Target for Inflation: 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 U.S. 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."

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.

Comments

[User 334156:]

Good Artical. Politics and Economics have minced words for so long nobody can really understand what is being said.

I feel the root of our current problems is in the mid 80s-early 90s. When computer technology allowed for vast, vast improvements in manufacturing efficencies of all kinds. In reality prices should have been *falling* for almost everything during that time period, as they should still be doing now.

Instead following a 'CPI stability' montra, the central bankers were forced to increase the money supply to maintain numerical 'price stability' against the natural efficency improvements. The fantastic increase in available money of all kinds, lead to the artificial growth and speculative bubbles that those same central bankers arenow trying to re-inflate.

Jan 09 08:38 AM

[TripleG:]

Going back to the gold standard would be a nice idea but it will never happen. There are too many interests in paper currency, trading currencies, manipulating exports/imports, etc.

Jan 09 09:15 AM

[Smarty_Pants:]

"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"

Yes. Some might even think it was deliberate.

What most don't realize is what economic destruction results from the continued issuance of paper money beyond the value of true goods. One need only look to history for instructive examples:


[The] adventure in paper money ended badly for France in general and the monarchy in particular. On September 29, 1790, another 800 million [paper] assignats were authorized. By 1791 another 600 million were run off.

In 1791, mobs stormed the Paris food shops looking for bread. The government imposed price controls with the threat of the guillotine for any merchant not in compliance. The French state decreed that any person selling gold or silver coins, or making a difference in a transaction between paper and gold, would be imprisoned in iron for six years.

By May 1794, any person who even asked if payment was to be made in gold or paper was subject to the death penalty.

By 1796 the situation was in such chaos that the French burned all their paper money and the means of [its] production:

“on February 18th, 1796, at nine o’clock in the morning, in the presence of a great crowd, the machinery, plates and paper for printing assignats were brought to the Place Vendome and there, on the spot where the Napoleon Column know stands, these were solemnly broken and burned.” (Andrew Dickson White, Fiat Money Inflation in France.)

So the French turned to ... gold ... and for a century prospered on a full gold standard.


Note that these events were occurring during the years when our Constitution was being written. Small wonder that many quoted from our founding fathers can be found referencing this topic. They had their own Zimbabwe scenario unfolding in France and had enough sense to realize the proper cause and effect. Small wonder that the Constitution requires States to accept only gold and silver as means of payment.

The abandonment of that requirement by the US and the establishing of the Federal Reserve will prove to be the source of great distress for our country, as it was for France in the 18th century.

For readers out there who insist that a full gold backed system won't work, I would suggest they re-read and consider the experience of 18th century France.

"for a century [they] prospered on a full gold standard."

Jan 09 10:27 AM

[SW Richmond:]

Price stability is essential for an economy to function. Any look at a FOREX chart shows just how fickle is the trust that's placed in fiat currencies.

Jan 09 11:03 AM

[moonbat1775:]

Consider a money backed by common stocks in certain companies. As those companies prospered the money would increase in value. Now consider that if the bank that issued that money lent it to those companies it would in effect be investing in the value of its own money. So, instead of a stable money as in one backed by gold, we would now have appreciating monies backed by equity. The monies would not be limited in value or quantity since the stock in new companies could be sold to the bank to purchase new money. Click on MyWebsite for an example of such a bank.

One objection raised is that equities are too volatile to be used for backing money. However this is a result of fractional reserve banking (FRB). A stock market based on 100% reserve equity backed monies would be stable and not subject to the deflation inherent in FRB.

Jan 09 11:29 AM

[Smarty_Pants:]

In days of old, when coins were gold,
And fiat not invented,
All paid in cash from their saved up stash,
And both parties were contented.

In days of old, when coins were gold,
There was saving before lending,
Before the loan, the gold was shown,
There was no "gold-pretending".

Jan 09 12:02 PM

[jaycey:]

The reason, IMHO, for stabilizing prices rather than money is because there are serious income transfer issues for borrowers vs lenders if prices fluctuate unpredictably. The economy needs price stability to encourage investment.

Any discussion of our bubbles that doesn't take the US trade deficit into account isn't worth the pixels it's printed on. The root cause of our bubbles is the trade deficit--the war between the (US) militarists and the (Asian) mercantilists. We're not going to solve any problems until we start talking about the right things!

www.telegraph.co.uk/fi...

Jan 09 05:16 PM

[Naive:]

Gold = depleating resource (limitted future supply)
+
World population = growing (unlimitted future demand)

Result = Disaster

Jan 10 12:53 PM

[Dave Wrixon:]

The issue has got very clouded.

What needs to happen is that Fiscal and Monetary Policy need to be coordinated to prevent either overheating or excessive cooling of the economy.

Much of the problem is that the central banks took their eye off the ball. Fixated with consumer price indexes which were grossly distorted by cheap imports from emerging economies, they just lost the plot.

The most pragmatic approach would be to cobble together an empirical index of indices that targets the wider picture of economic momentum. To be totally effective this should focus on leading, not lagging indices, so policy adjustments are made in real time.

Many of the straw poll data that comes well in advance of government statistics is going to be the most useful. For example loan approvals are much more useful indicators of house price moment than the official government stats, which by the time they are issued are of more interest to archaeologists and historians than economists.

Jan 11 04:56 AM

[Dave Wrixon:]

And the Truth.....

Fiat money systems presaged the longest period of political and economic stability in our history, and resulted in unprecedented technological advancement.

Yes, the central bankers and politicians screwed it. Nothing new there.

The Gold Standard did not work back then and it sure as hell ain't going to work now. Even if you were made World Dictator tomorrow, You could not make it work.

What we are actually looking at here is a pump and dump operations. Vested interest who have bought gold simply trying to hype it to dump back on to the naive and gullible.


On Jan 09 12:02 PM Smarty_Pants wrote:

> In days of old, when coins were gold,
> And fiat not invented,
> All paid in cash from their saved up stash,
> And both parties were contented.
>
> In days of old, when coins were gold,
> There was saving before lending,
> Before the loan, the gold was shown,
> There was no "gold-pretending&a...

Jan 11 05:04 AM

[Dave Wrixon:]

And the bottom line.....

If there were a Gold Standard today, it wouldn't be the yellow metal. It would be much more likely to Oil or Energy in general, Real Estate or even Carbon Permits.

Money needs to be backed by what makes the World goes around. At the moment that commodity seems to be Debt, which is why we have Fiat.

Jan 11 05:09 AM