A year ago
(August 2), I sent out a report, “Inflation and Inflation Indexes.”
I have posted it here (this week only).
there was monetary inflation but fairly low price inflation. Today,
there is actually monetary deflation but twice the rate of price
inflation that prevailed a year ago.
What is going
is this likely to go on?
In my 2005
report, I made this point, which bears repeating: Inflation is a
monetary phenomenon. When a central bank adds to its holdings of
assets, it does so by creating new money and purchasing the assets
with the newly created money. This money is spent into circulation
in order to buy the assets, and then spent by the recipients of
this money. The new money multiplies through the fractional reserve
commercial banking system.
The vast majority
of money users know nothing of central banks, fractional reserve
banking, and the arcane formulas used by statisticians to define
money — competing definitions. What the average money user
knows is that the items he normally buys are either rising in price,
staying the same, or falling. In fact, consumers have only a vague
sense of this. What catches their attention is what a particular
asset costs, especially one that is getting media attention. It’s
like global warming. The public’s sense of increased heat is fanned
by the media’s coverage of the story. Worldwide, thermometers may
not actually be rising, which
has in fact been the case since 1998.
of an official index number for prices is a complex task. The statisticians
choose representative — they tell us — commodities and
services to monitor in their index. Then they “weigh” each commodity
or service as to its overall importance in a representative —
they assure us — person’s budget. Then they take random samples
of representative — they cross their hearts and hope to die
— transactions, but always retail transactions. Then they use
a highly complex formula to compute the index. Then they adjust
it for seasonal variations.
it still looks as though prices are rising, which will push up the
federal government’s cost-of-living adjustments (COLAs), especially
for Social Security, they deflate it by applying a “hedonic pricing”
deflator. This adjusts prices downward according to hypothetical
increases in quality, which are of course incapable of being quantified
even when not hypothetical. In short, the statisticians make up
a deflationary number for each product that is plausibly improving
produce several related index numbers that have certain prices removed,
such as energy or food, which are said to be volatile and therefore
not indicative of the trend.
You pay your
tax money — depreciating — and you get your choice.
INDEX I MONITOR
For a number
of reasons, I follow the Median
Consumer Price Index, which is published monthly by the Federal
Reserve Bank of Cleveland.
It’s not that
I take the figure seriously as an indicator of prices that affect
me personally. What interests me is the trend of the index. While
I have little confidence in any of these official indexes, I do
have confidence that the statisticians who compile them are committed
to them as “the best that anyone can produce.” As bureaucrats, they
resist any tampering of the formulas. So, I can see the trend of
a particular index.
In July, 2005,
the Median CPI was rising at about 2% per annum. As
of June, 2006, it had risen by 3.3% over the last 12 months.
Its monthly increase was .4%, which puts it in the 4.6% per annum
range if this rate continues.
This is a significant
increase in the annual rate of price inflation when compared with
what prevailed a year ago.
At the same
time, the rate of monetary growth has not only fallen, it has gone
negative. I follow the adjusted monetary base. From June 7 to August
2, it dropped at an annual rate of 0.5%. In recent weeks, both MZM
(money of zero maturity) and M-2 have turned downward. You
can monitor all of them here.
period is not crucial. There are ups and downs constantly in these
charts. The annual rate of increase of MZM and M-2 is in the 5%
range. The annual rate of increase for the adjusted monetary base
is 3.5%. So, with respect to Federal Reserve policy, there has been
relatively low inflation, and it is falling. This is significant.
There is constant
speculation — verbal and financial — about the next
announcement of the Federal Reserve’s Open Market Committee (FOMC).
If you noticed, the media kept reporting on forecasters who said
that there woild be a pause in the upward move. Then, every eight
weeks, the FED increased the federal funds rate by .25%. The FOMC
paid no attention to the forecasters. Neither did I.
When, on August 8, the
FOMC left the rate alone, the Board said it was because price
inflation is becoming less of a problem. There is a reason for this:
the FED’s monetary policies in 2006, which have tightened money.
ought to look more carefully at the adjusted monetary base. This
statistic provides the best recent evidence regarding FOMC policy.
What it is telling us today is that the FED under Bernanke is slowing
the increase of monetary reserves, which slows the increase of the
monetary base. This is disinflationary.
In a time
of rising price inflation, which we are in, a disinflationary monetary
policy is supportive of an officially announced policy of raising
the federal funds rate, which is the rate at which banks lend to
each other overnight — the shortest of rates. Here is why.
indicate prior monetary expansion. This echo effect will eventually
begin to reflect recent monetary policy, which is tighter today
than a year ago. Those retail sellers who expect to be able to pass
on rising costs to consumers will find that consumers balk. New
money is less plentiful than expected.
happens, retailers find that they have expanded too much. They must
now retrench. They scramble for short-term credit to carry them
over during the retrenchment period. This increases the demand.
