Really Bad Ideas, Part 5: The Fed Should Have – And Defend – An Inflation Target

by John Rubino, Dollar Collapse:

Central banks in general and the Fed in particular are struggling to understand a world in which they’ve thrown everything they have at the economy without generating “beneficial” inflation. Their confusion can be traced back to some profoundly false assumptions.

Here’s a good overview of the current debate:

 

Fed ‘should defend’ inflation target or risk losing credibility: Bullard

(Reuters) – The Fed needs to mount a clear defense of its 2 percent inflation target and stop raising rates until the pace of price increases strengthens, St. Louis Fed President James Bullard said on Thursday.

 

The central bank risks losing credibility, and perhaps triggering a recession, if it continues to insist on “normalization” and higher interest rates without better evidence that prices are firming, he said in an interview with Reuters.

“If you are going to have an inflation target you should defend it. If you say you are going to hit the inflation target then you should try to hit it and maintain credibility,” Bullard said.

Persistent weakness this year in the Fed’s preferred measure of inflation means “we more or less lost all the progress that we made the last two years” toward the 2 percent goal, Bullard said. Continuing to raise interest rates in that environment “can send a signal to markets that the inflation target is not that important.”

The Fed’s preferred measure of inflation slipped from 1.7 percent in April to 1.4 percent in June, July and August.

Bullard, a non-voter on policy until 2019, said colleagues who blame the decline on large, one-off price moves for some goods and services were too “finely chopping” their analysis, and overlooking the fact technology or some other force is restraining prices. The argument that recent weak inflation is driven by temporary factors is perhaps the dominant view at the Fed, with culprits including major changes in cell phone pricing and the impact of slower-rising Medicaid costs.

“This idea of throwing out the unpleasant number and finely chopping the price index, you get down to a set of prices that barely can be considered representative and I think that is inappropriate,” Bullard said. “Maybe this is temporary, maybe this will bounce back. What I say to that is you want to see evidence…This is going in the wrong direction. And it is not consistent with the stories that the committee has been telling,” of inflation reaching the Fed’s target in the “medium term.”

“If the committee continues to raise rates that could turn into a policy mistake…I think inflation could drift lower instead of higher. I think a misperception about where rates need to be in this environment could possibly trigger recession if it was carried to an extreme.”

Bullard’s comments are a pointed intervention in a debate that is preoccupying policymakers worldwide, and forcing research into and a possible rethink of the way prices are set in the post-crisis world. Bullard himself completely reversed his assessment of inflation more than a year ago, flipping from among the committee’s hawks to now its most dovish.

Some Thoughts And Assertions
An inflation target implies that modest inflation is actually a good thing. This is simply wrong. Inflation is a “stealth tax” through which governments confiscate a bit of savers’ wealth each year without admitting it. If explained honestly such a trick would be a political loser always and everywhere.

Nor do rising prices increase growth or reduce debt. Just the opposite. Knowing that a currency is going to depreciate because the government has promised to make it so, rational citizens borrow as much money as possible since they’ll be paying future interest in ever-cheaper currency. This leads to what mainstream economists define as “growth” but is actually just 1) pulling future consumption into the present at the cost of lower consumption in the future and 2) malinvestment, as businesses, seduced by artificially-low interest rates, start projects that wouldn’t pass muster if the cost of money was realistic (that is, determined by market forces). So the quality of the capital stock declines over time and productivity falls.

The result: A system where the amount of debt soars, the amount of bad debt rises as a share of total debt, productivity growth slows and the inflation needed to generate future “growth” rises steadily. Governments are then forced to push interest rates ever-lower and eventually negative, which drains savers’ capital even more aggressively and tricks businesses into even more extreme malinvestment. Sound familiar?

An inflation target implies that economists can actually measure the phenomenon. This is also false. Right now, governments create an official inflation number by arbitrarily including some things and excluding others – like stocks, bonds, and house prices. The latter “assets” are for some reason assumed not matter to “the cost of living” when in fact they matter greatly. And many of them are soaring. As the following chart illustrates, stocks and junk bonds are up over 200% since 2009.

Inflation-distribution-Oct-17.jpg

If you’re trying to save and invest, soaring financial asset prices make that process vastly more expensive, which is one definition of inflation. If you’re trying to find a decent home for your family, soaring home prices either make this impossible or squeeze out the other crucial things like health care, high quality food and good schools. Which is also a form of inflation.

Here’s a former central banker (funny how the former ones always seem to make more sense) on this subject:

 

Inflation isn’t low, it’s just hiding in the stock market: ex-head of Bank of Israel

(Fidelity) – Inflation is not really low, nor is its cause a mystery, Jacob Frenkel, the former head of the Bank of Israel said Friday.

 

The culprit is the global central banks, said Frenkel, who is now the chairman of JPMorgan Chase International.

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