Joseph G. Carson

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Policymakers are involved in another debate about inflation, but this time its because some think reported inflation is too low, not too high. The new view is not based on any formal review or research. Rather, some policymakers think a consistent failure to hit the 2% price target risks "unanchoring" inflation expectations, resulting in a much lower ceiling on official interest rates than otherwise would be the case, thereby limiting policymakers ability to respond to a weakening economy. As a result, some policymakers have floated the idea that an intentional over-shoot of inflation, or a so-called makeup policy should follow any under-shoot.

One would think a good starting point for this debate would start on price measurement, what’s included and what’s not, as there is no absolute perfection or agreement on how to measure the change in prices. It was not too long ago (mid-1990s) policymakers led by then Fed Chairman Alan Greenspan complained that published price statistics over-stated inflation. That comment started a political outcry for change, the naming of an Congressional Advisory Commission and the issuance of the “Boskin” report---which proposed a number of changes in price measurement, all with the intent to lower the published rate of inflation.

The statistical agencies ended up introducing a number of changes including product substitution, quality adjustments and faster introduction of new goods. There is no consensus on how much these changes reduced the rate of consumer price inflation. Estimates range from a few tenths to as much as two percentages points, and it is unclear if these reductions in the rate of inflation are a permanent feature each and every year, or fluctuate from year to year.

Roughly the same time government statisticians were implementing recommended changes from the "Boskin report" they also decided to abandon the rent series for homeowners and to use the renters rent series for homeowners and the rental market. Research conducted by two Federal Reserve staff economists found this change had the effect of keeping “measured inflation artificially low” during economic expansions. In other words, the findings of the Fed staff concluded that the natural lift to reported inflation from a rise in housing activity during business upswings has been neutralized if not reversed by this change in measurement.

Ordinarily, changes like this would not matter but the combined rent series account for 30% of the overall index. And estimates from the new measurement of housing costs, depending on the status of housing market, range from as a little as a few tenths to as high as two percentage points---or fairly close to the estimates of the proposed changes in the “Boskin” report.

Biases in consumer price measurement of a few tenths of the annual rate of inflation do not matter much when reported inflation is high. Yet, these biases do matter when, as is the case today, reported inflation is low, and policymakers remain puzzled over why cyclical inflation has not been consistently higher.

Controversy over the consumer price index is not new. Back in 1997, then Fed Chairman testified before Congress stating that the aim of any measure of inflation is that it needs to be unbiased. Mr. Greenspan argued "an examination of all available evidence" should be conducted to determine if the current measurement of prices had an equal chance to overstate and understate reported inflation. Mr. Greenspan's concluded based on the evidence at that time there was a 100% probability that inflation was being over-stated. Similarly, one could conclude that based on the research of the Fed's staff on the measurement of housing costs there is a 100% probability that reported consumer price inflation is being understated, and has been for some time.

As policymakers undertake a review of their policy framework it would be prudent to also examine it's key focus, the measurement of consumer prices. The real danger in this debate is that policymakers make a change in policy to address a problem that doesn't actually exist.


Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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Policymakers are involved in another debate about inflation, but this time its because some think reported inflation is too low, not too high. The new view is not based on any formal review or research. Rather, some policymakers think [...]

The New Inflation Debate

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At the January 29-30 Federal Open Market Committee meeting policymakers decided to adopt a “patient posture” arguing that they saw “few risks” in maintaining the current target range for the federal funds. Easy money conditions have created large financial balances that already have the potential to destabilize the business cycle. As such, policymakers face an uneasy trade-off between one economic objective (price stability) and another (financial stability). In hindsight, the decision to risk financial stability may be viewed as a mistake.

Policymakers look at asset prices only insofar as these price movements influence the general inflation trend. That is myopic and misguided on several fronts.

Real estate prices for owner-occupied housing and their cousin “implied rents” were part of previously published consumer price series only to be removed (in 1983 and 1998) when government statisticians argued “bad data samples” biased the accuracy of the measurement. Removing the price signals from the housing market for technical statistical reasons does not mean that real estate inflation is no longer part of the general inflation trend in the economy or suddenly unimportant to monetary policy.

