Fed chief warned on inflation target

[EJ]

Fed chief warned on inflation target
February 19, 2007 (Krishna Guha - Financial Times)

It would be a "terrible mistake" for the Federal Reserve to adopt any form of inflation target to guide its interest rate decisions, Barney Frank, the Democratic chairman of the House financial services committee, has told the Financial Times.

Mr Frank, whose committee is one of two in Congress charged with oversight of the US central bank, said such a target "would come at the expense of equal consideration of the other main goal, that is employment".

Mr Frank noted that Alan Greenspan, the former Fed chairman, always resisted an inflation target on the grounds that it would reduce his operational flexibility.

AntiSpin: I sense they are going to take all the operational flexibility they can get. Everyone here knows my take on deflation, disinflation, inflation, and hyper-inflation, in the context of a post debt and asset bubble deflation, so I won't repeat it. I will say that as we are editing the debate I had with Rick Ackerman last week for posting here soon (after Finkel this week, and Dr. Hudson after that), it is becoming clear that a confusion of terms that is clouding the discussion.

From the iTulip.com Glossary we have:

inflation : n. (Janszen 2006) 1. to an economist, an increase in the general or "all goods" price level resulting from an oversupply of money; 2. to a government statistician, a political football thrown onto the field as producer and consumer price indexes, continuously reformulated and subject to interpretations invented to suit various constituencies over time, such as the under-reporting of home price inflation via an equivalent rent formula when home prices are rising and rents are falling, in order to hide the fact of a housing bubble that is needed to keep the economy from falling into recession (see housing bubble); 3. to the person on the street, rapidly rising prices of non-traded goods and services, especially insurance, education, and health care, resulting from an excess of cheap credit and the inappropriate use of credit to purchase depreciating assets.

deflation : n. the opposite of inflation, a negative rate of inflation, e.g., "CPI inflation averaged -1.3% in 2007."

disinflation : n. declining rate of inflation, e.g., "CPI inflation declined to 2.1% in Q4 2007 from 2.5% in Q3 2007."

A "little" deflation may in fact be "deflation" technically, but it is hardly an economic catastrophe at the levels Japan has maintained for the past 15 years or so. I have traveled to Japan several times from the tail end of the bubble in the late 1980s when a room at the Hyatt in Tokyo cost me over US$500 to 2001 when the same room went for US$180 to 2005 when it went back over US$500. Economic expansion has been very slow during the period, but did not contract as economies that suffered from severe deflationary depression have, such as in the U.S. during The Great Depression. Traveling in Japan off and on over those 15 years, one did not get the impression of a "poor" country. Far from it. In fact, during the Japanese "lost decade" when the Japanese outsourced manufacturing jobs to the U.S. and, by designing better cars, have been able to take over the automobile industry in the U.S. while the finance economy boomed, and its industrial economy declined.

Keynesian economics says that there are two ways that money is borrowed into existence in an economy: by private sector borrowing (e.g., credit cards, auto loans, mortgage loans), and by public sector borrowing (e.g., purchase of treasury securities by the Fed.) Absent gold reserve constraints, the degree of expansion of the money supply by the Fed via borrowing is theoretically limitless. If private sector borrowing becomes dysfunctional, public sector borrowing can be increased to compensate. Currently the Fed is allowed to monetize U.S. treasury securities. However, the Fed has announced on several occasions that if an extreme case were to arise, several asset classes which are currently restricted, such as mortgages and stocks, may become unrestricted and purchased by the Fed in order to support their price.

Recall that during the most severe deflationary period for Japan, that the Bank of Japan purchased stocks directly on the Nikkei. These were later sold off slowly as the market recovered. The Fed has been clear that it is willing to perform a similar role, if necessary, to support U.S. asset markets, be they real estate, stocks, or some other asset class, depending on the risk their collapse poses to the finance economy and, secondarily, to the industrial economy. The list of potential purchases under extreme conditions ranges from mortgage-backed securities to mortgages to stocks to General Motors' bonds.

The Japanese experience is instructive because it shows how politics and economics combine to produce difficultly predicted results.

Is the Bank of Japan Barreling toward a Bailout?

Now the central bank is under intense pressure from the ruling Liberal Democratic Party and its allies in the Finance Ministry to buy more stocks, plus corporate bonds, and even real estate. Insiders worry about the huge growth in the bank's potential liabilities. Policy Board member Shin Nakahara insists: "There should be a limit to the bank's discretionary purchase of such risky assets."

