Is anyone at the Fed watching the TIPS? *****Update 6/24/09*****

I just wanted to let you guys know that I am having increasing problems with computer viruses.  Some of you have noticed span in the RSS Google reader.  I have also lost my links information, and now I have lost my ability to write new posts.  The reason for my “Drudge-like” attention-getting update is that since I can’t post anything new, my only way to contact you is by amending existing posts.  I have been working on a new post, one of my “grouchy” ones, but can’t post it yet.  Instead I’ll complain about today’s Fed action, or should I say lack of action.  The S&P fell about 8 points right after the 2:15 announcement.  The 5-year TIPS spread is now back down to 1.42%.  Where’s that hyperinflation everyone on the right keeps promising us?  And by the way, where’s that global warming Al Gore promises?  I’m not comfortable unless it’s at least 85, and it’s been in the 60s in Boston this summer.

Seriously, I have no reason to doubt the science on CO2 and global warming, but the real action is in the economics of global warming.  The new Journal of Economic Perspectives has 3 interesting pieces on the subject.  One thing I took away is that the apocalyptic visions being made of extreme global warming just won’t happen.  I predict a maximum of 2 more degrees centigrade.  Geoengineering is for real.  I’d like to know more about how serious the problem of ocean acidification from CO2 really is—it could become a key issue.  And also more research on the possibilities for technologies that remove CO2 from the air at remote locations where it can be buried.  My hunch is that we’ll try to create clouds from sea water at higher latitudes if temps threaten to rise more than 2 degrees, and then work on a technology to remove CO2 already emitted in the second half of the 21th century (to deal with the ocean acidification problem.)  If I am right, that’s tilts the argument away from Stern’s more ambitious agenda, toward Nordhaus’s less costly approach to the problem.

BTW, I’m told that tomorrow morning my debate with Lee Ohanian (on the issue of deflation/inflation) will begin on CBSMoneyWatch.com.  It will be a three part debate.  Sorry for all the problems here, and thanks to those who have stayed around despite the problems.  I think Austrian economists may like the next post.

Let’s take a look at inflation expectations since the stock market (and TIPS spreads) hit a low in early March:

Date    5 year TIPS yields   5 year T-bond yield   TIPS spread    S&P 500

3/9/09         1.52%                       1.90%                 0.38%           676.53

4/1/09         0.93%                       1.65%                 0.72%           811.08

5/1/09         1.24%                       2.03%                 0.79%           877.52

6/1/09         1.02%                       2.55%                 1.53%           942.87

6/10/09       1.08%                       2.93%                 1.85%           939.15

6/19/09       1.23%                       2.80%                 1.57%           921.23

6/22/09       1.23%                       2.70%                 1.47%           893.04

We had a nice run up in the spring, as higher inflation expectations were associated with higher equity prices.  I don’t know the cause of this.  It might have been the pickup in Asia, especially China, and it might have been partly due to quantitative easing by the Fed.  But from the moment the Fed announced its QE policy I argued that it was inadequate.

A recent article on Yahoo discussed a bearish World Bank report on the world economy.  It looks like the pickup in Asia is not being seen in other areas.  Of course slow growth could be due to either less AD or less AS.  But if you look at the way commodity prices and inflation spreads responded to today’s report, then I think it’s pretty clear the markets are still very concerned about weak AD.  See what you think:

NEW YORK (AP) — Expectations of a weaker global economy are giving stock investors more to be wary about.

Major stock indexes retreated by more than 2 percent Monday, sending the Dow Jones industrial average to its lowest level this month after the World Bank estimated the global economy will shrink 2.9 percent in 2009. It previously predicted a 1.7 percent decline.

Deteriorating hopes for a quick economic recovery also weighed on the prices of oil, metals, and other commodities. Those commodity price drops in turn sent energy and metal producers’ shares falling.

. . .

The Federal Reserve will also be in the spotlight after its two-day meeting on monetary policy that ends Wednesday. The central bank is widely expected to hold its key funds rate steady near zero, but investors want to know whether policymakers will say the economy is recovering or still in need of aid.

