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.