Monday, September 28, 2015

Inflation is not too low

There's a meme running around that says that deflationary pressures are so acute (think falling oil and commodity prices, coupled with cheap Chinese imports) that the Fed is almost powerless to get inflation up to its 2% target and therefore they would be crazy to start raising short-term interest rates.

I think the current level of inflation (approximately 1.5% if you look at a variety of indicators) is just fine, and I wouldn't mind at all if it were a bit lower. In fact, zero sounds right to me, because I have never understood why 2% is ideal and zero is not. Inflation—no matter how low or high—is insidious; it robs the poor and ignorant, while benefiting governments and the financially astute. It transfers wealth from the private sector to the public sector, with the bulk of the wealth confiscation coming from savers and the uninformed. Governments (and their complicit partners, central banks) create inflation, and—surprise, surprise—governments are the major beneficiaries of inflation.

Regardless of what you think the ideal rate of inflation is, the real problem is figuring out how to measure it.

The mathematicians at the BLS face the daunting task of figuring out just how much prices for personal computers have declined over the years, given that their speed, memory, and capabilities have multiplied by orders of magnitude. How am I to compare what I spent in today's dollars on my first Mac SE in 1987? I paid about $2700 for it, but it had a small black & white screen, 1 MB of RAM, and a 20 MB hard drive. It talked to the internet at snail speed, and it took hours to back up the hard drive to floppy disks. For $2500 today, I can buy a MacBook Pro that is so much more powerful you'd think it came from a parallel universe: 16 GB of RAM, 512 GB SSD, 9 hour battery, and a 15" screen that rivals a National Geographic photo. It can download terabytes of data in the time it took my Mac SE to back up a few floppy disks. To make matters worse, today's laptop can perform functions (like editing full-length HD movies) that weren't even possible in 1987.

How can hedonic pricing figure this out?

As the chart above shows, the BLS has made a good faith effort to resolve this seemingly impossible task. They figure that a dollar spent on personal computers in 1998 is equivalent to about 4 cents today. In other words, they figure that the prices of personal computers and peripherals (which comprise only a few percentage points of the overall CPI index) have dropped by almost 96% since 1998 (nominal prices haven't dropped all that much, but the bang for the buck has been gigantic). The BLS is telling us that personal computers are almost 24 times more powerful today per dollar than they were just 17 years ago. I'm not sure that's correct, but then I don't think anyone knows the right answer. How important a role should the massive deflation of personal computers alongside their huge technological advances play in the overall CPI index? It's transformed society and the way we work and communicate with each other. What we take for granted today was not even possible at any price in 1998. Maybe computers have effectively fallen even more in price, and/or they should have a larger weight in the CPI.

But it's not just personal computers that have fallen in price. As the chart above shows, the BEA calculates that the costs of durable goods in general (e.g., TVs, cars, computers, appliances) have fallen by 32% on average since 1995. Meanwhile, the costs of just above everything else have been rising. (I chose 1995 as the start date for this chart since that is the first year in history that the prices of durable goods fell even as other prices rose. It's also not a coincidence that 1995 was the first year that China started exporting cheap goods to the U.S. in a serious fashion.)

Consider that the "Services" index in the above chart is a good proxy for personal incomes (both have risen by approximately the same amount since 1995). What this means is that durable goods have become very cheap relative to incomes in the past 20 years. One hour's worth of income today now buys almost two and a half times more in the way of durable goods than it did 20 years ago. Wow.

Is it a bad thing when our wages allow us to buy more of the things that enrich our life? If durable goods deflation is good, why should falling prices of other things be bad?

In any event, the falling prices of durable goods have to some palpable degree contributed to lowering the rate of inflation that we all have experienced. China gets the bulk of the credit, since China figured out how to transfer hundreds of millions of workers from the countryside to modern factories. A substantial portion of the world's workforce became dramatically more productive in a relatively short timeframe, and this resulted in a huge increase in the productivity of the average human being on this planet. More productivity in China has resulted in higher living standards for everyone. Progress of this sort is most definitely NOT a zero-sum game. (Donald Trump, call your office!)

When sharply lower oil prices (down by more than 50% since the summer of 2014) are factored in to the inflation indices, the result is lower headline inflation. But there's nothing wrong or sinister about that, is there? Cheaper computers, cheaper gasoline, it's all the same: our dollars go farther and our living standards rise. It's times like this when we have to look at "core" inflation, which factors out food and energy prices. As the chart above shows, the core rate of inflation according to the PCE deflator is 1.3% in the 12 months ended August, while the headline rate is a mere 0.3%.