I have suggestion for the Wednesday meeting.  Announce that as of July 1st the 1/4 point interest payment on excess reserves will be replaced with a 1% penalty rate.  This will give banks time to do an “open market purchase” of $800 billion worth of Treasury securities.  As they replace their excess reserves with T-bonds, the reserves will go out into circulation.  It would be QE without the Fed having to add any more risky assets to its balance sheet.

I know that most people will say the Fed has already done too much.  And I imagine some people will tell me (correctly) that the TIPS spread is not always reliable.  It doesn’t always measure inflation expectations perfectly.  There are liquidity issues as well.  OK, let’s say you’re right.  Let’s say that 5 year T-bond yields have not been falling since June 10th because of lower inflation expectations, rather they are falling because in a depression people want the most liquid asset next to cash—US Treasury securities.  Is that supposed to reassure me?

[PS:  I do know about the problem with the Viagra ads in the RSS feed, and hope to get it fixed soon.  Until then you can simply type the blog address.  Also, I may soon be involved in a couple debates with other economists on the question of inflation fears.  I will let you know.]


Tags:

 
 
 

40 Responses to “Is anyone at the Fed watching the TIPS? *****Update 6/24/09*****”

  1. Gravatar of Alex Golubev Alex Golubev
    22. June 2009 at 14:11

    TIPS may be unreliable and have issue, but they’re good enough to see that deflation is still the main concern and not inflation. So you’re still right in that everythign is pointing to more defaltion and Fed is hogging the monetary viagra, not that i’m for re-inflating. $20 says that we get a new completely impactless acronym to kickoff a shortsqueeze before the month end as opposed to more monetary stimulus.

  2. Gravatar of Alex Alex
    22. June 2009 at 14:42

    “I have suggestion for the Wednesday meeting. Announce that as of July 1st the 1/4 point interest payment on excess reserves will be replaced with a 1% penalty rate. This will give banks time to do an “open market purchase” of $800 billion worth of Treasury securities. As they replace their excess reserves with T-bonds, the reserves will go out into circulation. It would be QE without the Fed having to add any more risky assets to its balance sheet.”

    Scott,

    They can´t do that. They built a dam where they shouldn´t have* and filled it with water. Now the town downstream needs more water. You can´t just blow the dam and let the ranging waters flow down the canyon taking everything with it. You have to open the valves and slowly let it drain.

    Alex.

    * I´ll assume for exposition purposes that you are right and that policy was too tight.

  3. Gravatar of Jon Jon
    22. June 2009 at 19:01

    WSJ one week ago basically claimed stimulus funds are now sloshing around in the markets ‘idle’.

    http://online.wsj.com/article/SB124485077689511459.html

  4. Gravatar of Eric Crampton Eric Crampton
    23. June 2009 at 00:53

    I think that there’s a bug someplace in WordPress for you that’s replacing rss text as viagra spam. Problem is discussed at http://wordpress.org/support/topic/282365 in general. Or am I the only one getting viagra spam when viewing posts in Google Reader?

  5. Gravatar of ssumner ssumner
    23. June 2009 at 03:59

    Alex, Yes, I’m afraid the actions will be merely token moves. With many warning about high inflation, it’s hard to get a big institution (used to compromise) to move aggressively.

    Alex#2, I actually agree, the Fed would have to draw off some water first. I just wanted to show the potential is there, if we use it. The Fed can do some open market sales if necessary.

    Jon, I couldn’t read the whole piece for some reason. Is there anything important that I should know about? The part I could read seemed a bit simplistic.

    Eric, Yes, I mentioned that at the end of the post, I hope to fix it soon.

  6. Gravatar of JKH JKH
    23. June 2009 at 04:29

    Scott,

    I think the following link is a worthwhile read. Although diametrically opposed to your view on reserve interest, it is nevertheless a first rate explanation of the conventional view. I think it is an accurate reflection of the Fed’s view on these things; McCulley is the best at this in my opinion. Unfortunately, he tends to get whipped with the “talking book” charge, obscuring what he actually has to say about money and bond markets. His view is also consistent with things I wrote here earlier on.

    BTW, I would love to read something technical in a Bernanke speech on why the Fed chooses not to charge interest on reserves in this environment, just as a response to the idea.

    http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2009/Global+Central+Bank+Focus+June+2009+Exit+Strategy.htm

  7. Gravatar of More on Interest Rates « The Everyday Economist More on Interest Rates « The Everyday Economist
    23. June 2009 at 06:25

    [...] Scott Sumner looks at the TIPS spread. You will notice that (1) the TIPS spread implies that expected inflation is [...]