The bank has already crossed a dangerous line. It has to maintain capital adequacy ratios just like other financial institutions. For the fiscal half-year period ended last September, it didn't: Because Japanese pulled so much yen out of the banking system, the ratio fell below its minimum target of 8%, to 7.6%, for the first time in 12 years.

Hayami, 77, successfully resisted pressure to hit the accelerator on the bank's bond purchases at a two-day central bank meeting beginning on Jan. 21. But his term expires in March, and things could get really radical then. Prime Minister Junichiro Koizumi could tap a maverick--someone who'll make an aggressive effort to counter Japan's spiral of deflation by buying up everything in sight. Morgan Stanley analyst Takehiro Sato says that under such an "anything goes" monetary policy, the central bank could seek to relieve the debt burden of banks and corporations by adding more stocks, corporate bonds, and real estate to its portfolio. The idea would be not only to halt deflation but generate inflationary expectations that would give companies pricing power and prompt consumers to start spending again.

Ka-Poom Theory posits two distinct periods in an asset and debt deflation/inflation cycle. "Ka" is a period of disinflation attended by a decline in the money supply, falling asset prices, contraction of private sector credit, and negative GDP. In the last 2000 - 2001 "Ka" cycle, gold prices declined from around $300 to $250, marking the "ass" of a 20 year long bear market in gold. (Since then, his ass is all we've seen of him.) "Poom" is a period of inflation created by an expansion in public sector borrowing, reductions in taxes, lower short term interest rates, and currency depreciation attended by an increase in the money supply, recovering assets prices, expansion in private sector credit, and positive GDP growth. Executed as intended, the result is as we had in the U.S. economy until mid 2006: increase in the money supply, housing bubble, and positive GDP growth.

To help keep this discussion clear, I propose additional refinements to the terms we use.

debt deflation : n. a decline in the aggregate level of debt carried by all sectors of an economy, private and public. Caused by either 1) debt defaults (abrogation of contracts and failure to pay principle amounts) or 2) accelerated repayment of principle and interest enabled by increased nominal incomes due to inflation in wages and other sources. In the case of debt defaults, the price of assets declines by the price of traded-goods may or may not decrease, and the price of non-traded goods may or may not increase. The price of traded-goods will increase if dollar depreciation is significant. The price of non-traded goods will increase only if wage inflation rises or private sector credit expands to previous levels.

hyperinflation : n. inflation in excess of 100% annually. Created by the conditions of high foreign indebtedness and loss of interest by creditor nations in supporting the indebted nations' currency.

runaway inflation : n. inflation greatly exceeding central bank inflation targets, but not reaching the level of a hyperinflation, less than 100% annually. Examples are Russia 1992-1993 and Mexico 1984 to 1989. Starts when the government must print money to pay fixed expenses that cannot be significantly reduced for political reasons (e.g., salaries to government employees) and when taxes are not sufficient and access to sources of borrowing are not available.

Example: Mexico 1980s

Inflation neared 100% in two years during the inflation, but life went on.


In the grand scheme of things, no big deal.

Can the Fed reflate asset prices to keep the finance economy from descending into a self-reinforcing deflationary cycle without causing a rise in the general price level? In the last instance (2000 - 2007), the answer was, Yes. Can the Fed reflate asset prices to keep the finance economy going without causing a bubble to form in one of more assets? The answer appears to be, No.

Ka-Poom says that politicians will generally take the path of least resistance in a pinch, will choose to limit the political risks of high unemployment over the perils of inflation. Barney Frank is keeping up the stereotype, but his view is nothing special.

Policy option for discussion: Can the Fed engineer a soft landing for the finance economy and manage the decline in the industrial economy to limit unemployment growth by allowing import prices to rise via dollar depreciation, enabling the carrying cost of existing long term external debt to be reduced via repayment with depreciated dollars, and for the prices of non-traded goods and services to fall with a reduction in demand? Can they keep aggregate all-goods CPI inflation, the sum of traded and non-traded goods, on net, more or less constant?

[Finster]

Re: Fed chief warned on inflation target

Fed chief warned on inflation target...

It would be a "terrible mistake" for the Federal Reserve to adopt any form of inflation target to guide its interest rate decisions, Barney Frank, the Democratic chairman of the House financial services committee, has told the Financial Times.

Mr Frank, whose committee is one of two in Congress charged with oversight of the US central bank, said such a target "would come at the expense of equal consideration of the other main goal, that is employment"...

