing this post because of what I think is a lot of confusion about prices, inflation, and monetary policy.  The most likely answer to the above two questions is false.Bernanke does not call my grocer and he does know something about inflation though he may not be explain what he knows very well.

Some background on this topic can be found at my earlier post on January 26^th at  http://larrydavidsonspoutsoff.blogspot.com/search/label/Inflation%20or%20Deflation

Price change is REALLY bothering a lot of us now. I am especially offended when Big Red Liquors raises the price of Jack Daniels. But we all know that I can save money by switching to Old Rotgut with little change in outcome. We all also know that a lot of people are being seriously negatively impacted when they buy tomatoes, corn, gas, and a lot of other things. So price change is a very serious matter.

The confusion comes (1) when we call this price change inflation and (2) when we start wondering why the Fed doesn’t do something about it. So let’s work on the first point first – what does price change have to do with inflation?

Inflation has more than one definition. For example, we can inflate an inner tube or a penile pump. In these cases inflation has a very general and vivid meaning.  More seriously, inflation can also be a measure of how much prices are impacting a nation at a given point in time. We measure this definition of inflation as the percentage change in an index of prices. An index of prices is a simple mathematical tool that averages together the prices of many items. When we talk about the Consumer Price Index we are speaking about a number that averages together the prices of all the things a typical urban consumer buys. Wow – that’s a load. One thing to know about the CPI and any price index (for example we also have a Producer Price Index) is that since it is an average of all these prices it is possible that one price might go up 1000% one month yet the overall index might not budge. That is, despite increases in the prices of corn or tomatoes, if the price of Blackberries (and I don’t mean the fruit) goes down, the average of all prices might not change at all.

So it is possible that you are getting whacked by rising prices in the grocery store or at the gas pump yet the published CPI figures are saying there is no change in the national price level or inflation. A reading of no change tells you a couple of things. First, the average urban consumer is paying about the same as they were before for all items. Second – IF YOU ARE NOT THE AVERAGE URBAN CONSUMER then this publication of the CPI tells you almost nothing. Yup, that’s right – it tells you zip. If you don’t have a car and you gag on fruits and vegetables while you sit at your computer playing Resident Evil-4 until 4 am, then it might be that you are spending a lot less today on the items whose prices are rising the most. Of course, if you are just the opposite – a fruit-eating  vege-loving media-phobe then your  cost of living is rising dramatically.

Okay – so you might be spending more on some things and less on others and you didn’t realize it all averages out. Or you might, because you are different from the average consumer, be paying a lot more (or a lot less) than what the CPI is telling you. Either way, FROM A PERSONAL STANPOINT the CPI can be a very misleading index of the impact of prices on you and your family. So the CPI might have risen by 4% last month and Larry’s CPI might have been 0% or 20%.  It depends very much on what Larry has been buying. 

That brings us to our second major point – what can the Fed can do about inflation when it is rising too fast. The first thing to note is that the Fed does not call up grocers or gas station clerks – that is not written in its charter. The FED has no magical or direct connection to the prices of individual items. So if gas prices are too high – this is not anything the Fed is empowered to directly work on. So let’s start with the idea that the Fed cannot help you with your own inflation problem.

So what can the Fed do? Basically it can do what it always does – use its control over money to influence the growth of aggregate demand (AD) and expectations about the growth of future AD.  If people believe that AD is growing too fast, then they will translate this into a higher expected future inflation rate. The Fed can try to restrain these expectations by tightening the growth of the money supply.  Notice that this more or less impacts prices of all goods and services more or less proportionately. So if YOU ARE PRIMARILY CONCERNED WITH FOOD OR ENERGY PRICES, then Fed policy is not a very powerful way to focus on your main concerns.  It is like having only one kind of pill in your medicine chest. Clearly it might be better to have separate pills for such maladies as common cold, allergy, upset stomach, and a weak stream.

The Fed is doing its job when it DOES NOT aim at prices of particular goods and instead is working on a nation’s overall inflation problem. Inflation in this sense is best defined as a PERSISTENT and SIMULTANEOUS increase in most of the items that comprise the price index. Persistent means that the Fed believes the price changes will last a while – long enough for its broad tools to impact the nation’s AD. Simultaneous means that the inflation problem is widespread enough in terms of various goods and services that impacting it through the nation’s AD makes some sense.  AD is not a good tool to focus on men’s blue walking shorts or dill pickles – but it is designed to have success on the whole basket of goods purchased by consumers.

That is why the Fed focuses its policy analysis on a measurement called core or median inflation – these are measures that largely omit or ignore short-term changes in highly volatile food and energy prices so the Fed can focus on the persistent changes in most of the items. The FED knows when food and energy prices are rising and they know this hurts people. But the Fed avoids this information much like Odysseus tried to gaze away from the Seirenes.  Will it sounds seductive to be all things to all people, focusing too strongly on the wrong targets can only lead to eventual failure.

Today it seems that much of the inflation that is distressing us so much is not the result of too much current aggregate demand in the US but it more the result of food and energy prices rising. While we might wish that the Fed would lean against this storm of price increases, it might not be something we really want. To have much of an impact on food and energy prices the Fed’s restraint would also bring with it declines in prices of many items which have not been rising rapidly. This might hurt many producers who have not yet fully recovered from the last recession.

So what can you do? Probably what you usually do when a difficult set of circumstances largely out of your control challenges you and your family. You do a little thinking (for most of you that means arguing) and see how you can minimize the damages. Look down and notice that you have feet! Maybe you can walk more. I know someone who drives to the grocery store at least once a day. That someone could take fewer trips to the grocery store. That someone will probably not be very nice to me after she reads this. You can take vacations closer to home and you can eat less popular fruits and vegetables. Let’s face it, we have a lot of control over what we buy and it might be fun eating Brussels sprouts and turnips as we skate to work and skip to our favorite lunchtime cantinas with $5-off coupons. Okay so maybe that’s not so much fun – but at least we know that most bouts of rising food and energy prices don’t last a long time. 

The real inflation threat to us, however, is if the Fed keeps fighting a recession that is long-gone and ends up increasing AD too high for too long and we get the real thing – rising inflation and rising inflationary expectations. That unfortunately will last a while and won’t be so easy to avoid. A future post will look into that issue in more detail and technicolor.