If I were a central banker, I would be afraid.
If I were a central banker getting ready to embark on another round of quantitative easing, I would be very afraid.
Here’s why. Central bankers in the U.S. are being bombarded with market-based signals suggesting their fears of deflation, or falling economy-wide prices, may be misplaced.
Gold prices continue to set new highs. The U.S. dollar, the global reserve currency, keeps sinking amid expectations the Federal Reserve will dilute the existing stock starting at its Nov. 2 to 3 meeting.
Commodity prices, both industrial and agricultural, are on a tear. The CRB Spot Raw Industrial Price Index, which includes scrap metals, cotton and rubber -- but not oil -- hit an all-time high this week.
Junk bond issuance already set a record for the year, with demand for high-yield debt narrowing spreads to Treasuries. Investors are pouring money into emerging markets debt issued in local currencies by countries that used to be considered banana republics. Mexico sold $1 billion of 100-year bonds last week, double the announced issue size, at a yield of 6.1 percent. Just ask yourself: Would you lend money to Mexico for 100 years? Exactly.
If the Fed’s goal was to make investors move out the risk curve, it succeeded. An alternate interpretation: Zero-percent interest rates are causing a misallocation of capital, a nice way of saying, “asset bubbles.”
The markets aren’t validating the Federal Reserve’s preoccupation with a deflationary spiral. In fact, the message is just the opposite.
And why not? The Fed has told us inflation is below the level it considers consistent with maximum employment and price stability. For the record, various measures of inflation show prices rising anywhere from 0.9 percent to 1.5 percent on a year-over-year basis.
As a general rule, if a central bank wants higher inflation, it gets higher inflation, sometimes more than it bargained for. Inflation is a monetary phenomenon -- something easy to forget amid the preoccupation with inflation expectations -- and the Fed is the proprietor of the U.S. dollar printing press.
After 30 years of price stability uber alles, the Fed now wants us to believe that it wants higher inflation (wink-wink, nudge-nudge)?
Fed Sharp Shooters?
And that’s not all. We’re asked to believe the Fed can hit a precise inflation target. (How’d that money supply targeting work out in decades past?)
“If inflation in 2011 were a 0.5 percentage point below the Fed’s inflation objective, the Fed might aim to offset this miss by an additional 0.5 percentage point rise in the price level in future years,” New York Fed President Bill Dudley said in an Oct. 1 speech.
To invoke price level targeting -- stabilizing the price level, or the consumer price index, not the percent change in the CPI -- at this point is disingenuous at best and dishonest at worst.
Take a look at the upward sloping CPI, even during the Great Moderation starting in the mid-1980s, and you will see the price level is anything but stable. The U.S. dollar buys less than half of what it did in 1982-1984, according to the Bureau of Labor Statistics.
For more than 40 years, the price level has been rising, year in, year out. And now policy makers want to compensate for what they claim is a one-year undershoot in the rate of change in the CPI?
That’s only part of the Fed’s strategy, as outlined in the minutes from the Sept. 21 meeting, released Tuesday.
With the benchmark rate already near zero, “an increase in inflation expectations lowers short-term real interest rates, stimulating the economy,” according to the minutes.
What about lowering real long-term rates, the Fed’s motivation for QE2? For that to happen, nominal rates would have to stay stable, which is fine for a textbook but not in the real world, says Jim Glassman, senior U.S. economist at JPMorgan Chase & Co.
Lost in Translation
Perhaps Fed chief Ben Bernanke will sort through this tortured logic when he speaks about monetary policy in a low- inflation environment at a Boston Fed conference today. Here’s the Cliffs Notes version to help in translation:
“You know the Fed is committed to price stability in the long run. In the short run, we want you to think that we want higher inflation, which we really don’t and don’t intend to deliver. Just believe what we say, not what we do, and everything will work out fine.”
Every time policy makers talk about inflation expectations, I want to know just whose expectations they are targeting. The man on the street? The 14.8 million Americans who are unemployed? Small businesses, which are more concerned about the rising cost of health care and taxes than higher prices? Or is it bond traders’ expectations, reflected in the price of Treasury securities? The Fed never makes that clear.
These Fed folks and their academic acolytes need to step away from their models and get out in the real world. (For an alternative view of inflation expectations, see my March 2007 survey.)
Maybe the Fed can fool some of the people some of the time, but it can’t fool all of the people all of the time. In the process, policy makers may end up fooling themselves that they can create expectations of a little more inflation without delivering a lot of the real thing.
(Caroline Baum , author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)
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