The Fed seems to view that it has turned the corner on inflation, yet we are still above target. The PCE inflation has been rising for the last three months and is above 2.5%. The CPI has also been rising for the last 3 months with the current number at 2.9%. The problem has not been solved, and we see to be in a sticky period of inflation above target. It appears as though September was an outlier, and the Fed made a mistake at cutting 50 bps in September.
A recent survey looked at how consumer think about inflation and there seems to be strong opinions on the negative aspects of inflation. See "Why Do We Dislike Inflation?". Consumer clearly believe that it diminishes purchasing power and wages do not seem to match the increases in inflation. Hence, there must be costly adjustments to budgets and behavior especially for low-income groups. Inflation hurts financial assets and reduces savings and there is little trust that wages will keep up with the price changes. The anger about inflation is directed both at government and business with the government being over 3 times more likely where the anger is placed. Consumers also think that inflation hurst our international reputation, decreases political stability, and decreases social cohesion. This is some very interesting food for thought and suggests that the Fed and government in general should more closely listen to consumer views.
There is a large disconnect between the inflation preferences of consumers and those of the central bank. The general population would like to see lower inflation - much lower than the 2% target, so it is no surprise that current inflation rate is not making consumers happy. Consumers have a preference for inflation at .2% which is lower than the magic 2% of central bankers. See the paper "Inflation Preferences".
Consumers focus on the fact that inflation reduces real wages and that it also reduces the purchasing power of their money balances. Both as good strong economic arguments. So if consumers have a strong preferences for lower inflation, why does the Fed persist with its view that 2% is the necessary target especially when consumers are not making judgments that are irrational?
So, what should the Fed do given this strong consumer preferences for lower inflation? The authors realize that the Fed has two choices: one, adapt to the preferences of consumers and bring down the inflation target, or two, influence consumer preferences by educating them on the benefits of having higher inflation.
This is a weird paper that seems to advocate that the Fed just needs to inform consumers that their life would be better if they suffered an erosion of their real wages and purchasing power because it would make the Fed job easier to reach their dual mandate of controlled inflation and full employment. Consumers just need to be educated on why the consistent pain in losing purchasing power is better than higher unemployment. I want to see Chairman Powell talk to the America people and tell them it is necessary for them to accept the Fed preferences over their own view and experience.
"Inflation is a social phenomenon," Powell said. "If people believe that inflation will be higher, then it probably will be. And if they believe that inflation will come down, then people who make and take prices and wages, they will make sure that it does come down. So, it's absolutely critical that we be credible."
- Powell press conference
Should we give him the benefit of the doubt or just call out the craziness of this comment. Of course, inflation is effected by expectations but where do those expectations come from? Perhaps the Fed itself as the the producer of money!
You cannot just say that if you believe something, it will happen. Are expectations always rational? No. is a component of inflation expectations backward looking? Yes. However, if you are the head of the Fed, you have to take responsibility for your actions.
Inflation has been the number one economic issue for both the Fed and consumers, yet many policymakers have focused on the inflation of the last few years as a supply shock from the pandemic that was abnormal. Inflation is returning to normal levels; however, the inflation of the last few years was anything but normal. There has been a focus on core inflation, but the headline and anti-core is what may drive expectations.
The first chart shows what has been called anti-core inflation. This is the inflation associated with food and fuel costs. This is the inflation that consumers face every time they go to the store. Anti-core inflation was not just high but extraordinary. The spike hit 40% which was just below the highs in Great Inflation. Headline CPI was the highest in over 40 years which has driven expected inflation highs for the next five-year period. Given the experience of the last three years, inflation expectations will not just return to 2%. The Fed has a consumer expectation problem and lowering rates at this time will not solve this problem.
Campbell's Law - The more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor
Jerry Muller's corollary to Campbell's Law, "Anything that can be measured and rewarded will be gamed."
Goodhart's Law, "Any measure used for control is unreliable." or "When a measure becomes a target, it ceases to be a good measure."
Let's think about the 2% inflation target. Why do we need to have a 2% target? What makes it so special? How close do we have to get to 2% to say the Fed is successful? What happened to an average inflation rate of 2%? If we want to average to a 2%, then should the Fed push to something below 2%?
Can you have deflation and economic growth? Is there something like good deflation and bad deflation?
It is becoming increasingly clear that the focus on some arbitrary target can lead to more economic problem. If we control price inflation, we may just allow for greater asset price inflation. The goal is not some inflation number but stable purchasing power and effective growth. This may mean that the Fed intervenes in markets to provide financial stability but that is a last resort and not a policy of denying loses. We should not be data driven but goal driven. Let's be clear on the goals and why they are relevant.
Inflation has come down from highs, but prices are still higher than what was seen four years ago. The value of savings has been eroded and if you did not see your wages increase, your purchasing power has declined. In the paper "Geopolitical Shocks and Inflation", the author shows that there is a link between inflation and geopolitical risk and it has gotten stronger over the last two decades. Geopolitical shocks lead to increases inflation.
A comparison of inflation indices: the Consumer Price Index (CPI), which is produced by the Bureau of Labor Statistics (BLS); the Personal Consumption Expenditures (PCE) price index is prepared by the Bureau of Economic Analysis (BEA).
The PCE fell slightly this month, but it is hard to tell what this means for the CPI. There is correlation because both are driven by price changes, but the wiggles and differences in the short run are hard to forecast.
Differences in the indices:
1. Formula effects. The CPI and the PCE index are constructed from different index-number formulas. The CPI index is an average based on a Laspeyres formula, whereas the PCE index is based on a Fisher-Ideal formula.
