How Should the Fed Be Looking at Inflation?

by: Old Trader

According to Wikipedia’s History of the Federal Reserve System, among the purposes of the Federal Reserve Bank is:

To manage the nation's money supply through monetary policy to achieve the sometimes-conflicting goals of

* maximum employment

* stable prices, including prevention of either inflation or deflation

* moderate long-term interest rates

It seems to me, at least, that currently, the Fed is focusing solely on the second part of the sentence, “stable prices, including prevention of either inflation or deflation”, while completely ignoring the first part of “stable prices”. Of course, this begs the question of just how inflation is measured. The Fed’s chosen metric is “core inflation”, which excludes such volatile measures as food and energy.

From one perspective, it can be understood why core inflation, which tends to be relatively slow to change would be preferred, since the commonly accepted method of adding or removing stimulus from an economy is via the raising or lowering of interest rates. (For the purposes of this article, I’ll not get into where we are now - forced into the use of QE to stimulate the economy, since rates are already at, or very near, the bottom). If the Consumer Price Index (also known as “Headline Inflation”) were to be used, one might well see interest rates jumping up and down, purely as the result of factoring in food and energy prices.

So, by their chosen metric, the US is NOT suffering from inflation, but as one looks around the globe it would seem that we’re somewhat unique in that regard. Since October 7, 2010, China has been raising rates steadily, in an effort to cool down its economy; Brazil has enacted currency controls in their efforts to stem inflation; and in Tunisia, the government was overthrown because of anger at rising food prices, among other issues. The UK and Trichet, over at the ECB, are both looking at stimulus removal as well for fear of unleashing the inflation “genie” if nothing is done.

More cynical readers will, no doubt, point out the fact that it is in the interests of the US government to understate inflation because of such factors as COLA adjustments to Social Security recipients. Another reason, in my opinion, is because of the first item listed in the mandates with which the Fed is charged, the promotion of full employment (typically viewed as an unemployment rate of 5%, considerably below the current number). If a more “aggressive” measure of inflation, such as the Consumer Price Index were used, the prescription called for would be raising interest rates, which typically slows economic activity, putting additional pressure on the employment numbers.

I believe that there’s a viable “middle ground” available that would help bridge the current gap between core and headline inflation, without a resulting “yo-yoing” of the measured rate of inflation because of excessively volatile inputs. It seems to me that a truer measure might be obtained by excluding food from the computation, as is currently the practice for measuring core inflation, while adding in energy costs, which would be added on a quarterly or semi-annual “average” basis to dampen any spikes caused by factors such as weather and/or political events.

The reason that I think it makes sense to remove food from the equation is that in the US (as well as most other developed nations), food represents a substantially lower portion of a country’s population’s cost of living. This is certainly not the case in many, if not most, of the emerging markets.

I’ll readily agree that this would still be a less than “perfect” solution, but a vast improvement of the current situation, which might be likened to a doctor denying that a patient is running a fever because he’s using a poorly calibrated thermometer.

Sources: Reuters, Wikipedia

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.