Friday, May 27, 2011

Why the Fed's inflation targeting is not working

Years ago, in the early 2000s, the Fed told us that its preferred measure of inflation was the Core Personal Consumption deflator (though it also considered the headline PCE deflator important as well), and that its preferred target range for inflation was 1-2%. The chart above shows both the core and the headline versions of the deflator, in addition to the Fed's target range. Note that by either measure, inflation was above target for about five years, in the 2004-2008 period. Note also how volatile inflation has been in the past decade. Inflation has either been above or below its target, and erring by a lot, ever since the 1-2% inflation target was announced. So much for targeting inflation.

Actually, inflation targeting was never a good idea. Since monetary policy acts on the economy with long and variable lags, targeting inflation is akin to driving by looking in the rearview mirror. Similarly, it's akin to piloting a boat: once the boat is turning, it will keep turning for awhile, even if you turn the helm in the other direction. You can't wait for inflation to show up before doing something to prevent it, you have to anticipate where inflation is going and adjust policy proactively.

The Fed hasn't been acting proactively, they've been reacting, and that's one reason inflation has been so volatile. A reactive Fed undermines the value of the dollar because it creates extra volatility and uncertainty, and it also boosts the demand for gold and commodity prices as investors attempt to hedge against the dollar's loss of purchasing power.

Although inflation looks to be more or less within its target range as of April, on the margin prices are rising by much faster than appears in this chart, which only shows year-over-year changes in prices. The headline deflator is rising at a 4.6% annualized rate over the past three months, and at a 3.6% annualized rate over the past six months. The core deflator is rising at a 1.9% annualized rate over the past three months, and at a 1.5% annualized rate over the past six months. Without a tightening of monetary policy, and in view of the fact that the dollar remains very weak, the yield curve very steep, gold prices very strong, and most commodity prices are still very close to all-time highs, it is not unreasonable to assume that both the red and blue lines on this chart will move well above the Fed's target inflation range over the course of the year.

Yet despite the increasing likelihood that inflation is rising and is already at the upper limit of or above the Fed's preferred range, the Fed has somehow convinced the market that there will be no policy tightening until sometime next year. Savvy investors who realize that inflation is moving higher but the Fed is apparently unwilling to do anything about it for a long time conclude there is even more reason to seek inflation protection, and that feeds back into higher gold and commodity prices, and a weaker dollar.

Investors and speculators are thus several steps ahead of the Fed, as evidenced by the strong rise in gold, silver, and commodity prices this year. That will only contribute to inflationary pressures near term, keeping inflation volatility and uncertainty alive for longer than necessary. The Fed could do us all a favor by making policy more proactive, and that means paying attention to monetary indicators which point to rising inflation pressures, such as the value of the dollar, gold prices, commodity prices, and the shape of the yield curve.


Public Library said...

Good post and totally evident to anyone who leaves their house on a daily basis.

We need to dismantle the Fed and the Banking cartel. Reduce Government spending and ability to fight preemptive wars.

We are moving from a slow motion train wreck towards a high speed rail disaster.

TradingStrategyLetter - Weekly Summary said...

Are peole still listening to the Fed and believing what they say?

Unknown said...

In simple language, inflation means rising prices and it shows the increase in cost of living. In economics, inflation is explained as rise in the general level of prices of goods and services in an economy over a period of time. With the rise in price levels a unit of currency will buy fewer goods and services. As a result, the purchasing power of money will be reduced with inflation. In other words the real value of money will be lost day by day along with inflation.

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