Thursday, January 08, 2009

Inflation Target: Getting it Right

In today's context of financial disarray, verbal clarity is vital. Many financial commentators, and even some serious economists, make grave errors that sprout from the misuse of terminology.

One of the most mangled of these terms is "inflation." This word has come to mean two different things over the last century, both in the understanding of the public and in the mind of otherwise highly erudite scientific economists. Some speakers and writers mix the two variations within the same paragraph.

Here are the two distinct meanings that they often confuse:

1. [Price] Inflation: The degree of increase in the CPI and other price indices. More and more, this is the meaning used by some of the most influential people in the world today, among them even most of the Federal Reserve Board members, legislators, and former and future presidents. It's the one we all understand when we see the word "inflation" in the news media.

However, there is another, in fact more precise, economic meaning of the term:

2. [Monetary] Inflation: The rise in money supply, i.e. of money and credit, over and above what the market requires, leading always to eventual price distortions. These distortions may manifest themselves in CPI increases, or they may not. They may appear instead as speculative bubbles such as the real estate bubble of 2006. Such bubbles reduce consumer purchasing power, relative to what it would be if there were no bubbles, through the siphoning off of corporate wealth to speculative activity, rather than towards increasing worker wages and funding solid new capital ventures.

This may come as a surprise to you, but this second meaning is the one in Webster's New World College Dictionary, 4th ed., as I noted in my May 2007 post. Here is the exact Webster's quote:

"inflation ... 2a) an increase in the amount of money and credit in relation to the supply of goods and services b) an increase in the general price level, resulting from this, specif., an excessive or persistent increase, causing a decline in purchasing power. [emphasis added]."

How amazing to find that Webster's is more precise and on point than most economists today, including the research staff and board of the Federal Reserve, the very people harnessed with the responsibility for controlling the same phenomenon that they cannot define or use correctly in their research--with dire consequences.

In a recent article by Krishna Guha of the Financial Times, we learn that the US Federal Reserve is moving "to establish a de facto inflation target in order to shore up inflation expectations and reduce the risk of deflation." This "inflation target" would be based on a measurement of the "personal consumption expenditure deflator on average over the medium term." The "personal consumption expenditure deflator" [PCECTPI] is the measuring stick used by the Fed to calculation the "rate of inflation."

target
[Thanks to Joe-ks.com for the image.]

Admittedly, the Federal Reserve has an impossibly fuzzy mandate. (See my Los Angeles Business Journal article, Page 1, Page 2, and Page 3.) They are supposed to (1) maintain full employment, and (2) control "inflation." But which one? The text of the law is unclear.

My cursory study of a number of the Federal Reserve's research papers, including this one written by Ben Bernanke, allows us to draw the conclusion that the Fed believes they can best fulfill their dual mission by maintaining "price stability," and that they see a clear cause-and-effect relationship between "zero inflation" and "price stability."

It would seem, then, that the Fed does not see any other way of measuring the appropriate amount of money and credit the system needs other than by trying to interpret the effects of their monetary adjustments on general prices, as seen in their version of the CPI, the above-mentioned PCECTPI.

Is that the way to measure the efficacy of their monetary interventions? I don't think so.

For example, I can think of a number of situations that would show zero inflation on the PCECTPI statistics, i.e. perfect "price stability" according to the Fed, but where the public would be the victim of monetary theft through reduction of purchasing power (which is mentioned in the text of law, if my memory serves). Here's one:

Imagine a new technology that cuts the cost of production of all manufactured things in half. (Over a period of a few decades, such advances have done exactly that, if not more.) Imagine that the Fed, by targeting "price stability," allows the money supply to reach a point where it causes the price index to read zero, or perfect price stability. (They currently are not aiming at zero, but rather 2 percent annual increase.) Isn't it clear that, over time, at price stabilization, their actions would be forcing us all to pay at least twice as much as our products are worth?

This sounds like an exaggeration, and I realize that it doesn't take into account the increases in our wages. But this is essentially what the Federal Reserve has done. And have our wages truly kept pace with price inflation? Certainly not in the last few years.

But where has monetary excess gone if it isn't in general prices? It has gone into the hands of our more playful producers and speculators, to create the dot-com boom and the more recent real estate and Wall Street bubbles. Why work for a living when you can make more money so much more easily by playing poker?

The Fed's major booboo in economic analysis stems from--well, first of all from their lack of humility, but also from their underlying confusion of the difference between Price Inflation and Monetary Inflation.

What the Fed needs to fight is "inflation" as defined in Webster's dictionary, i.e. excessive money and credit creation; and targeting price stability will just not do the trick.

However, they are bankers, not supermen. We may have given them an impossible task. And if they can't find a modern tool to do a better job, they should reinstate one that has functioned pretty well for centuries, a monetary measuring stick (gold has worked pretty well), so that the market can find money-and-credit equilibrium itself.

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8 Comments:

Anonymous Don Lloyd said...

Katy,

2. [Monetary] Inflation: The rise in money supply, i.e. of money and credit, over and above what the market requires, leading always to eventual price distortions...

Does not the qualification 'over and above what the market requires' make the defination both invalid and ambiguous?

Regards, Don

7:19 PM  
Blogger Katy said...