Equity prices, meanwhile, can convey important information about the supply of liquidity, risk-taking and speculation, important factors for policymakers to consider when deliberating on the overall stance of monetary policy.

Asset prices run through the economy and financial markets, creating large gains (and losses during reversals) in nominal wealth to holders of real and financial assets. All of the nominal wealth gains generated during the tech-equity and housing bubbles were lost during the subsequent corrections. In 2018, household financial balances in relation to nominal income hit a new record level, exceeding the peak valuations recorded at the end of the tech and housing bubbles.

The import of large financial balances is not lost on policymakers. At the Federal Reserve Bank of Kansas City symposium at Jackson Hole in August 2018, Federal Reserve Chairman Jerome Powell stated, “in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation.”

Tipping points for asset price cycles can come from a variety of sources or factors. For example, at some point profit rates may fall and not live up to the expectations expressed in equity prices or household may have taken on too much debt and credit markets begin to turn away from extending new loans, or it could come from just a normal tightening of financial conditions.

It is worth noting that as financial balances have gotten larger and larger in relation to income the tipping points have occurred at successively lower and lower levels of interest rates. Official policy rates peaked at 6.5% during the tech-bubble and 5.25% at the peak of the housing bubble. Although it is too early to call a peak in the current cycle there was an alarming “wobbliness” in equity prices in the fourth quarter of 2018 (with prices shrinking nearly 20%) when official rates were only a bit above the 2% mark and perceived to go even higher.

The lower and lower rate threshold suggests the fundamental underpinning for each asset cycle has become weaker and weaker. The fact that equity asset prices were pressured at such a low level of nominal rates is a surprise, but maybe this is one of the unintended consequences of flooding the markets will excess liquidity, via record low rates and asset purchases, for the past decade. At some point, even small reversals in liquidity provisions trigger an out-sized (negative) impact on asset prices.

Downturns can develop from the asset markets themselves, and they can develop quite quickly as evident in the large 1.2% decline in retail sales for December against a backdrop of relatively strong gains in employment and wages.

It is hard to predict what happens next, as easy money "buys" the policymakers time. Yet, the real danger in promising easy money conditions is that it fuels more speculation and risk taking in the asset markets which ultimately threatens the business cycle policymakers are trying to protect. The key question is whether or not this asset price-led business cycle will have a different outcome than the previous two? I have few doubts.


Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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At the January 29-30 Federal Open Market Committee meeting policymakers decided to adopt a “patient posture” arguing that they saw “few risks” in maintaining the current target range for the federal funds. Easy money conditions have [...]

The Fed's Mistake

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It has long been observed that inflation is a monetary phenomenon. The foundation for this observation was developed decades ago when accelerating and decelerating rates of consumer price inflation were associated with similar patterns of growth in money. Nowadays, the concept of money itself is under constant refinement, and money growth is no longer part of the Federal Reserve objectives, which raises an important question, is there a new working theory of inflation?

I raise this question for the simple reason that structural changes in the financial markets coupled with regime changes in the conduct of monetary policy have altered the transmission process of monetary policy in a way that inflation is no longer predictable based solely on money growth nor limited to the standard price measures.

In the past several decades, the US has experienced two fundamentally different types of inflation (or price) cycles, with one associated with fast growth in money while the other form was not, and yet each cycle proved to be a monetary-driven event with similar outcomes.

For example, from the early 1960s to the early 1980s the US economy experienced successive periods of relatively fast gains in consumer prices and all were associated (fueled) with fast gains in money. And, from the mid-1990s to today, the US economy has experienced consecutive cycles of unprecedented gains in asset inflation, fueled by relatively low interest rates, easy credit conditions assisted in part by growth of non-bank banks, and more recently with additional monetary accommodation via the expansion of the Fed’s balance sheet.

