I wrote a
piece on January 19th about the Fed’s 2% inflation goal mostly
saying that the 2% was a ruse – a way to take your eye off the ball. The Fed
wants the unemployment rate lower and the economy stronger and the low recent inflation
gives them the excuse to keep their pedal to the metal.
But there is
more to the story. So let’s beat on the inflation goal again but in a different
way. It seems clear why the Fed might want to adjust policy so as to reduce the
unemployment rate. Higher unemployment hurts people. Lower unemployment is a
sign of a healthier economy. I am not saying that the Fed is good at lowering the
unemployment rate, but it seems to make sense that lower unemployment might be
a desirable end.
During much
of my lifetime, the Fed’s main goal was to reduce pesky inflation. That seemed
reasonable too. Inflation is annoying. Ask folks who lived in any country
ravaged by 100% inflation. Inflation hurts. Even when inflation hits 5-10% per
year few of us like that. But the Fed tossed all that out lately. Their goal is
to raise inflation. What? Why would they want to do that?
The answer
has nothing to do with inflation or prices. The answer is that low prices might
be an indicator of flagging or deficient national demand for goods and
services. Influencing sagging spending makes sense but if you are concerned
about low aggregate demand then why doesn’t the Fed come clean and say it is
trying to raise AD? The answer is that AD is like love. Love is not directly
measurable. Does she love me or does she not? We are always guessing about such
things. If you want to know if someone loves you then you look at behavior. Apparently
the Fed thinks it can look at measured prices to know what is happening to AD.
The problem with
looking at inflation to gauge AD is that it simply is not very good for that
purpose. For one thing, inflation reflects aggregate supply (AS) as well as
AD. When inflation falls because of
increases in AS – then the Fed should not be reacting to that. So if the Fed
has no direct measures of love or AD or AS, then inflation can be a dangerous
and misleading indicator. When inflation falls is it because AD went down or
because AS went up? It is hard to know
and reflexively presuming AD and inflation are the same thing has frequently
led to grave policy errors and unnecessary economic suffering.
A second
important problem with using inflation as a measure of AD is that inflation is
like Steve Martin – wild and crazy. Inflation measures jump around like a kid
on a red ant hill. Below I use some inflation data to make my point. The Fed might
as well use lighting strikes to measure AD…it is a fool’s game to use inflation
numbers.
My measures
of inflation today are called implicit price deflators for GDP. They are published by the Bureau of Economic
Analysis and found at bea.gov with the various GDP statistics. Notice in the
detailed table below there are inflation numbers for 2014 and 2015 for every
component of GDP. This is a very comprehensive measure. It is broader
than the consumer price index since it includes inflation rates of prices for
things like plant, equipment, and exports. The closest thing to the CPI in this group is the
deflator for personal consumption expenditures.
I said above
that inflation numbers are wild and crazy and could not possibly be good
proxies for what is happening to AD or anything else. The overall index for
inflation (for GDP) was 1.6% in 2014 and then 1.0% in 2015. The Fed would say
that the national inflation rate fell and might be a problem if AD fell in 2015
and worsens in 2016. So far so good. But let’s look inside the wrapping of that
sausage.
While the
prices of consumer goods were falling by 2.9% in 2015 notice that the prices of consumer services rose by 1.9% after increasing by 2.3% in the year before. Note that the inflation of consumer services averaged those two years
around 2%. Thus consumer services prices are at the Fed’s spoken limit. By the
way, consumer services were approximately 65% of all consumer spending and 45%
of GDP. In contrast, wild and crazy durable goods are only 13% of consumer
spending and 9 % of GDP. The durability
of future inflation rates are much more associated with the heavyweight
consumer services and much less influenced by wildly gyrating prices of consumer durable goods.
The GDP
component we call investment includes purchases of capital goods – plant, equipment,
software, buildings, and more. While consumers buy residential investment, the rest
of these items are generally purchased by businesses. Notice the behavior of
prices in this category. While the prices of the nonresidential portion of
investment goods barely budged in 2015 (0.2%), prices of newly produced
residences rose by 2% after rising by 6% the year before. Finally look at the
behavior of both import and export goods.
Prices fell in those categories by 7-8% in 2015 after being pretty flat
in 2014.
When you
read the first line of the table and see that the US inflation rate fell to 1% in
2015 one might get the impression that the prices of most or all goods and
services followed in lock step and somehow national AD must be on the decline. But
this could be very misleading since the average masks a lot of different and conflicting changes – each one having a very different implication for AD or AS. Clearly spending on the
biggest part of GDP, consumer services, was strong enough to put inflation of
consumer prices at the Fed’s goal value. If you add prices of new residences,
you get the same result – healthy enough spending to put inflation at 2%.
So what
causes the impression that inflation is falling? Clearly sectoral issues that may
or may not be AD in origin make the results very muddy. For example, prices of
consumer nondurable goods retreated because of gasoline prices. Lower gasoline prices, however, should give consumers more money to spend on other items. Prices of
imports and exports figured into much lower prices of those categories. Again,
how much do these international changes reflect ongoing AD issues that our within our sphere of influence?
A closer
look at inflation numbers suggests a mixture of temporary changes in
highly volatile sectors and a mixture of AD and AS impacts. They paint a very
unclear picture of how national AD is changing and a poor clue as to what will
happen to inflation and AD in the future. The Fed should stop talking about
inflation and be more honest about its true goal. The Fed has become Supergirl
of modern times. Even the tiniest worry about unemployment or economic weakness
sends the Fed into action. This was never the intention of the framers of the
Federal Reserve Act and ignores all of the unintended negative impacts and imbalances that
such policies have shown time and again.
Table.
Inflation as measured by changes in
implicit
price deflators of GDP
2014 2015
| Gross domestic product | 1.6 | 1.0 |
| Personal consumption | 1.4 | 0.3 |
| Goods | -0.4 | -2.9 |
| Durable goods | -2.3 | -2.1 |
| Nondurable goods | 0.6 | -3.3 |
| Services | 2.3 | 1.9 |
| Investment | 1.8 | 0.6 |
| Fixed investment | 1.9 | 0.6 |
| Nonresidential | 1.0 | 0.2 |
| Structures | 1.5 | -0.5 |
| Equipment | 0.7 | 0.7 |
| IP products | 0.9 | 0.0 |
| Residential | 6.1 | 2.0 |
| Net exports | na | na |
| Exports | 0.1 | -4.9 |
| Goods | -0.7 | -6.8 |
| Services | 1.9 | -0.6 |
| Imports | -0.2 | -7.7 |
| Goods | -0.5 | -8.9 |
| Services | 1.2 | -1.7 |
| Government | 1.8 | 0.2 |
| Federal | 1.6 | 0.7 |
| National defense | 1.4 | 0.2 |
| Nondefense | 2.0 | 1.4 |
| State and local | 1.9 | 0.0 |
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