I'm not sure I understand your question, Don. Please explain to me how the addition of the "over and above" clause makes the definition invalid and ambiguous, to your way of thinking. As you can see from the Webster's quote, the word "inflation" is defined as "an increase in the amount of money and credit in relation to the supply of goods and services [emphasis added]", or as the rise in prices caused thereby, which in turn causes a loss of purchasing power. Please rephrase your question for me.

11:59 PM  
Anonymous Don Lloyd said...

Katy,

AFAIK, the historical definition of inflation that was accepted before the creation of the FED was an increase in the supply of money, period.

While you can say that an increase in the money supply does tend to reduce the exchange value of the monetary unit, the significance of that change is different for everyone. The belief that the market requires an artificial stabilization of overall prices in general is a large overstatement. It seems likely that attempts to stabilize absolute prices are far more distortionary to the economy as the attempts affect relative prices.

Regards, Don

7:39 AM  
Blogger Katy said...

Don, I'll take your response in separate subparts.

1. "AFAIK, the historical definition of inflation that was accepted before the creation of the FED was an increase in the supply of money, period."

From my reading of the literature, my definition has been in use for many decades, perhaps even before 1913. But we can debate this another time, because this is not my major point.

2. "While you can say that an increase in the money supply does tend to reduce the exchange value of the monetary unit, the significance of that change is different for everyone."

I don't really have an argument here, except to point out that the aggregate loss is profound.

3. "The belief that the market requires an artificial stabilization of overall prices in general is a large overstatement. It seems likely that attempts to stabilize absolute prices are far more distortionary to the economy as the attempts affect relative prices."

If I understand you correctly, we don't have any argument here. I agree that an attempt to stabilize prices distorts the economy. This is exactly what the Fed is trying to do with its "price stabilization" efforts.

So where do we differ? I'm still unclear.

10:45 AM  
Anonymous Don Lloyd said...

Katy,

First of all, we know that, given an existing money, a larger or smaller static quantity of it cannot by itself benefit society.

When we are talking about inflation, we are talking about a change in the supply of money between two different times.

Any attempt to stabilize prices must involve two measurement points, both in the past. But the hoped-for effect must lie in the future, inaccurately (in both level and time) offsetting some effect about which nothing is known. But the choice of the measurement points is arbitrary -- a month back, a year back, or back to 1913. Britain nade this kimd of mistake in the 1920's when it attempted to go back on the gold standard at the prewar gold price. It never makes sense to try to undo past inflation.

Another problem with including market prices in a monetary supply side of inflation is that it inherently depends on changes in money demand. Even if the FED were to create no new money at all, the targetting of the mixed inflation definition means that the FED would have to create or destroy money in response to all sorts of variations in money demand, such as an increase in the use of credit cards or a change in the average payday to payday interval.

Monetary supply inflation should be restricted to supply, and not affected by demand.

Regards, Don

2:32 PM  
Blogger Katy said...

Don, I'm at a loss for words. Thanks for your input.

3:18 PM  
Blogger MC Shalom said...

Sorry, Chairman Ben S. Bernanke, But Quantitative Easing Won't Work.

In a Liquidity Trap although Saving (S) is abnormally high investment (I) is next to 0.

Hence, the Keynesian paradigm I = S is not verified.

The purpose of Quantitative Easing being to lower the yield on long-term savings and increase liquidity it doesn't create $1 of investment.

In a Liquidity Trap the last thing the Market needs is liquidity.

Quantitative Easing does diminish the yield on long-term US Treasury debt but lowers marginally, if at all, the asked yield on long-term savings.

Those purchases maintain the demand for long-term asset in an unstable equilibrium.

When this desequilibrium resolves the Market turns chaotic.

This and other issues are explored in my tract:

A Specific Application of Employment, Interest and Money
Plea for a New World Economic Order



Abstract:

This tract makes a critical analysis of credit based, free market economy, Capitalism, and proves that its dysfunctions are the result of the existence of credit.

It shows that income / wealth disparity, cause and consequence of credit and of the level of long-term interest-rates, is the first order hidden variable, possibly the only one, of economic development.

It solves most of the puzzles of macro economy: among which Unemployment, Business Cycles, Under Development, Trade Deficits, International Division of Labour, Stagflation, Greenspan Conundrum, Deflation and Keynes' Liquidity Trap...

It shows that no fiscal or monetary policy, including the barbaric Quantitative Easing will get us out of depression.


A Credit Free, Free Market Economy will correct all of those dysfunctions.


The alternative would be, on the long run, to wait for the physical destruction (through war or rust) of most of our productive assets. It will be at a cost none of us can afford to pay.

In This Age of Turbulence People Want an Exit Strategy Out of Credit,

An Adventure in a New World Economic Order.


A Specific Application of Employment, Interest and Money [For Economists].


Press release of my open letter to Chairman Ben S. Bernanke:

Sorry, Chairman Ben S. Bernanke, But Quantitative Easing Won't Work.


Yours Sincerely,

Shalom P. Hamou AKA 'MC Shalom'
Chief Economist - Master Conductor
1776 - Annuit Cœptis.

7:51 AM  
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4:53 AM  

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