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Economy in Brief

Monetary Policy Is Not in A "Good" Place
by Joseph G. Carson ([email protected])  November 12, 2019

Policymakers have become enmeshed in the "politics of their numbers" and mistakenly see an inflation shortfall when in reality it's a policy problem.

Monetary decisions nowadays are based on a single price gauge that is not fully market based or widely used. Seemingly unaware of the inaccurate inflation premises that rate decisions are being made on, policymakers are at risk of compounding the policy error by thinking monetary policy needs to get more accommodative to achieve its inflation target.

Misstep in policy decisions can separate finance from the economy, creating imbalances, and result in bad outcomes.

Federal Reserve and Inflation Statistics

Twenty years ago the Federal Reserve made a curious switch in its preferred inflation gauge when it stopped publishing consumer price (CPI) forecasts and began to frame inflation forecasts in terms of the personal consumption (PCE) price index.

The decision to switch was based on the view that the PCE index was superior because it involved a more comprehensive measure of consumption and also captured the changing composition (substitution) of consumer spending. Only half of that is true, and not in the "good" ways that policymakers were led to believe.

It is true that the PCE price measure is derived from a much broader measure of consumer expenditures as it includes the purchases made by the consumer (which is what the CPI covers) but also purchases made on the behalf of the consumer, by businesses and the government. Yet, the broader inclusion of goods and services not purchased by the consumer creates a problem for price measurement for the simple reason public goods are not "sold" to the consumer, and therefore, government statisticians have to "make-up" prices.

According to the Bureau of Economic Analysis (BEA), the government agency that publishes the PCE price index, about 70% of the PCE price index is based on CPI prices (or the inflation consumers actually experience), another 12% is based on business prices, and the remainder includes various input costs and non-market prices tied to public goods and services or items given or transferred to the consumer by businesses and the government.

Also, the notion that the PCE price index is a superior index because it captures shifts in consumer spending patterns (or substitution from one item to another) in a timely manner is simply false. The detailed product data do not exist in real time for BEA to capture shifts in spending patterns.

BEA bases the vast majority of the product distribution of PCE expenditures on a product to industry ratio from the economic census, which is released every 5 years. BEA does get some detailed product purchases on annual basis, but even here the data arrive a year after initial publication of the PCE price index and the scale of these data are far too small to swing the PCE series one way or the other.

Why Does All of This Matter?

In 2019, policy decisions based on PCE or CPI rules called for dramatically different rate outcomes. For example, the PCE index, excluding food and energy, increased 1.6% in the past 12 months and has been consistently below the Fed's 2% target for the past several years. The persistent low PCE readings pressured policymakers to cut official rates, resulting in three cuts over the past several months, and also came with a promise by the Fed chair to hold rates steady until PCE inflation moves higher.

Yet, on the flip side, if policy decisions were strictly based on the CPI it is reasonable to conclude that official rates would have been held in check or increased as was the initial intention of policymakers at the outset of 2019. To be sure, the comparable CPI measure increased 2.4% rate in the past 12 months, the highest rate since 2008 and changes in this price gauge has been near or above the 2% target for the past several years.

Conceptually correct and statistically accurate price measurement is fundamental to monetary policy decisions. The PCE price measure is not a superior index, nor is it widely used like the CPI for inflation indexation in private contracts, Treasury securities, and the tax code. Policymakers pin their rate decisions on a price index that only they use.

Misstep in rate decisions could push finance far ahead of the economy, creating an unstable balance. Policymakers' problems nowadays are centered in the growing and unsustainable gap between finance and the economy and not as they see it in the inflation data. Recent rate cuts have made the unstable balance more uneven, raising the odds of a bad outcome.

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