Although of a different form, the inflation (or price) cycles had a number of common characteristics. For example, all cycles proved to be persistent as each one had a self sustaining feature as the more and more prices rose it led to the expectations of more price gains, creating an inflationary (or speculation) mindset that was hard to break in the real economy or in the minds of investors. Also, inflation cycles created market distortions, such as allocating too much capital towards inflation-benefitting industries (i.e. commodities) or conversely sending too much capital towards asset-price benefiting industries (finance and housing). Yet the important common feature was that all inflation cycles ended with a bad outcome (recession); although the jury is still out on the current asset-price cycle.

Policymakers confront traditional inflation cycles because inflation feeds in part on itself, creating uncertainty and distortions in the economy and the flow of capital, depriving the economy of reaching its potential and eventually forcing a substantial tightening of financial conditions and a recession to unwind the destabilizing forces. Yet, asset inflation cycles also feeds in part on itself, triggering unbalanced capital flows, wealth inequality, ultimately leading to costly real and financial imbalances that eventually unravel driving the economy into recession.

If both forms of inflation cycles have like outcomes shouldn’t monetary policy view them similarly as they relate to the Fed’s mandates of financial stability, maximum employment and price stability?

Many questions remain unanswered, but perhaps the most important question has already been answered in that asset price inflation has become a new permanent feature of the transmission of monetary policy. Part of this is due to regime shifts in the conduct of monetary policy as policymakers moved from targeting money to targeting real interest rates (consumer prices less official rates) and now directly targeting consumer price indices. Real and financial asset prices are not part of the published prices so their price cycles have been able to run free of monetary oversight. Also, the new policy tool, the expansion of the Fed’s balance sheet, is intended to work through the portfolio channel, directly lifting the price of a broad range of assets.

The new working theory of inflation is that it is still a monetary phenomenon but today’s inflation form is shaped by how monetary policy is implemented. The new targeting regimes has let the real cost of credit for real estate and equity purchases to remain too low for too long, driving fast asset price cycles. Admittedly, asset prices are determined by many factors other than monetary policy, but recent perceived shifts in monetary liquidity (first tighter and then looser) followed by abrupt declines and sharp reversals in equity prices illustrate how closely linked the asset price cycle is to expected shifts in the stance of monetary policy. Policymakers should not ignore these price signals as past asset price cycles have led to bad outcomes.


Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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It has long been observed that inflation is a monetary phenomenon. The foundation for this observation was developed decades ago when accelerating and decelerating rates of consumer price inflation were associated with similar [...]

A New Working Theory of Inflation

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FOMC expects GDP growth above trend over the next three years

US core CPI inflation has begun to reaccelerate

Fiscal-policy aided factory building in the U.S. provided an unusually large boost to growth last year

US consumers much more optimistic than those in the Euro area and the UK

  Job openings take a step down in 2024

Fed's super core services inflation measure pushing up core rate

Blue Chip forecasters expect significant monetary easing this year except in Japan

Euro area economy stagnating while US grows above trend

Chinese and Japanese equity markets are diverging markedly

Chinese population declines in 2023 for second consecutive year

Outlook for US GDP growth on the rise; declining in euro area, Japan and China

There are still 1.4 job openings for every unemployed person in the US

US PCE inflation over the past six months has slowed to the Fed's 2% target

FOMC think rate hikes are done and looks for 75bps of decline in 2024

Weaker economic data surprises pushing down US interest rates

Recent disinflation has been widespread across Europe and North America

Recent decline in US inflation expectations helping to lower interest rates

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Blue Chip forecasters think Fed will be tighter for longer

Systemic stress on rise in Europe, less so in US

Recent increase in longer-term US market interest rates not due to inflation

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Charles Steindel

State labor markets were little-changed in March, but on the whole the report looked better than February’s. Only five states had statistically significant gains in payrolls (Arkansas, Georgia, Kansas, Kentucky, and Virginia), with two having .5 percent increases (Arkansas and Virginia).  The other states, and DC, had insignificant changes, though numbers had point increases comparable to those that were deemed significant. For instance, California had an increase of about 30,000, though that was less than .2 percent, and New Jersey was up around .3 percent.

