Tuesday, May 27, 2014

Misinformation and Monetary Policy

I wrote an article in the 1980s titled “Misinformation and Monetary Policy”. It was an academic-style paper published in the Review of the St. Louis Federal Reserve Bank. I would not suggest you read that unless you like having needles pushed into your eyeballs. The point of the article, however, is as true today as it was back then. The point is that inflation data can give you shingles. No, that’s not right. The point is that the actual behavior of inflation can sometimes be highly misleading.

The Fed is saying that inflation is not a problem. Fed officials know that too much money can cause too much inflation and the Fed stands ready to modify its current course of monetary ease once it sees the “whites of their eyes” – once they see inflation rising. This makes some sense. If the problem of money is too much inflation – you cannot say there is too much money if the inflation rate is low and stable. So the Fed has good reason to have a “watch and see” stance.

But here is the problem. There is a difference between inflation and the measure of inflation. For example, Casper the Friendly Ghost exists even if you can’t see him. Or maybe gravity is a better example. We are glued to the earth but no one can see gravity. Gravity is a force and it can be measured but only indirectly. It is known to be proportional to the mass of two objects and inversely proportional to the distance between them. Two small objects far from each other create little gravitational pull while two very large close objects would generate a lot of gravity. Okay so I am not an astro-physicist. Give me break.

The issue is that while gravity is never directly measured, we can use formulas to estimate its value. We do the same thing with inflation. Economists have models which tell us how much inflation is. Monetary models say inflation is high when money growth is high. But we don’t stop there. Governments spend a lot of money doing surveys and collecting data to try to measure inflation. But let’s be clear. These are two different things. We have inflation which cannot be measured – let’s call that Milton’s inflation. Then we have attempts to measure inflation – let’s call that Kardashian Inflation.

            Milton inflation usually does not equal Kardashian Inflation

This inequality is the source of policy disagreements since critics of Fed policy are looking at Milton Inflation while the Fed is focused on the Kardashian version.
To show why this all matters today, I use some traditional measurements. The first is theoretical Milton Inflation. We all know that the money supply increased a jillion percent and that means Milton inflation roughly equals a jillion percent. I exaggerate of course. But it is hardly worth care and precision since we know that the money supply has reached unprecedented proportions and if left at these values a return to some normalcy (especially in a thing called monetary velocity) the inflation rate could become very high. 

Now let’s turn to data on measured or Kardashian inflation. The place to begin is to note that we have a lot of measures of inflation. The one that is reported and circulated the most – the Consumer Price Index (CPI)– turns out not to be the preferred brand. It has some known defects like pimples and rashes in unmentioned places. A Similar index but with fewer distractions is something called the Price Index for Personal Consumption Expenditures (PPCE).  So I went to the Bureau of Economic Analysis (bea.gov ) and found that they had a ton of data going back to when I was in pig tails. I chose to examine measured inflation using the PPCE for the years from 2006 to 2014. The latest data point is the first quarter of 2014 or Q1 2014.  I look at annual percentage changes from the first quarter of each year to the first quarter the year before. There is much too much detail to put into a table so trust me when I report a few facts.

·        The PPCE increased by 1.1% from Q1 2013 to Q1 2014. PPCE was unchanged in 2009, bounced back to 2.1% in 2010 and averaged 2.1% per year from 2010 to 2013. So we can say that inflation is averaging around 2% per year but had a down year in 2013/104. Does that mean that inflation is low?

·        The PPCE has three major price components – prices of durable goods, nondurable goods, and consumer services. The reason that PPCE grew slowly in the past year is that the prices of durable goods fell by 2.2%. Within durable goods it was furnishings and durable household equipment that fell by 3.7%.  Because gasoline and other energy prices contracted by 2.8% in the past four quarters, we had flat nondurable goods prices. The prices of consumer services, in contrast, rose by 2% last year.

This is a lot of detail to throw at you. But one can come away with a story. Even Justin Bieber knows that housing has been slow to recover and that energy prices are high volatile. Looking at the last four quarters through Q1 2014, we see a lot of things that will probably not repeat in the coming year or years. The 3.7% decline in furnishings and household equipment was the worst performance of that category in the last 7 years. With a recovery, ever so gradual, in housing it is hard to believe that prices in this category will fall again. As for gasoline and energy – check out this stream of annual changes since 2008: +30.8%, -37.4%, +37.7%, +19.3%, +10.2%, -0.3%, and -2.8%. If this was your golf score you would be scheduling an appointment with your psychiatrist. Given the bouncing ball nature of energy prices it is hard to venture a guess for the coming year. But clearly, rising prices are not deniable after two years of declines.

The upshot is that consumer services have been growing steadily since the 1.5% rate of 2011. From this base a return to some normalcy in prices of consumer durables and nondurables would mean an inflation rate of above 2% and possibly well above 2%. And this is before we have much of a kick-in from well-anchored inflation expectations.

I am not ready to blame Casper the Friendly Ghost when I can’t find my car keys. The Fed doesn’t want to rely on Milton Inflation either. So we are stuck with interpreting measures like the PPCE.  Given the volatility of key PPCE components over time, interpreting these trends can be hazardous to one’s health and can lead to numerous interpretations. Since I am a card-carrying Miltonian I see inflation floating in my breakfast cereal. I also see it in the PPCE. Measured inflation in the last year was modest but may very well be misleading. The data suggests last year might be the eye of Hurricane Kardashian. 

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