But if we look at the annualized rate of change in both the indices over the past six months, the picture changes significantly. As the chart above shows, headline inflation by this measure is 1.8% and the core rate is 1.6%—pretty close to high end of the Fed's target. Oil prices are no longer falling, and the dollar has been relatively stable for the past six months. Maybe the CPI over the past six months is giving us a better reading of underlying inflation than most people realize.

As the chart above shows, the headline CPI is running at a 2.3% annualized rate over the past six months, and the core rate is running just over 2.0%. The ex-energy version of the CPI is up at a 1.9% annualized pace over the same period. Put all these together and I think it's safe to say that inflation today is at least 1.5%. How this presents a problem to anyone outside of the energy and computer industries (Apple's profit margins are still huge, by the way) I just don't know. Why it should keep the Fed from raising interest rates by a puny 0.25% I fail to comprehend. Shouldn't the Fed be forward looking? 


anonymous said...

Completely disagree with your defense of "hedonic" revisions to the CPI based on measurements such as CPU speed and memory. What matters is overall utility: in 1987 your Mac SE allowed you to prepare reports and crunch numbers well enough to meet 1987 requirements; in 2015 your MacBook Pro allows you to do EXACTLY THE SAME THING in 2015 where business requirements have changed. Your analogy would be useful if you were running 1987 applications on and had 1987 requirements of your MacBook, but you don't. Similar cost for the two machines, same utility, no massive hedonic skewing of the CPI is required or justified. If you think this isn't the case, drag your SE out of storage and print out some chunky 1987 graphics for your next presentation and see how well they go over with your customers.

Same thing applies with TVs: $1500 bought you a top of the line TV in 1980 that allowed you to be wowed by the programs being broadcast in 1980; a similar amount buys you a large screen TV that amazes you with 2015 programming. No change in utility, no change in cost, no adjustment required.

You say "but appliances now cost half of what they did a generation ago". Sure, but my parents' 1952 'fridge is still keeping beer cold in the basement, their 1970 replacement lasted 30 years and their 2000 replacement lasted only 12. An improvement? Not unless you happen to own a trash hauling business.

The trouble is that there is a unresolvable conflict of interest within the government between maintaining a defensible CPI methodology and having to pay increased amounts for CPI indexed entitlements. "Hedonic adjustments", ignoring decreased product lifespans, and unrealistic weights given to luxury vs. staple items are just some of the ways that the CPI has been manipulated over the years to avoid government programs keeping up with the real cost of living.

I don't feel strongly about zero vs. low inflation or deflation, but I do want the argument to start off with an accurate, fact-based measurement otherwise I'm just letting myself be duped.

Johnny Bee Dawg said...

I follow Mark Perry's lead and use hours of work needed to buy various items to compare costs between decades. He takes old Sears catalogues and newspaper ads to compare prices and average hourly wages with today.

My 40" HiSense 1080p TV I just bought cost me $289 at Best Buy this month. That's amazing to me. It connects to the Internet, seamlessly plays any movie I want from a half dozen sources, and has a better picture than the $5000 Sony I bought less than a decade ago. The overall utility is light years ahead of virtually everything I could have bought just a few years ago. Even if it did have similar utility, it costs a fraction of earlier TVs, whether using constant dollars, inflated dollars or hours worked.

Bottom line is that it take vastly fewer hours of work to buy almost everything today, whether it's food, appliances, cars, computers, houses, etc. And the quality of all f it is superior.

W.E. Heasley said...

Excellent post!

Benjamin Cole said...

Nice post. But then, what would be the pressing need for the Fed to raise rates either?

The Fed seems to think that 2% inflation on the PCE allows for the most economic growth, yet keeps inflation under control. That target, which is supposed to be an average, has been undershot for most of three years now. Should a central bank hit its publicly stated goals? Should the Fed have any credibility?

I suspect the Fed is too tight, and the United States is leaving a lot of growth on the table for the sake of cutting an inflation rate that is too low already.

Really, I wish the Fed would go for much lower unemployment rates. I think Americans will embrace free enterprise and capitalism if there are chronic labor shortages. Remember, voters vote their economic interests.

Get ready for Donald Trump!

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