Yikes. Frank has expressed some pretty good perspectives on executive compensation and corporate governance ("shareholders should be given more say"), but on this he couldn't be more off target.

The Fed can create neither wealth nor employment. It can only debase the currency, and incentivize people to unload it as fast as they can. In the early stages of inflation, this naturally supports employment, but over time it results in impoverishment of the middle class, and ultimately the nation as a whole. All one need do to look for evidence is look at the results in our savings rate, current account deficit, and sinking national wealth.

Then only more yet more inflation can postpone the pain. But like any other drug, eventually it must be stopped and the withdrawal endured, or escalated until it kills.

[jk]

Re: Fed chief warned on inflation target

Policy option for discussion: Can the Fed engineer a soft landing for the finance economy and manage the decline in the industrial economy to limit unemployment growth by allowing import prices to rise via dollar depreciation, enabling the carrying cost of existing long term external debt to be reduced via repayment with depreciated dollars, and for the prices of non-traded goods and services to fall with a reduction in demand? Aggregate all-goods CPI inflation, the sum of traded and non-traded goods, will remain more or less constant.

quoting myself, from another thread

if the fed monetizes, say first by direct purchase of treasuries at long maturities, and even buys gse bonds, they might succeed in dropping mortgage rates but i'm not sure that would be sufficient to restart a bousing bubble. i doubt it, actually. simultaneously the dollar would be dropping and i've got to ask, 'where would the liquidity go?' we might get a dollar carry-trade - low rate borrowing in dollars as well as cash generated via sales of dollar-based debt instruments, with the proceeds going abroad for investment, further weakening the dollar. but it would take quite a drop for dollar based wages here to become globally competitive. i don't foresee much of the liquidity going into wages [any disagreement here would be welcome]. meanwhile oil and other globally traded goods would go through the roof, which means food prices also shoot up. so it's pretty easy to conjecture the u.s. consumer being tapped out paying the mortgage [though arms would get cheaper again], food, heat and transportation.

with incomes eaten up by the basics, less remains for other consumption. So let’s imagine what “core” inflation numbers might look like:
food has a large energy component via natural gas based fertilizers and the costs of running tractors in the fields and tractor-trailers on the roads for transport. Energy is used for both transport and heat, and both food and energy are excluded from the “core” numbers. The large number of empty houses and empty condos will continue to overhang the market, and will be rented to produce some income to defray their carrying costs. Rents will thus be held in check, and owner’s equivalent rent thus restrained. The lack of residual cash to make other purchases restrains price increases for other goods.

Voila! Core inflation is restrained even as the dollar drops like a rock.

p.s. a number of posts in various threads have asserted that the fed would defend the dollar vis a vis other currencies. why should the fed care about the dollar? even conspiracy theorists should know that the big bucks folks have bought things- real estate, companies, art - as well as moving assets abroad. who cares about the exchange rate?

[Uncle Jack]

Re: Fed chief warned on inflation target

"In the grand scheme of things, no big deal."

Right, it's like life; in the end we all revert back to mean (no life). In the grand scheme of things we're all just a blip on the radar.

By the way, I'll be the first to second your proposal for the new definitions, er, refinements.

[Tet]

Re: Fed chief warned on inflation target

From the iTulip.com Glossary we have:

inflation : n. (Janszen 2006) 1. to an economist, an increase in the general or "all goods" price level resulting from an oversupply of money; 2. to a government statistician, a political football thrown onto the field as producer and consumer price indexes, continuously reformulated and subject to interpretations invented to suit various constituencies over time, such as the under-reporting of home price inflation via an equivalent rent formula when home prices are rising and rents are falling, in order to hide the fact of a housing bubble that is needed to keep the economy from falling into recession (see housing bubble); 3. to the person on the street, rapidly rising prices of non-traded goods and services, especially insurance, education, and health care, resulting from an excess of cheap credit and the inappropriate use of credit to purchase depreciating assets.

deflation : n. the opposite of inflation, a negative rate of inflation, e.g., "CPI inflation averaged -1.3% in 2007."

disinflation : n. declining rate of inflation, e.g., "CPI inflation declined to 2.1% in Q4 2007 from 2.5% in Q3 2007."

