Should Central Banks Focus On Core Inflation?
Here’s a morning note from UBS’ Andy Lees in London on core inflation that made me think. Andy writes:
Opinion – By focussing on core inflation rather than headline inflation, central banks are making a major policy mistake. Because of declining geological reasons, the energy network is expanding rapidly relative to the world economy. This capital shift, implemented through the CPI of food and energy rising, has to be included in the central banks policy decisions. It is a tax, but it is a tax by Mother Nature and so there is no getting around it. By focusing policy on the core economy, the central banks are making a major mistake. Rather than rising energy prices causing the minimum capital transfer from the rest of the economy to maintain net energy supplies, ie the Goldilocks scenario, central bank policy will force prices rapidly higher, stimulating investment but at the same stage causing a collapse in demand. Low prices kill future supply but high prices kill immediate demand. Only if prices remained within a narrow band can serious problems be avoided. Central bankers and economists made this mistake in 2007/08 and they are making the same mistake again. Debt accumulation or government policies that allow the temporary misallocation of that capital will effectively push the price temporarily outside that band and need a corrective collapse. By government misallocating capital they are starving the energy network of the funds necessary to maintain net supplies, forcing prices to go even higher to ensure the necessary investment. Easy monetary policy is creating its own disaster. Rather than central banks smoothing out cycles they are creating aggressive cycles whereby commodity constraint will act as the final arbiter.
This is very much in line with what Claus wrote regarding the inflation-deflation debate. After that post, I wrote to Claus that "my question at the end is about a goldilocks scenario that isn’t stagflationary or depressionary. That’s what policy makers are looking for, isn’t it?" He agreed that this goldilocks scenario is "largely what drives the US outperformances story at present." But we are both sceptical it can be achieved. Before I get into why let me frame the problem here. The central issue is two-fold.
Biflation is the problem
First, there is the human element of it. Reader Dan says we are seeing biflation: "Deflation in what you don’t need (stuff from Wal-Mart except food), inflation in what you do, e.g., healthcare (and I would add, what is protected by government, i.e., tuition)." That’s a big problem for lower income people and the average emerging market worker. There is a real human cost to inflation here.
But, then there is the argument over core versus all-in inflation measures. Which should be the driving force of policy making? I said back in November that:
The rise in food and energy prices should be taken into consideration by government officials conducting pro-inflationary policies. What should be of concern regarding commodity price inflation is how it represents a regressive tax on lower income workers and consumers in emerging markets and developing countries. Lower income consumers spend a much greater percentage of income on food and energy. So when commodity prices increase, it has a disproportionate effect on them. One reason we saw food riots in emerging markets in 2008 has much to do with this.
The Core versus Headline Inflation Conundrum
This is the conundrum then. Ben Bernanke is concerned about the U.S. economy. His argument is that emerging economies have plenty of economic levers at their disposal and they should avail themselves of these if inflation is a problem for them. This has nothing to do with the Fed, he argues. The Fed is concerned with managing monetary policy for U.S. domestic economic interests. Moreover, the Bernanke argument is that core inflation is a better measure of trend inflation. Mervyn King at the Bank of England makes essentially the same argument. In an environment of productive and labour overcapacity, costs are simply not going to feed through into sustained increases in the price level. Bernanke or King would argue that focusing on food and energy costs in any way would create a large degree of policy uncertainty and have the Fed moving against inflationary pressures in a way that could precipitate debt deflation.
Take a look at the video with Armored Wolf’s John Brynjolfsson below from two weeks ago. I think he makes Bernanke’s point well when he says at about the 1:15 mark:
"The Fed needs to be aware that the popular press out there, the blogs and so on are talking about food inflation but the reality is the Fed targets overall inflation and to some extent core inflation. But both overall inflation and core inflation are heavily influenced by what’s known as homeowner’s equivalent rent and for every P/E or hot dog that’s going up in price, you’ve got a third or 40% of the CPI flat or stagnating and the Fed is trying to manage the average price level. The last thing in the world I want the Fed doing is managing relative prices, that is micro-managing the economy."
John says sums it up thusly: "The last thing in the world we want to do is have monetary policy based on the price of soybeans."
This is the problem exactly.
How Fed Policy Works
Claus puts it well when he recounts events from 2008 when speculation in the commodity markets led to a parabolic rise in the price of oil.
The stronger the meltup, the stronger the correction. This is a classic dictum in the world of finance and, translated into the inflation v deflation debate, it means that the stronger and longer the outbreak in commodity prices last, the larger is the risk of a deflationary correction – and we are then talking about a re-run of 2008. It also raises important questions regarding the policy tools used by global central banks. Bernanke and company can hardly claim, ex post after the crash, that they were right not to react to rising headline inflation when it stands to reason that the low interest rates were the main source of the commodity melt-up in the first place (and indeed will also be the source of the next meltup a couple of years from now). In this sense, it almost amounts to a self-fulfilling prophecy that, as the wall of lingering inflation and stagflation rise to a zenith, you also know that the time is nigh for the correction.
I agree with John Brynjolfsson that we don’t want the Fed micro-managing the economy. I would go one further and say that the inflation targeting the Fed does do is an impossible task. I would rather have markets set interest rates. But in the system we have, short-term interest rates are centrally planned. Janet Yellen explains the mechanisms well.