  8. Gravatar of Lord Lord
    23. June 2009 at 18:08

    How much of a constraint are exchange rates on their thinking?

  9. Gravatar of Jon Jon
    23. June 2009 at 18:23

    How much of a constraint are exchange rates on their thinking?

    Not at all, if Ben’s views dominate.

    http://online.wsj.com/article/SB124571683373339299.html

  10. Gravatar of al al
    23. June 2009 at 18:27

    Sumner,

    This is off the topic, but I thought you’d be interested in this WSJ editorial:

    http://online.wsj.com/article/SB124572415681540109.html

  11. Gravatar of ssumner ssumner
    24. June 2009 at 04:03

    JKH, I don’t see those pieces as “diametrical opposed” to my view. I don’t disagree with the Bernanke quotation. But he never explains why interest on reserves is a good thing.

    The only obvious problem I see with the author’s argument is the paragraph under the heading “The Present reality”. The huge rise in excess reserves occurred before, not after the fed reduced rates to zero.

    My main arguments have been:

    1. Because of interest on reserves we need not fear high inflation. The author agrees.

    2. We actually need even more inflation, so we should have a lower interest rate on reserves. The author doesn’t offer an opinion on that option, but the logic of his argument (that interest in reserves holds down inflation) would suggest I am right, lower interest on reserves would mean higher inflation. And we need higher inflation.

    I agree that it would be nice to see Bernanke explain why an interest penalty on excess reserves would be a bad idea.

    Lord, Bernanke has indicated that exchange rates to factor much into his thinking. They certainly aren’t preventing him from reflating, as the dollar is much stronger than a year ago.

    Jon, That confirms what I thought.

    Al, I’m not impressed by the WSJ editorial. They act like the 2000s turned out to be a high inflation decade. Wasn’t this the lowest since the early 1960s? I have said many times that Fed policy was a bit too expansionary during 2004-06, but not because of oil prices. The WSJ doesn’t seem to understand that the whole world doesn’t revolve around the US. It was high demand in countries like China that pushed up commodity prices in mid-decade. The Fed should control what it can control, NGDP. I’d be more impressed with the WSJ if they had warned that money was too tight late last year. But all the editorials I have seen in the last few months have been by people warning that high inflation is coming. If they’re such big believers in markets, why don’t they talk about TIPS spreads?

  12. Gravatar of David Pearson David Pearson
    24. June 2009 at 07:36

    Scott,

    Generally I agree, but there is one caveat: the banking system will want more liquidity than its had in the past, even with penalty rate.

    Prior to the liquidity crisis reserves at the Fed were tiny and banks carried carried mostly vault cash of 3% of assets. Cash is now about 10% of banking system assets (Fed H.8 Report).

    So, the question is, how much liquidity do banks need (in their mind, not yours)? Some number between 3% cash and 10% cash. You assume its 3% at a 1% penalty rate. What is the basis for this assumption? Have you calculated the impact on bank profits of holding cash at a 1% penalty?

    Here’s a quick stab: 7% of assets at 1% cost is 7 basis points of cost. What are bank normalized ROA’s given the yield curve? North of 1%? Let’s assume 1.07%, which yields a tidy 1% after the reserve penalty, which levered 10:1 gives us a pre-tax ROE of about 10%. Not bad in a ZIRP environment, wouldn’t you say? And I would argue normalized ROA’s are well, well north of 1% given current lending spreads.

    So 7 basis points of sacrificed profit will flood the banking system with credit? Maybe not…

    One more thing: please recognize that historical cash levels depended heavily, HEAVILY, on accessing liquidity in the securitization markets. Are you are making a call that those markets will again provide liquidity?

    What is the price elasticity of demand for Fed reserves? What about a 5% penalty rate? The fact is we are talking about career risk: insufficient liquidity can get a CEO fired, in this environment, faster than some small profit sacrifice.

    There’s a catch-22 here: the way to reduce excess reserves is to promise banks that the Fed will provide cheap liquidity when needed. Charging a high penalty rate for that liquidity works against this perception.