Inflation is all just a matter of where one wants to put the decimal point. A month ago we have a Fed official state that they can turn a penny into a nickel. Now that's a neat trick, how can he possibly even expect anyone to believe that. A couple of weeks ago I stumble upon Poland not using the Euro and discover that, hell Polaks came up with a plan to cure their inflation beast they simply moved the decimal place four places to the left on their currency in 1990 or so. Hey this certainly saves one from having to count real large numbers. A $10,000 note simply becomes a $1 note, that's a heck of a trick. Now today I'm reading that South America's savior Hugo the Math Wizard Chavez is thinking of pulling the same stunt in a year and he's going to simply move the decimal place on the B0livar three place over to the left. Inflation, deflation all just a matter of the decimal point or more importantly who's fantasy world you choose to live in. For me, I'm going to set out tomorrow and try to steal more from them than they do from me, we'll see how that turns out.

[bart]

Re: Fed chief warned on inflation target

Policy option for discussion: Can the Fed engineer a soft landing for the finance economy and manage the decline in the industrial economy to limit unemployment growth by allowing import prices to rise via dollar depreciation, enabling the carrying cost of existing long term external debt to be reduced via repayment with depreciated dollars, and for the prices of non-traded goods and services to fall with a reduction in demand?

Can you develop the part about "limit unemployment growth by allowing import prices to rise via dollar depreciation" further? Why would generally rising import prices limit overall unemployment?

Overall though, yes it is possible that a soft landing can be achieved. The probability isn't exactly screamingly high though, but with sufficiently good "control" over expectations and a few key indicators it is possible.

Can they keep aggregate all-goods CPI inflation, the sum of traded and non-traded goods, on net, more or less constant?

They've "managed" to keep CPI in range for years now via redefinitions, hedonics, geometric weighting, etc... so my answer is yes. My answer would be different if the question was about the real inflation rate.

[lewman]

Re: Fed chief warned on inflation target

eric,

I might have missed it in a previous post but in your opinion do you think the "ka" phase has already begun or has yet to ?

The way I look at it, while inflation indexes (either CPI as doctored by BLS or "true" CPI computed by the likes of ShadowStats) haven't shown much sign of disinflation, it has been happening in various asset classes (housing prices and most commodities have been falling since last yr ; bond prices even earlier since 03)

it seems to me that the "ka" phase has already started happening. I think when the last major asset class (stocks) starts to fall, the "ka" phase would end (or beginning to end), that would probably have a sizable psychological impact on consumers (as it did in 2000/2001); next consumers close their wallets and as the signs of a potential recession show, and the FEDs once again turn on the spigot, the "poom" phase will begin.

when the FEDs reinflate in 2001, commodities/housing/bonds responded almost immediately and stocks also but with an almost 2 yr delay; the big question is what would be the asset class that will benefit the most ?

Lewman

[EJ]

Re: Fed chief warned on inflation target



Recall that our CPI is a blend of slow inflating traded goods–low cost due to low cost foreign labor and Asian currency pegs–and rapidly inflating non-traded goods and services, especially tuition, medical care, and insurance. If a "compression" of these could be achieved, CPI inflation will remain more or less the same, without radical reconstitution of the indexes.

Dollar depreciation allows the industrial economy to expand, by increasing import costs and the relative cost-competitiveness of domestically produced goods, and by making domestically produced goods more price competitive on foreign markets. This comes at the expense of the finance economy, due to rising interest rates, as foreign lenders demand compensation for the higher dollar inflation premia.

Jobs lost in the finance economy could be compensated for by job growth in the industrial economy.

A lower trade deficit reduces the need for new borrowing to fund it.

Existing debt can be paid off quickly with depreciated dollars.

Problem: The finance economy is now significantly larger than the "real" economy. Job creation in the industrial economy won't be enough to generate sufficient surplus to pay the interest on the debt we already owe, never mind the new debt we need to take on to fund continued fiscal deficits. We need a new asset bubble.

[EJ]

Re: Fed chief warned on inflation target

eric,

I might have missed it in a previous post but in your opinion do you think the "ka" phase has already begun or has yet to ?

The way I look at it, while inflation indexes (either CPI as doctored by BLS or "true" CPI computed by the likes of ShadowStats) haven't shown much sign of disinflation, it has been happening in various asset classes (housing prices and most commodities have been falling since last yr ; bond prices even earlier since 03)

it seems to me that the "ka" phase has already started happening. I think when the last major asset class (stocks) starts to fall, the "ka" phase would end (or beginning to end), that would probably have a sizable psychological impact on consumers (as it did in 2000/2001); next consumers close their wallets and as the signs of a potential recession show, and the FEDs once again turn on the spigot, the "poom" phase will begin.

when the FEDs reinflate in 2001, commodities/housing/bonds responded almost immediately and stocks also but with an almost 2 yr delay; the big question is what would be the asset class that will benefit the most ?