Six states had statistically significant declines  in their unemployment rates in January, while one had a significant increase. The only move larger than .1 percentage point was a decline of .3 percentage point in Arizona.  The highest unemployment rates were in California  (5.3%), DC (5.2%) and Nevada (5.1%). States with unemployment rates of 4.8% (one point above the national rate)were Illinois, New Jersey, and Washington.   Maryland, Minnesota, Nebraska, New Hampshire, North Dakota, South Dakota, Utah, Vermont, and Wyoming  had rates of 2.8% or lower, with North Dakota at 2.0%.

Puerto Rico’s unemployment rate moved up to 5.8 percent, while the island’s job count moved up by 2,200.

State Labor Markets in March 2024

Paul L. Kasriel

In an April 16, 2024 Bloomberg News article entitled “**[What If Fed Rate Hikes Are Actually Sparking US Economic Boom?](https://www.bloomberg.com/news/articles/2024-04-16/booming-us-economy-inspires-radical-theory-on-wall-street?accessToken=eyJhbGciOiJIUzI1NiIsInR5cCI6IkpXVCJ9.eyJzb3VyY2UiOiJTdWJzY3JpYmVyR2lmdGVkQXJ0aWNsZSIsImlhdCI6MTcxMzM5MTUyNSwiZXhwIjoxNzEzOTk2MzI1LCJh)**”, it is argued that the Fed’s increase in the federal funds rate from 0.08% in March 2022 to 5.33% in July 2023, which, in turn, pushed up other interest rates, stimulated US domestic aggregate demand for goods and services by increasing interest income to holders of fixed-income assets. Wow! This novel hypothesis, if valid, turns monetary policy theory on its head.

Let’s look at some data. As can be seen in Chart 1, there does indeed seem to be some positive correlation between the level of the federal funds rate and the level of personal interest income. For example, when the Federal Open Market Committee (FOMC) hiked the federal funds rate from the beginning of 2016 through the first quarter of 2019, personal interest income moved up sympathetically. Although personal interest income had started increasing in 2014, before the FOMC had begun raising the federal funds rate. Similarly, as the FOMC began hiking the federal funds rate in 2022, personal interest income starting rising, too. So far, so good for this hypothesis that FOMC federal funds hikes raise personal interest income.

240418X1.jpg

But, when we compare personal interest income to total personal income, the story changes (see Chart 2). As the federal funds rate increased in 2016 through early 2019, personal interest income as a percent of total personal income moved up only marginally. In the 2022 through early 2024 period, the ratio of personal interest income to total personal income did move up, but only slightly higher than the level that prevailed in 2020, when the federal funds rate was effectively zero percent, and considerably below the 2019 level, despite a much higher federal funds rate in the more recent period. If higher personal interest income were responsible for the recent resilience in aggregate domestic demand, personal interest income as a proportion of total personal income would be higher. Alas, another beautiful theory spoiled by ugly facts.

240418X2.jpg

Let me offer a different hypothesis as to why US aggregate demand has remained resilient in the face of the FOMC’s federal funds rate hikes starting in 2022. This hypothesis was hinted at by one of my readers, Tague Goodhue, Managing Partner at Pantheon Investments, LLC. A year or so ago, Mr. Goodhue observed that although the growth in thin-air credit (the sum of the monetary base and loans/investments at depository institutions) had slowed dramatically, the amount outstanding of thin-air credit remained exceedingly high, such that the ratio of nominal GDP-to-thin-air credit, or the “velocity” of thin-air credit was comparatively low in terms of the period from the recovery of the Great Financial Crisis up until the Covid negative supply shock. This low velocity on thin-air credit implied that the public’s demand to hold rather than spend the resulting liquid assets created by thin-air credit was relatively high. If I had paid more attention to Mr. Goodhue’s observation I might not have made one of the worst calls of my career, including my retirement. That bad call being that a recession would begin in 2023 because of the precipitous slowing in the growth of thin-air credit. I won’t make that mistake again, just a different one.

As I mentioned, the creation of thin-air credit results in the creation of liquid assets. Plotted in Chart 3 are quarterly observations of thin-air credit (the blue bars) and quarterly observations of households’ and nonfinancial businesses’ holdings of deposits (demand, saving and time) and money market mutual fund shares (the red line). As you can see, starting in Q2:2022 through Q4:2024, the levels of thin-air credit and household/nonfinancial business holdings of deposits and money market mutual fund shares are almost equal.