Some General Observations
It is important to recognize at the outset that conventional and unconventional monetary policy actions bear many similarities. Forward guidance concerning the path of the federal funds rate, for example, is explicitly intended to influence market expectations concerning the future trajectory of shorter-term interest rates and thereby affect longer-term interest rates. That said, standard monetary policy actions also typically alter not just current short-term rates, but the anticipated path of short-term rates as well, influencing longer-term rates through the identical channel. In fact, central bankers have long recognized that this “expectations channel” operates most effectively when the public understands how policymakers expect economic conditions and monetary policy to evolve over time, and how the central bank would respond to any changes in the outlook.
The transmission channels through which longer-term securities purchases and conventional monetary policy affect economic conditions are also quite similar, though not identical. In particular, central bank purchases of longer-term securities work through a portfolio balance channel to depress term premiums and longer-term interest rates. The theoretical rationale for the view that longer-term yields should be directly linked to the outstanding quantity of longer-term assets in the hands of the public dates back at least to the 1950s.(2)
Each of these policy tools tends to generate spillovers to other financial markets, such as boosting stock prices and putting moderate downward pressure on the foreign exchange value of the dollar. My reading of the evidence, which I will briefly review, is that both unconventional policy tools–the use of forward guidance and the purchases of longer-term securities–have proven effective in easing financial conditions and hence have helped mitigate the constraint associated with the zero lower bound on the federal funds rate.
Translation: Fed policy creates a change in private portfolio preferences.
I want to be clear that this program has no direct effect on the real economy as banks are not reserve constrained; adding reserves via quantitative easing does not increase the amount of loanable funds available for creditworthy borrowers. Rather, banks make the loans first and then worry about the reserve requirement afterwards, borrowing reserves in the inter-bank market if necessary. The only way that QE affects the economy is through its psychological impact in changing private portfolio preferences because of expected low rates followed by expected future inflation and the resultant policy tightening.
Let’s talk about animal spirits then
I like Janet Yellen’s clear and transparent messaging. This is the way monetary policy should be conducted. Yellen is saying very clearly that the aim of Fed policy is to change the expected future path of Fed interest rate decisions. The Fed telegraphs to the market how short-term rates will or will not be affected by the real economy and expectations shift accordingly. As I have articulated before, long-term rates can be represented as a series of expected future short-term rates. Therefore, to the degree the Fed is successful in getting long-term interest rates to move, it is because it has adjusted those expectations (See MMT: Market discipline for fiscal imprudence and the term structure of interest rates).
The problem is animal spirits. "[P]olicy tools tends to generate spillovers to other financial markets". It can’t get more explicit than that. Yellen has said this before: “It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage”.
And there is a certain reflexivity to Fed policy in an environment of slack demand and overcapacity. The Fed lowers rates to stimulate demand. This provides tinder for a buildup of leverage. Think technology IPOs, emerging market mania, or commodity speculation. While the systemic risk from the leverage should be worrying in and of itself, the rise in financialized commodity assets is the area where this leverage can have the most immediate economic effects. Here’s the chain of events as explained them three years ago:
The Fed’s attempt to reflate the economy after the Tech Bubble by reducing the Fed Funds rate to 1% was successful beyond our wildest dreams. However, this aggressive policy never allowed the inherent disequilibria in the 1990s macro economy to dissipate. As a result, we have what appears to be an ‘echo’ bubble in housing which has just popped. As asset price inflation has been the major factor holding up the economy, this does not portend well for sustained robust economic growth in 2008.
The asset bubble of the late 1990s was one of the largest in history. Rather than allow this bubble to fully unwind, the Greenspan Fed created more asset bubbles, especially in housing, leveraged finance, private equity and asset-backed securities. It is possible that the U.S. will escape with a garden-variety downturn, but, in the face of one of the largest asset bubbles of all time, this is unlikely. In the end, a margin squeeze from high energy prices or a dollar shock could be crucial factors tipping us into a downturn. However, ultimately these factors will be merely the catalysts; the true cause of the expected malaise in 2008 lies in the imbalances in an asset-driven economy.
This downside scenario was not predestined. Unfortunately, crucial policy errors by the U.S. Federal Reserve all along the way have had led us to a ‘point of no return.’ The global economy, now supported in the main only by the overextended U.S. consumer, finds itself at stall speed, susceptible to any number of potential exogenous shocks. Ultimately, the economic malaise created by this confluence of events will take years to unwind. A positive outcome to this process is dependent wholly on liquidation of excess credit and consumption.
This process will be extremely painful in the short term, but will lead to a healthy economy long-term. Unfortunately, experience shows that these painful steps will only be taken as a last resort. Moreover, geopolitical events become volatile in a world of economic insecurity, leading to political upheaval and protectionism. Protectionism is a natural outgrowth of nationalist economic policy as it transfers wealth from foreign producers to domestic producers by cutting off access to lower cost excess capacity in the goods in service sectors.
The Fed is doing exactly the same thing it did in 2001 and again in 2008. Each time, it has needed to be more aggressive in its policy because it refuses to let the macro disequilibria unwind. It’s the debt. That’s the problem. And lowering rates or printing money doesn’t make this go away.
The Fed should concentrate on the core but…
The Fed and other central banks must take asset bubbles into account. That must be made explicit as a policy goal of the Fed if it is to be effective. This is Stephen Roach’s view. I would prefer the Fed be stripped of its existing mandates, allowing fiscal policy through automatic stabilizers to deal with full employment and the market to set interest rates. The Fed could then concentrate on its role as lender of last resort. But, Roach believes the Fed needs a third mandate in addition to price stability and full employment in order to be fully effective. He is right. If central banks are going to set short-term rates, they need to be mindful of the unintended consequences of policy decisions geared to managing market expectations and smoothing trend inflation. Asset bubbles are destructive – and not just housing bubbles, but credit bubbles more generally, whether geared to housing, stocks or commodities.