  13. Gravatar of David Pearson David Pearson
    24. June 2009 at 07:44

    BTW, I wonder, if you are right about excess reserve liquidity preferences at a 1% penalty rate, then…

    …why wouldn’t the banks just run out an buy 1-month t-bills? If they did, what would be the impact on velocity given that the t-bill rate is close to zero already? Is it possible the t-bill rate would again go negative as a result? And would the markets take this as a deflationary or inflationary signal?

    A negative t-bill rate would just expose monetization for what it is: the Fed subsidizing the budget deficit. That is the only way you will get velocity going in an overlevered economy.

  14. Gravatar of Jon Jon
    24. June 2009 at 09:04

    I think a plausible concern about the interest-on-reserves policy is that if the monetization is perceived as permanent, it isn’t clear why the banks would not be enticed to do a yield-curve conversion and loan out the funds at much more attractive long-term rates.

  15. Gravatar of TGGP TGGP
    24. June 2009 at 10:27

    Chris Masse of Midas Oracle has a post on the WordPress hack that results in the RSS feed displaying spam (only through Google reader):
    http://www.midasoracle.org/2009/06/23/wordpress-blog-hacked/

    In a comment to your post “Was Krugman right in 2002?” you asked what role the natural rate of interest plays in post-keynesian theory. As far as I can glean, they do not accept the concept. Barkley Rosser paraphrases Paul Davidson as saying that there no “fundamentals” (or at least ones that can be identified) to be displaced in a bubble.

  16. Gravatar of Jon Jon
    24. June 2009 at 11:47

    Jon, That confirms what I thought

    But are you convinced by BBs argument? IMO, the scenario he discusses: stagnate wages against rising commodity prices is a form of poverty. Its not at all clear that our standard of living depends primarily upon the fruits of lengthy production cycles such BB implies and is the alchemy of the modern CPI calculation.

    He does not seem to see that he’s begging the question.

  17. Gravatar of al al
    24. June 2009 at 18:09

    Sumner,

    I think the Austrians would disagree with you on that one. They would argue that loose monetary policy does not necessarily lead to an increase in CPI (don’t forget the tremendous increase in productivity from the likes of China), but it could still generate bubbles.

    Personally, I find the deflation (monetary contraction) outlook more convincing – though it’s possible there will be short-term inflation surges due to lags in monetary policy.

  18. Gravatar of Current Current
    25. June 2009 at 00:04

    al: “I think the Austrians would disagree with you on that one. They would argue that loose monetary policy does not necessarily lead to an increase in CPI”

    Yes. It may show up in changes in the price of capital and/or changes in capital structure. Neither show up in CPI data and like don’t show up in PPI data either.

  19. Gravatar of ssumner ssumner
    25. June 2009 at 03:48

    David Pearson, The following Fed graph shows no huge spike in vault cash:

    http://research.stlouisfed.org/fred2/series/VAULT

    Maybe I misunderstood your argument. I also doubt that banks need to hold unusually large amounts of ERs today. They have access to the fed funds market. But the most important point is that even if everything you say is 100% true, I would still support a penalty rate on ERs. Instead, I would simply raise the reserve requirement to whatever level you or the Fed thinks banks need to hold in today’s fiancial environment. The point of my proposal (which is discussed much more fully in an earlier post entitled “reply to Mankiw) is to give monetary policy traction at the margin. I certainly don’t want to hurt banks. If necessary, the fed could pay a higher positive rate on required reserves.

    Regarding your second point, I am not trying to reduce T-bill rates (which as you note are near zero) rather I hope my plan will boost expected NGDP growth and hence raise rates. The point is to get cash out of the ER category and into circulation—or if large ERs are needed, assure that any additional OMOs go into circulation. The “transmission mechanism” is not lower rates, it is the monetarist “excess cash balances” meechanism.

    Jon, I’m confused. If the monetary policy is viewed as permanent, banks would expect hyperinflation. In that case why would they want to loan the funds out long term?

    Thanks TGGP.