Lewman

"Ka" is happening in the housing sector of the finance economy. However, until a finance market "event" occurs that starts a selling panic in one of the many leveraged asset markets, we will not see a classic "Ka" asset deflation event, nor a dramatic Fed response. In the current inflationary environment–characterized by high commodity prices, especially energy–Fed can only cut rates after a clear and present danger has appeared to justify it to the bond markets. A crash sometime this year, followed by the three 1/4 point rate cuts that Goldman is predicting, is plausible.

[grapejelly]

Re: Fed chief warned on inflation target

Don't worry about it: dollar depreciation is accompanied by increased generation of credit which finances asset bubbles. This is almost inevitable today...I nominate commodities and tangibles as the next "Great Asset Inflation" pick.

[jk]

Re: Fed chief warned on inflation target

Don't worry about it: dollar depreciation is accompanied by increased generation of credit which finances asset bubbles. This is almost inevitable today...I nominate commodities and tangibles as the next "Great Asset Inflation" pick.

commodities, tangibles and FOREIGN ASSETS. mutual fund flows last year were heavily weighted to overseas investments. if the fed lowers rates enough we can get a dollar-carry trade, borrowing in dollars and investing overseas for the income, the capital gains and the currency profits as the dollar continues to trend down.

[Finster]

Re: Fed chief warned on inflation target

Can you develop the part about "limit unemployment growth by allowing import prices to rise via dollar depreciation" further? Why would generally rising import prices limit overall unemployment?

Depreciating the currency decreases real wages and makes labor cheaper. But just for the workers being paid in that currency. Foreigners' real wages are unaffected, so the depreciating currency appears to domestic consumers as "rising import prices".

In the run, it's a self-destructive policy. First of all, it's dishonest, since it relies on the Keynesian ruse of trying to fool people into thinking their wages are holding up when they're being cut. Second, it penalizes saving because the saver's dollars depreciate, and penalizing saving is not exactly what our consumption-heavy economy needs. Third, the amount of currency depreciation to rectify global imbalances is enormous, and the amount of inflation that would be required to deal with them with currency as the only tool would be catastrophic for the middle class.

Want import prices to rise? Tax them. It's not as if the government isn't running deficits. Even if it wasn't, you could use the revenue to cut taxes on domestic production (income taxes) and make trade freer right here at home where we need it most. This would allow you to keep employment strong without cutting wages, and even increase after tax pay, making the American worker better off, not worse. Domestic production would increase, since the rewards for producing would increase. The cost of consuming foreign production would increase, helping to balance the current account deficits that threaten our economic future. You'd also decrease dependence on foreign oil. You'd decrease dependence on foreign funding for our deficits. As our deficits have gotten progressively worse, it’s the policy option that we haven’t tried.

[bart]

Re: Fed chief warned on inflation target

Third, the amount of currency depreciation to rectify global imbalances is enormous, and the amount of inflation that would be required to deal with them with currency as the only tool would be catastrophic for the middle class.

That's the area which I was trying to address. If the dollar dropped 20%+, it would make little overall difference except in a very few segments.

It could be used for expectation control though, and I suspect that's what EJ is driving at... but I'm not at all certain.

[Finster]

Re: Fed chief warned on inflation target

That's the area which I was trying to address. If the dollar dropped 20%+, it would make little overall difference except in a very few segments.

It could be used for expectation control though, and I suspect that's what EJ is driving at... but I'm not at all certain.

Not only that, but the Fed may have to hike rates just to maintain the status quo in the dollar. Looked at the other way, we could get a sizable drop in the dollar if the Fed does nothing on rates. Imagine what may transpire if the Fed actually cuts!

Turning to another line of inquiry, can someone please address why we should be hoping for a "soft landing" in the first place? How did we leave terra firma to begin with?

[WDCRob]

Re: Fed chief warned on inflation target

"Ka" is happening in the housing sector of the finance economy. However, until a finance market "event" occurs that starts a selling panic in one of the many leveraged asset markets, we will not see a classic "Ka" asset deflation event, nor a dramatic Fed response.

I'm curious about whether the collective wisdom of iTulip thinks an all out attack by the US on Iran would trigger this panic?