Tuesday, February 16, 2016

2% Inflation -- A Fool's Quest

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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