2. Weight effects. The relative weights assigned to each of the CPI and PCE categories of items are based on different data sources. The relative weights used in the CPI are based primarily on the Consumer Expenditure Survey, a household survey conducted for the BLS by the Census Bureau. The relative weights used in the PCE index are derived from business surveys—for example, the Census Bureau’s annual and monthly retail trade surveys, the Service Annual Survey, and the Quarterly Services Survey.
3. Scope effects. The CPI measures the change in the out-of-pocket expenditures of all urban households and the PCE index measures the change in goods and services consumed by all households, and nonprofit institutions serving households.
4. Other effects. A variety of remaining differences consisting of seasonal-adjustment differences, price differences, and residual differences must be taken into account for a complete understanding of the differences between the CPI and the PCE index.
The discussion on inflation can be heated on whether the blame is with the Fed or is this just a tempest in a teapot about the transitory problem. There is no doubt that the pandemic with supply chain dislocations was a strong contributor to inflation.
Claudia Sahm is one of the leaders of the transitory story and her case is strong, yet it seems like the last mile problem of getting to 2% is hard, and the slowing of inflation is not the same as reversing the inflation of the past. Prices are still high and that means if wages have not kept up with inflation, buying power has been diminished.
The question is not whether the Fed must hold rates higher for longer to slow demand and get inflation down to 2% but for how long. Since the transitory problem lasted longer than expected, we can also say that the rate rise will have to last longer than expected. Fiscal policy with deficits at 7% at full employment is a contributor that has yet to be offset. The conclusion is that the movement to normalcy is just going to be longer, yet the fear is that another shock will take us higher and not push us to target. The value judgment is that the Fed under-estimated the inflation lag structure.
Why are so many consumers unhappy in the current economic environment? We can think about the Cantillon Effect, names after the 18th century French economist. If there is new money in the system that can create inflation, it may first impact the rich who can increase their wealth. There may not be a general rise in prices as usually taught, albeit all prices may be increasing, but there are relative price changes which will affect different households differently. Because inflation can be localized and can be gradual, different groups will respond and be impacted by a shock to money that can lead to inflation. For example, increases food prices will have less impact on rich households because food is a smaller portion of their consumption basket.
Consumers who do not have wealth or do not have the knowledge or the capability to exploit increases in money may not be able to adjust or adapt to higher inflation pressures created from those who were able to exploit greater money earlier. These poorer households will be more impacted by the increase in goods without the ability to exploit the money increases.
Hence, there is a distributional effect from inflation that is often not avoided in the inflation discussion. The inflation shock over the last two years has had a disproportional effect on lower income household who are not able to generate a wealth effect or are not able to take advantage of a monetary shock.
The wealthy are feeling good about the economy. Poorer households who are unable to protect themselves from inflation may have a different view.
“You never regain the purchasing power you have lost to inflation. There’s no such thing as deflation in modern monetary life…The important thing is the loss of purchasing power…that is not going to be recaptured, and that’s I think, the political significance of this number.” - Jim Grant
The core problem with inflation in a modern era is the fact that no deflation will occur. What you lost in purchasing power will not come back. Even if your wages increase, your savings will not be able to buy the same basket as two years ago.
"There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency." - Keynes 1919
We must think about inflation beyond the numbers and the impact on Fed policy and asset prices. There is a political component.
You can frame this debasement comment in two directions, a decline in the value of the currency or a decline in the value of domestic purchasing power. Inflation debases your purchasing power - for the same bundle of cash will get less goods. The debasement of the currency is a relative price issue. The dollar can still gain in value versus another currency, a relative gain. Currently, we are not seeing a decline in the value of the dollar but a significant decline in domestic purchasing power.
Society is destroyed through the growing gap between low- and high-income households. The wealthy have a greater ability to protect against inflation while lower income households are not able to grow wealth and are likely to have more constraints on wage increases. Their marginal propensity to consume is higher. There is not slack in their budgets for higher real prices. If there is no chance for economic growth, thinking is focused in how to get more from others, a redistribution. Politics allow for redistribution especially with the economic majority attempting to take from the minority, those who have wealth. We must accept that politics will be driven by inflation shocks.
Inflation is coming down. The Fed tightening is working. The consumers are saved. We are returning to normal. You have heard the arguments but that is based view that does not account for the true ravages of inflation.
Yes, the rate of inflation is coming down but that does not mean that the basket of goods bought at the grocery store will fall. The cost of goods is not getting cheaper. It just means the rise in prices have slowed. If you have not seen your wages go up with the rate of inflation, your purchasing power has fallen. Your savings will not be able to buy the same basket of goods that you were able to purchase a year ago.
How can we say that the world is better just because the rate has slowed. Wealth especially for those who have less to begin with has been destroyed. Your house may have increased in value but that is not a liquid asset which can be used to purchase goods today.
The inflation relativist who may be look at the rate inflation may be happy, but the consumer purchaser who is an absolutist may not feel so good. If the price increases of used cars have fallen, that is great, but if the price of those cars have increased over the last few years, there is no bargain for consumers. Used cars have increased 50% over the last three years and new cars have increased by almost 30% while income has only increased 13%. Tell me why this would feel good for consumers. Assume use car prices fell 20%; the consumer will still be behind.
Hard to say we have whipped inflation if real purchasing power has still declined.
We have cost-push, demand-pull, headline, and core inflation to name just a few descriptors. We have also been exposed to shrinkflation, products at the same price but have less. Now we are hearing about greedflation from the chief economist of the OECD.
We have heard this term before, but it now shameful to try and keep your margins the same during an inflationary period. If your costs are going up, shouldn't firms try and pass those costs onto customers? Customer demand may fall and the pass-through may not be possible, but it is in the interests of shareholders for managers to make the attempt to pass on costs. The customers will decide whether the margins can be maintained. Is this process greedy or just the normal behavior of businesses doing their job?
