Orthodox Fed Approach to 'Deflation' Authors Our Woes

The idea and concept of inflation is relatively straightforward, but in practice it is an unmitigated mess. Despite being such an important aspect of monetary cooperation with the real economy, we can no better measure inflation now with advanced computer technology than when Rice Vaughan wrote A Discourse Upon Coins in 1675. In it, Vaughan observed that true money (specie) is no less peculiar than real goods,

"Use and Delight, or the opinion of them, are the true causes why all things have a Value and Price set upon them, but the Proportion of that value and price is wholly governed by Rarity and Abundance: And therefore the Proportion of value between Gold and Silver must needs differ in several Times and Places, according to the scarcity or abundance of those Mettals."

Carefully observing the history of government standards on gold and silver money in England and France, Vaughan noticed that monetary "prices" led to distinct and discrete episodes of economic change, both good and bad. There was a definable link between money, prices and economic sufficiency,

"A sixth cause, is the Low price of our Moneys, especially of our Silver Moneys, which is the cause assigned by many that much of the Materials that would be brought hither into England, if the price were higher, is now transported into other parts."

This was an attempt to begin to sketch the rough contours of how monetary inflation or imbalance might concern real economic function. Of that time in England, the price of silver was thought too low and was thus creating an artificial scarcity, impeding real commerce. However, the specific monetary remedy was not at all easy to see, fraught with real difficulty. What was the true proportion of gold to silver that would lead to proper balance? If that could be found, what was the preferred method, "reducing the gold unto the silver, or by advancing the silver unto the gold?"

In February 2000, the Federal Reserve noted in its Annual Report to Congress that it had, until that date, "framed its inflation forecasts in terms of the consumer price index." From that point forward, the Fed would now look to the PCE deflator as a measure of inflation in the US economy since it had "several advantages relative to the CPI."

One of the quirks of the CPI, due to its official uses in government activities, was that it could never be revised after issue. Once figured, it was set in stone and thus impervious to any philosophical advancements. But more than that, the PCE methodology was believed to "avoid some of the upward bias associated with the fixed-weight nature of the CPI." Since the CPI measures the prices of a "basket of goods", it cannot anticipate or measure the adoption of new goods nor any quality improvements in existing goods. This is the infamous iPad price distinction made by New York Fed President Bill Dudley at an inopportune moment in March 2011.

Dudley was technically correct, but the episode demonstrated a very real element to the measurement problem. Price declines in goods like iPads (as they captured more functions and abilities into subsequent versions) and big screen TV's are very much beneficial, but how much do they really offset the price of eggs, milk and gasoline? As Rice Vaughan observed, we cannot know exactly how and how much commerce has been redirected by monetary imbalances; in the 2011 case a significant segment of the population was forced to redistribute spending away from iPads (or technology in general, iPads did very well then) just to maintain non-discretionary spending levels.

There is no distinction given or assumed as to why prices in either segment behave as they do or did. If an iPad 2 is twice as "powerful" or functional as the first generation, then productivity and innovation has performed an increase in living standards that has no monetary origin. The increase in the price of gasoline may be due to other factors, on the other hand, not the least of which is the relative scarcity/abundance of currency and credit in this case. For official inflation measures, the prices and factors of each distinct good are assumed to take on a uniformity that just does not exist.

It is intuitive and even obvious that we would accept and embrace without reservation the former type of inflation factor, productivity leading to either declining prices or increased functional capacity, while seeking to limit the latter. However, combining the two results together in an index does not accomplish the task of finding the best economic path. If the relative scarcity (overabundance) of currency is driving prices upward in only certain segments, that should be identified and measured on its own free of entanglements with "good" price changes resulting from unrelated and positive attributes.

By assigning a monetary function/cause with all price changes, economists are under-estimating the impacts of monetary changes. It also highlights a serial miscalculation on the part of orthodox central banking.

Central banks, owing to the great volume of study of the 1930's, place a disproportionate emphasis on keeping deflation at bay. Deflation, defined in conventional economics, is the worst possible outcome; full stop. A central bank will do anything and everything to stop even the preconditions of deflation. In terms of the Federal Reserve, this is consistent with the existing "dual mandate" because, to the orthodox mind, deflation is the biggest threat to both price stability and maximum employment.

In March 2011, then, Dudley's comment is a poignant reminder about the need for discernment between economic factors. In his reckoning, at that time, QE was a necessary means to put upward pressure on inflation expectations in order to relieve any further existing deflation tendency or preconditions as the Great Depression passed. That may have led in certain places to price changes that were not necessarily desirable on their own, but at least they were expected to be balanced enough to make it overall more palatable. But what that potentially meant for the economy was really that policy actively sought more of the milk/eggs/gasoline "inflation" and less of the iPad offset. If the economy actually followed that policy directive, it would yield exactly the opposite of what we would define otherwise as economic success because policy makes no distinction about types and sources of price changes.

As a means to ensure that the economy does not suffer deflationary collapse, the Fed, along with every other major central bank (and most minor), seeks to force positive inflation at all times. The idea, again the dominance of psychology in monetary policy rather than actual money, is to "anchor" inflation expectations around a specified target in order for the economy to sort of police itself. Owing to rational expectations theory, the Fed expects that if "markets" believe a central bank can force inflation into the economy via threat of debasement, they will act in accordance with that belief and thus create those very conditions. If inflation does indeed anchor to the target, deflation is a "tail risk" of very low probability.