    Jon, I didn’t know that you were asking me to address his arguments. I don’t think that the Fed can have any long term affect on real wages, so that should not factor into its calculations. Instead it should simply try to stabilize NGDP (or inflation), and let the market determine real commodity prices, real wages, the real exchange rates, etc, etc. Bernanke seems to focus his comments on inflation, not NGDP, but since he also cares about RGDP, we aren’t far apart in our goals. As for his judgment—he was right in his prediction that we would not return to 1980s style inflation. As I’ve said, I think monetary policy was slightly too expansionary after 2003, so I might be somewhere in between the WSJ and Bernanke.

    I probably didn’t fully answer your question. Maybe you could restate it based on my views expressed above.

    Al and Current, Yes, you are right about the Austrians. We had some long debates a few months back.

  20. Gravatar of David Pearson David Pearson
    25. June 2009 at 06:11

    Scott,

    Reserves at the Fed show up as “cash” in the H.8 report. That is what I was referring to, not vault cash. So you might agree that $800b is the “new normal” for cash, in which case the Fed’s 1% penalty rate on that $800b in reserves would just hurt the banks. I agree that raising the RR to that level, and THEN flooding the market with excess reserves, might get velocity going. However, you don’t explain why the banks wouldn’t just buy one month bills with the excess reserves.

    The only way to virtually assure that banks lend the money out is to promise them, credibly, inflation tail risk. This is the one thing that both you and the Fed refuse to do, and its the thing that Krugman has advocated (that the Fed act “irresponsibly”).

  21. Gravatar of Jon Jon
    25. June 2009 at 08:23

    Bernanke seems to focus his comments on inflation, not NGDP, but since he also cares about RGDP, we aren’t far apart in our goals. As for his judgment—he was right in his prediction that we would not return to 1980s style inflation.

    My focus was on his root claim that commodity prices are irrelevant. Although you say he was ‘right’ that we did not experience 1980s style inflation that is premised on having comparables. The much reduced CPI-U of the 2000s relative to the 1980s could be so precisely because it omits those price components that boomed in the 80s and boomed in the 2000s.

    In which case we *did* experience comparable inflation in the 80s and 00s.

  22. Gravatar of Thruth Thruth
    25. June 2009 at 10:38

    Jon: “The much reduced CPI-U of the 2000s relative to the 1980s could be so precisely because it omits those price components that boomed in the 80s and boomed in the 2000s.”

    If we spend less on commodities, why shouldn’t they get less weight in CPI calculations?

  23. Gravatar of Jon Jon
    25. June 2009 at 11:36

    Thruth:

    Its a counterfactual problem. Why did spending shift as you say? The current BLS approach is to attribute the shifts as exogenous relative to inflation; that is, they assume the change is due to shifts in the demand schedule rather than the supply schedule, but why assume this? The BLS says a fixed market-basket overstates inflation because consumers substitute to avoid the inflation, but that statement itself admits that the shift is exogenous.

    Once you internalize what’s going on, you see that the inflationary process is not neutral–not only is it happening more than admitted under BLS CPI-U but it is also effecting the balance of production: shifting consumer demand away from commodity infused goods and into services.

    Moreover, in contrast to prior periods, the shift away from commodity goods is not self-correcting. That is, domestic consumption of commodities is an increasingly marginal component of world-wide consumption. This means that the real-value of commodities does not fall as this process develops.

  24. Gravatar of Jon Jon
    25. June 2009 at 19:26

    Jon, I’m confused. If the monetary policy is viewed as permanent, banks would expect hyperinflation. In that case why would they want to loan the funds out long term?

    Why is it a dichotomy? If I make a one-time injection of money is that hyper-inflation?

  25. Gravatar of ssumner ssumner
    26. June 2009 at 06:02

    David Pearson, You have misunderstood my views. Previously I argued that the interest on excess reserves need not hurt bank profits. It can just be applied only at the margin–you can pay positive interest on required reserves. And I have endlessly argued that inflation targeting (or better yet NGDP growth targeting) is an essential part of making monetary policy credible. Indeed I have argued it is the most essential.

    Krugman’s “promising to be irresponsible” argument is just silly. They Fed needs to promise 5% NGDP growth, and then do it. There is nothing irresponsible about such a policy. But if you take away that silly phrase, then Krugman and I basically agree—the Fed needs to target a higher rate of inflation (or NGDP) than what investors currently expect.