Yet the supply of new money — a major source of short-term credit
in today’s capital markets — is slowing. This combination drives
up short-term rates. So, the FED’s policy has been consistent with
the FOMC’s announcement of rising rates. In any case, it is the
free market, not the FOMC’s announcement, that sets the FedFunds
rate. Speculators believe the FOMC only to the extent that FOMC
policy reinforces its officially announced interest rate.
It will not
take much to push short-term rates above long-term rates. This is
the famous inverted yield curve. Long-term rates have been falling
in recent weeks. This indicates that investors are moving money
into 30-year T-bonds as a way to lock in their interest rate return.
This indicates that they are worried about the return on alternative
investments. They may also be worried about falling short-term rates:
an effect of a recession. Short-term rates fall when a recession
hits because short-term capital is preserved this way.
7, 30-day T-bills were paying 4.95% and 30-year T-bonds were paying
5%. We are close to inversion. You
can monitor these daily figures here.
It is not
that an inverted yield curve causes a recession. Rather, it reflects
a change in investor sentiment that is consistent with recession.
Investors lock in a higher rate of return by buying T-bonds. They
know there is price inflation of almost 5%. This, coupled with income
taxes, puts their expected return into negative territory. They
are losing wealth. Why would they do this? Because they believe
they will lose even more wealth by keeping their money in stocks
or short-term T-bills. Why? Because they expect a recession.
AND PRICE INFLATION
put pressure on sellers to reduce output, lower inventories, and
fire workers. All of these survival tactics put downward pressure
on prices. There is greater supply being offered for sale in order
to reduce inventories. To attract buyers, retailers reduce prices.
This has a
ripple effect through the capital goods markets. Reduced demand
for final consumer output reduces demand for the tools of production
that produce output. It also reduces demand for commodities.
This is why
I expect the price indexes to peak in 2006. By the end of 2007,
I expect the rate of increase to be lower.
I do not expect
general price deflation. We have not seen this in half a century,
and even then only for a year. The public will not believe that
price deflation will hit the U.S. economy.
will expect the FED to open up the money spigot, once it looks as
though price deflation is a possibility. To allow prices to deflate
would be to follow policies associated with the Great Depression.
investors by now know that Bernanke regards FED monetary policy
in the 1930s as a great disaster. Bernanke
wrote this in 2002 for Milton Friedman’s 90th birthday.
practical central bankers, among which I now count myself, Friedman
and Schwartz’s analysis leaves many lessons. What I take from their
work is the idea that monetary forces, particularly if unleashed
in a destabilizing direction, can be extremely powerful. The best
thing that central bankers can do for the world is to avoid such
crises by providing the economy with, in Milton Friedman’s words,
a “stable monetary background” — for example as reflected in low
and stable inflation.
Let me end
my talk by abusing slightly my status as an official representative
of the Federal Reserve. I would like to say to Milton and Anna:
Regarding the Great Depression. You’re right, we did it. We’re
very sorry. But thanks to you, we won’t do it again.
This is not
just an investment issue. This is an employment issue and career
Reserve System forced down short-term interest rates to the lowest
level in American history if we factor in price inflation. Savers
took a terrible beating. It was done in the name of saving the stock
market and keeping the housing boom alive, which is a major source
of perceived wealth for consumers and a major employer.
concluded that there will not be employment-threatening recessions
any more. The last one that did force up unemployment was in 1990,
which is a distant memory for most Americans: the Cold War era.
in June, 1992 — an echo effect of the 1990 recession —
For young workers,
that era is not only forgotten, it was never experienced. For older
workers, it was part of their youth. Most people are not afraid
married workers, the unemployment rate is always significantly lower
than for the general economy. Still, it is unsettling when the “Help
Wanted” signs disappear. Raises are delayed. Promotions become scarce.
A gloom settles into the corporate boardrooms. Personal dreams of
personal wealth through stock options crash along with the stock
The FED does
not want to get blamed for this. It will do whatever he can to reverse
it, once it becomes a factor in the economy.
I think the
rate of price inflation will slow in 2007. I think unemployment
will rise above 5%. Until the yield curve inverts for 30 consecutive
days, I will not call a recession, but it has that look about it.
of Greenspan’s FED were always inflationary, from the month he walked
in until the week he walked out. That policy relentlessly forced
up prices and postponed a much-needed reallocation of capital values
and prices. Alan Greenspan spent his entire career at the FED warning
against price inflation while pursuing a monetary policy that guaranteed
FED has lowered the rhetoric against price inflation, while pursuing
policies that will call price inflation to a halt and then produce
price deflation within two years. But the cost of maintaining this
policy will be a long recession and rising unemployment.
I don’t think
Bernanke or his fellow Board members are willing to pay this price.
Congress would demand a reversal, which is beyond Congress’s legal
authority to enforce, but is well within Congress’s ability to create
exceedingly bad publicity for the FED, which bureaucrats never want