Where inflation, in official measures, does not meet or remain at or near target, that constitutes the precondition for deflation. Again, in rational expectations theory, that would mean "markets" are not responding as if the Fed's intentions are credible. If the economy will not "anchor" expectations near target, that presents a tremendous potential problem for the orthodox central bank.

When the FOMC got together a little over a week ago and shocked the consensus by not tapering, the last inflation report they received was for July 2013. It was the fourth consecutive month where the "core" PCE deflator (the preferred inflation measure) remained at 1.2% year-over-year. Despite the assumed cumulative pressure of QE3 & 4, the economy refused the Fed's prodding to move up to target. Since January 2012, the core PCE deflator has been rather steadily falling (though not collapsing), showing very little regard to policy maneuvers.

That might suggest inflation expectations are being anchored well below target, and thus firmly in the deflation precondition zone. Since dollar liquidity did respond to policy expectations (taper threats), the ensuing tightening across funding markets raised the specter of having both a low inflation anchor tying to a volatile reduction in dollar availability (manifested not only in the US bond markets, but also in emerging market turmoil). It is the combination of dollar tightness and low inflation that is assumed to be the prerequisite conditions for deflation.

In that context, what the Fed did with regard to not-tapering makes sense. I think if you examine the chronology of the taper concept, it becomes clearer. The Fed began the early part of 2012 very much confident in its ability to manufacture a recovery, belated as it would have been, because of the open-ended feature that was engaged in contrast to previous monetary episodes. That confidence allowed policy some leeway to re-prioritize toward other factors, including the growing imbalances and "froth" in certain markets (notably housing and junk debt, with some reference to stock prices).

By May, the FOMC members began to actively talk at these markets by suggesting taper, cloaking it all in the growing recovery narrative that was being supported by assumed job growth. The Establishment Survey, the main publicized measure of employment, kept the recovery story plausible enough despite nearly every other measure of employment showing far different conditions. It was assumed/hoped that this recovery would be both self-fulfilling and take the sting out of any taper talk effects.

After a summer filled with tremendous dollar volatility, lackluster employment growth even in the Establishment Survey (and worse in the others), and a stubbornly low inflation environment, the Fed had little choice to re-prioritize back to deflation fighting; bubbles be damned at that point. Orthodox economics will countenance any number or size of asset bubbles if deflation is even the slightest prospect.

Given how businesses have responded to monetary expectations management, it raises the real prospect that rational expectations theory is actually invalid in this post-crisis context; at least in the manner anticipated by historical study. If the Fed creates inflationary expectations by engaging QE, they are really anticipating that businesses will spur new economic activity to "get ahead" of that potential inflation. If you expect prices to rise a few months down the road, you buy or produce today before prices adjust, or at least that is what the monetary textbook proclaims.

A manufacturing business might be able to respond in that fashion, since it could, in theory, build up an inventory of goods using lower cost inputs before their prices go up. But a service sector business has no such means to react "favorably" to expected price increases. A doctor's office can no more create inventory than it can move up its production schedule. The doctors, the business owners, instead can only pass along rate increases to the best of their ability or, more likely, take lower pay or profits. There is no direct channel for a positive marginal impact on current business activity.

Instead, what really occurs is businesses, in anticipation of cost pressures, place an inordinate priority on managing their cost structure. The doctor might cut the hours of staff or seek other means of cost efficiency. That is true of even manufacturing businesses that do have that inventory outlet. It is, in tight financial times, far easier to manage costs elsewhere than to finance inventory growth. Thus the impulse to hire and expand is actually short-circuited by inflation expectations, particularly in a service-oriented economy.

Bill Dudley, then, assumes that the lack of inflation showing up in the official measures is due to the iPad "effect" when in fact it is simply a generalized lack of demand for "money" and credit. But, opposite that, the price pressures on milk, eggs and gasoline are very real and take an economic toll as these conditions persist.

To further this point, one need only observe the behavior of corporate businesses since the trough of the Great Recession. Record profits signify not a healthy business climate, but that primary appeal of constantly cutting and managing costs. Investment consists mostly of financial transactions in stock repurchases and M&A (done at tremendous premiums). There is no income growth or sustainable employment opportunities because businesses, in opposition to mainstream analysis, are seeing a depressed environment attached to expectations for cost pressures. It all becomes self-reinforcing as long as inflation is expected, no matter if it ever gets picked up by the official measures.

It is important to note that QE by itself has no direct bearing on real economy prices. Bank reserves, the primary byproduct of QE, are not at all correlated with bank lending, credit production or the level of money in the economy (owing to the financial system's growing dependence on non-traditional banking and nonbanks). This type of monetary policy is only an indirect method for cajoling behavior in both real economy agents and the financial system (by controlling spreads and appealing to balance sheet expansion through non-market bids for risk-free assets). Reserves are not true "money" or even usable currency, as the term "money printing" does not really describe quantitative easing; financial firms, including foreign banks, are the source of US dollars in the real economy, particularly since dollars are only computer-generated ledger balances.

After more than four and a half centuries of struggling to even define what constitutes inflation, it is more than a little unsettling that authorities continue to appeal to it as a management tool for economic control. That is particularly true if the FOMC is interpreting low official inflation through the lens of deflation preconditions instead of a lack of demand for credit. Inflation was never really a monolithic variable, but it emerges as one in the modern conception trying to make it definable in mathematic terms. So much depth of understanding is lost in that transition, not just as an academic study but in the real economy as it tries, and fails, to overcome this constant strain.