    I have no problem with the banks taking the full 800 billion and buying nothing but one month T-bills. The point is not to boost lending, it is to raise NGDP growth expectations. As long as the banks reduce their demand for ERs then NGDP growth should rise.

    Jon, I just don’t buy that argument. I am old enough to remember when wages would rise at double digits rates. This past decade had no where near the inflation of the 1980s, by any reasonable index.

    Good point Thruth.

    Jon, Our economy has steadily been getting less commodity intensive for at least 150 years. It doesn’t reflect relative price changes, as the relative price of commodities has trended downward.

    Jon, Maybe “hyperinflation” is too strong, but they have doubled the monetary base. If that is permanent, then if we exited the liquidity trap wouldn’t prices quickly double.

  26. Gravatar of Jon Jon
    26. June 2009 at 07:01

    Our economy has steadily been getting less commodity intensive for at least 150 years. It doesn’t reflect relative price changes, as the relative price of commodities has trended downward.

    This argument feels like another false dichotomy. Merely because the monotonicity is the same does not mean that the explanation is the same in all factors. For instance, modern engineering is much more sophisticed. Our understanding of materials and the accessiblility of computer modeling allows us enables us to use less. Consider for instance a 1950s telephone. Its very ‘solid’ but also very heavy. Contrast to your modern cell phone, but by this argument a plastic adirondack chair from walmart is a ‘marvel’. Its so shorn of material that it is on the verge of collapsing yet does not. It uses materials very sparingly. Yet we might agree that the act of using it, of being on the edge and feeling the chair flex, is unpleasant. So when we see such an creation prevade the marketplace is this advancement or poverty?

    I think that sort of counterfactual inquiry is very challenging to answer–and it cannot be answered by failing to detect the signal of commodity prices within the BLS CPI index. As that index is by modern construction one which hardly such a signal. Thus my charge that BB was begging the question. Whether his conclusion is correct (as seems to be your opinion), his logic is wrong.

    Right Answer from Wrong Method => Bad Science.

  27. Gravatar of Jon Jon
    26. June 2009 at 07:13

    Jon, Maybe “hyperinflation” is too strong, but they have doubled the monetary base. If that is permanent, then if we exited the liquidity trap wouldn’t prices quickly double.

    Isn’t it reasonable to believe that the Fed can unwind *some* of the injected base? Therefore only some of the funds will be perceived as permananent.

    Moreover, the inflation assumption is spread over the loan term. If a lot of inflation comes early that gets weighted down over time.

  28. Gravatar of silvermine silvermine
    26. June 2009 at 07:35

    Temperatures have been cooling for years, the Sun is quieter and dimmer than it’s been in 50-100 years. And Mann’s plots are all based on made-up statistical methods that don’t work. But other than that…

    Scientific models in science need to make predictions and they need to be right. Most of the “global warming” predictions repeatly do *not* come true. This shows the model is greatly flawed.

    The models do not model actual matter. They are full of “fudge factors” that are simply just variables that make everything work out right. Seriously. It’s far too common in science these days, and they go over board with them.

  29. Gravatar of ssumner ssumner
    27. June 2009 at 09:50

    Jon, I think we are talking past each other. I didn’t mean that hyperinflation will happen. I agree it won’t. I simply meant that high inflation would occur if the MB increase were permanent.

    And I also dislike cheap furniture fro big box store. But what does this have to do with your argument that the inflationary process is non-neutral. I agree the CPI has lots of flaws, but that doesn’t make inflation non-neutral.

    Silvermine. I am in no position to second guess the scientific consensus. I agree there are lots of flaws in methodology in science, and social science. But again, the best scientific models predict more CO2 should warm the earth. CO2 is rising fast. And most studies show temps rising. Yes, not everyone agrees. As I’ve said I favor temp futures markets, to get a more honest appraisal of what’s likely to happen.

  30. Gravatar of Jon Jon
    27. June 2009 at 15:23

    And I also dislike cheap furniture fro big box store. But what does this have to do with your argument that the inflationary process is non-neutral. I agree the CPI has lots of flaws, but that doesn’t make inflation non-neutral.

