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Rex Nutting
March 30, 2011, 12:49 a.m. EDT
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Housing is dead; it can't hurt the economy
First Take "º
Good news on jobs from several sources
By Rex Nutting, MarketWatch
WASHINGTON (MarketWatch) "“ You don't have to be a gold bug to wonder if the Federal Reserve has completely lost its mind.
Can't the Fed see what's happening to the prices of commodities, such as gasoline, grains, metals and other raw materials? Is the Fed blind to the inflation that's raging all around?
Yet, the Fed still clings to its easy-money policy, insisting that the fragile nature of the economic recovery demands its continued support. It's expected that the Fed will keep buying Treasury bonds for three more months as part of its Quantitative Easing 2.0 campaign, and will keep short-term interest rates near zero "for an extended period" in an effort to keep the economy growing.
In other words, the Fed will keep pumping cheap money into the economy until the patient can stand on its own.
Some Fed officials, such as Charles Plosser, the president of the Philadelphia Fed, are getting nervous. "I worry about us getting behind the curve" on inflation, he said recently. What he means is that he fears the Fed will be slow to change course, and will let inflationary pressures build up before acting decisively to raise the cost of money. Read our coverage of Plosser's views on ending QE2.
Plosser is in the minority on the Federal Open Market Committee. Most members of the committee agree with Chairman Ben Bernanke that the recent rise in commodity prices has been caused mostly by supply shortages in the face of rising global demand, not by excessive money growth. They think the recent increases will be temporary and won't lead to higher prices for other goods and services.
The members of the Fed "” even such inflation hawks as Plosser "” predict that inflation will remain modest over the next few years. According to the latest economic outlook from the Fed, consumer prices are expected to rise less than 2% a year this year, next year and the year after. Read the Fed's economic projections.
Consumers don't see the world in the same way at all. According to the latest survey from the Conference Board, Americans expect prices to rise 6.7% in the next 12 months. Read more about the big drop in consumer confidence in March.
Why is there such a large discrepancy between the Fed's view of inflation and ours? In part it's because of the way our brains work. We all have biases in the way we view the world. Our memories emphasize recent events and big changes, but we hardly recall the things that don't change much.
In terms of inflation, we remember that gasoline and food prices have risen sharply over the past two or three months, but we forget that gas and food prices plunged in 2008. What's more, we don't think at all about the fact that lots of prices "” for instance, the cost of washing a load at the laundromat, or the amount of our mortgage payment, or the co-payment at the doctor's "” haven't changed in years. Of all the things we buy, nearly three-fourths have so-called "sticky prices" that don't change often.
Our minds are fooling us: We notice the prices that fluctuate all the time, but we ignore the much larger share of our spending that's on sticky-priced goods and services. Over the past year, sticky prices are up about 1.2%, while flexible prices are up more than 4.5%. According to Fed economists Michael Bryan and Brent Meyer, sticky prices predict future inflation much better than flexible prices do. Read Bryan and Meyer's research on predicting inflation.
Incidentally, one of the stickiest prices of all is the price of labor "” wages, which are rising at an extremely slow pace of 1.7%. And has anyone noticed that home prices "” the ultimate sticky price "” are falling again? Read about the sixth straight decline in the Case-Shiller home price index.
When thinking about how to calibrate monetary policy in order to keep prices stable, it's better to consider sticky prices rather than the flexible prices that pre-occupy our minds and our daily discussions about the dangers of inflation.
Here's the key point for the Fed: Because sticky prices are changed infrequently, businesses tend to set them at a level that will cover their own expected higher costs over that interval. Sticky prices have a built-in inflation expectation component!
The concept of sticky versus flexible prices is closely related to the idea behind so-called core inflation, which looks at inflation trends by excluding food and energy prices, on the grounds that those prices are volatile. (Food and energy prices are among the most flexible prices we have, often changing daily in response to forces of supply and demand far beyond the Fed's control.)
The point of paying attention to core inflation has always been to look beyond temporary price fluctuations so we can more accurately predict where overall inflation will be next year or the year after. It would be foolish for the Fed to change policy dramatically every time the price of eggs goes up or down.
The idea is sound, but the Fed's reliance on core inflation has been a public relations disaster, leading people to wonder sarcastically if Fed officials are so out of touch that they think we don't have to drive or eat. The emphasis on core inflation has destroyed the Fed's credibility.
The Fed now has a problem best articulated by Chico Marx, who posed the timeless question: "Who you gonna believe, me or your own eyes?" Should we believe the Fed when it says consumer prices will probably rise about 1.5% to 2% a year, or should we believe our own eyes and our own brains, which we know aren't the most reliable witnesses?
The Fed is probably right about inflation not being a problem now, but no one believes it. That creates a credibility problem, and something worse: If consumers and businesses begin to expect higher inflation, it could become a self-fulfilling prophecy.
Rex Nutting is international commentary editor for MarketWatch.
March was another month of modest improvement for jobs, according to several reports released in the past few days, writes Rex Nutting.
11:30 a.m. Today11:30 a.m. March 30, 2011
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"Visa and MasterCard lead financials higher. $V $MA http://stk.ly/h73zWh" 1:03 p.m. EDT, March 30, 2011 from MarketWatch
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"Paul Allen blasts Microsoft co-founder Bill Gates in memoir: video http://on.mktw.net/dLB7Jf" 11:30 a.m. EDT, March 30, 2011 from MarketWatch
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