240418X3.jpg

Now, let’s look at the relationship between the private nonfinancial sector’s holdings of deposits and money market mutual fund shares and private Gross Domestic Purchases (private aggregate demand). This is plotted in Chart 4. It is, in effect, the inverse of a velocity concept. As can be seen, as of Q4:2023, the private nonfinancial sector’s holding of deposits and money market mutual fund shares as a percent of nominal private Gross Domestic Purchases remains high relative to percentage levels in years prior to the Covid negative supply shock of 2022. Thus, the private nonfinancial sector as of the end of 2023 still held an abnormally-high amount of liquid assets, assets that could easily be used to purchase goods, services and assets.

240418X4.jpg

As an aside, the data plotted in Chart 5 show that growth in a narrower variant of thin-air credit has picked up in the past two quarters, including its bank credit component. Could it be that the Fed’s monetary policy has eased in the past two quarters despite the fact the federal funds rate has been held steady at 5.33.

240418X5.jpg

In sum, I would argue that the “new” view on how monetary works, namely that higher federal funds rates are stimulative, is utter nonsense. (I was going to use another term, but this is a family publication). Rather, the massive amount of liquidity that the Fed created in reaction to the Covid negative supply shock has not disappeared in either an absolute sense, but more importantly in a relative sense. This implies that the private nonfinancial sector, at least through Q4:2023, still has excess funds that it can use to purchase goods, services and assets.

Another Beautiful Theory Spoiled by Ugly Facts

The Federal Reserve's persistent use of the 'forward guidance' policy tool, which involves offering forecasts of growth, inflation, and policy rates to influence financial market conditions, is a misguided approach. This tool operates under the assumption that the Fed can accurately predict the future, a notion that is inherently flawed given the unpredictable nature of economic conditions.

In 2023, policymakers used its forward guidance policy tool to signal an end to its tightening policy cycle, thinking it had or would, in time, arrest the cyclical inflation cycle. At the end of the year, it went further, as it offered forecasts for 2024 that promised three official rate cuts.

Yet, in hindsight, forward guidance backfired. Promises of no more rate hikes followed by promises of lower official rates triggered a 100-basis drop in long bond interest rates and double-digit increases in equity prices. The dramatic change towards much easier financial conditions has helped produce economic results that the Fed was not expecting in its forward guidance. (Note: Q1 real GDP growth is estimated at 3%, while core consumer prices rose at an annualized rate of 5%, compared to forward guidance growth estimates of 2% and core inflation of 2.4%).

The challenge for policymakers is how to navigate the modification or discontinuation of the forward guidance policy tool. Forecasts from forward guidance are updated only four times a year, with the next update scheduled for the June meeting. While the Fed chair can provide an informal update at any time, official policy announcements are made at regularly scheduled meetings. A sudden deviation from the last forecast could disrupt the financial markets and undermine the Fed's credibility, if it still has any.

Yet, the problem with "forward guidance" goes well beyond the announcement dates. Policymakers offer forecasts on growth, inflation, unemployment, and policy rates for two years and a longer-run equilibrium level for each. And, regardless of whether current economic conditions are too hot or soft or inflation is too low or high, the Fed's forward guidance forecasts say, through the magic of monetary policy, growth, unemployment, and inflation will gravitate to trend.

Like everyone else, the Fed has had difficulty forecasting what the economy will be like in the next year, let alone in two or three years. Yet, unlike other forecasters, policymakers link an official rate path to its forecasts. That linkage makes official policy more predictable. However, it also creates the potential for a significant easings in financial market conditions, similar to what occurred since late 2023, long before policymakers achieved their intended outcomes.

Policymakers spent time "normalizing" official rates, and now they need to "normalize" their policy statement, making it shorter and with fewer promises. Eliminating forward guidance would also be a positive step because even though it implies "it all depends," it still drives market expectations of official rates.

The Fed's "Big" Mistake---- Continuing to Use Its Forward Guidance Framework As A Policy Tool

Viewpoints: February 2019

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The New Inflation Debate

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