    I think several different threads are getting interwoven here. My comments about ‘cheap furniture’ relate to the difficulty in evaluating whether and to what degree commodity prices matter from the perspective of a constant standard of living.

    When Bernanke argues that input-price increases are not ‘inflation’ because they do not correlate with BLS CPI-U, I find that argument circular: CPI-U is constructed with that conclusion as a premise.

    Keynes alleges in the General Theory that inflation can be non-neutral. In particular he argues that ‘labor’ can be deceived into accepting a reduction of real wages by way of an inflationary process. As it happens, unions became increasingly aware of inflation indexing even as Keynes penned the GT. So I think its fair to say that until 1995 or so, this sort of deception was impossible–CPI contained reasonable asset price proxies. But now lets look at present day: CPI is still regarded (socially) as an honest index of inflation. Yet it’s structurally different. Thus even with an inflationary process in motion, wages hold steady being set by the social acceptance of modern BLS CPI-U. Thus finished good prices exhibit very little inflation.

    Neutral of inflation depends on the inflation being perceived and understood. I think its plausible that it is not–precisely because the changes to commonly accepted metrics are poorly understood.

  31. Gravatar of ssumner ssumner
    28. June 2009 at 04:48

    Jon, I don’t agree that wages respond to the CPI, they respond to the actual rate of inflation. I don’t think most workers pay any attention to the CPI, they look at what they purchase. In any case, the supply of labor is fairly inelastic, and the demand (which would not be distorted by CPI errors) has a much greater impact on wages. So I don’t think the recent CPI errors have any impact on wage inflation.

  32. Gravatar of Alex Alex
    28. June 2009 at 06:07

    CPI measure the cost of living, it is the increase in a subset of final goods and services which are supposed to be representative of the consumption bundle of an average individual. Inflation is an increase in all prices: goods, services, factors of production, assets, everything is affected by inflation. Hence when you have inflation you will see it in the cost of living (increase in CPI). But sometimes you see changes in the cost of living that are not caused by inflation but by changes in relative prices.

  33. Gravatar of Jon Jon
    28. June 2009 at 07:37

    Scott:
    As I understand it, union contracts are heavily influenced by CPI. In particular, ‘cost-of-living’ clauses are frequently present which are then indexed off of an official statistic such as BLS CPI-U. My own experiences in non-union wage negotiations is that the company relies on similar data. Deviations from a CPI driven schedule depend on deliberate action by the employee which is quite rare.

    In my experience, employees lack independent knowledge of inflation–whether through official statistics or through personal knowledge. People don’t go through the trouble of tabulating their cost-of-living so precisely–even if they track their spending/budget they usually fail to collect proper information about quantity and quality to ascertain whether costs shifts are inflationary processes or something else.

    Once CPI becomes labor-cost dominated the system would tend to be self-consistent. Also more recently, we’ve had the phenomena of China and India helping pin wage-rates by adopting dollar pegs that influence prices of what they provide (labor).

    The equation of exchange really allows for the possibility that the inflationary process can cluster in certain prices and not in others. This is the very nature of money driven asset-price bubbles. Once you accept that wages are pinned, the inflationary process has to escape *somewhere*.

  34. Gravatar of ssumner ssumner
    29. June 2009 at 10:40

    Alex, The question of which measure of inflation is “best” depends entirely on context. The GDP deflator measures the increase in the price of good produced here, the CPI measures the prices of consumer goods purchased here. Other indices include asset prices. It all depends on why you need a price index. There is no one “right” way to measure prices.

    Jon I don’t think many wage contracts are linked to the CPI, I’d guess less than 10%. And even in those cases there is often an adjustment in the real wage, as the actual pay raise may be higher or lower than the CPI. I just don’t think measurement errors in the CPI affect people very much (except perhps those on Social Security.) people might quite their job because another job pays more, or because they don’t think its worth the effort (in terms of goods they can buy.) But do workers really look at the CPI when deciding on labor supply?

    Second point. There is no theoretically perfect measure of inflation, as economists can’t really even agree on what they are trying to measure. The basket of goods that people buy changes over time. What do you do then? No one can agree.

  35. Gravatar of Jon Jon
    29. June 2009 at 12:55

    Second point. There is no theoretically perfect measure of inflation, as economists can’t really even agree on what they are trying to measure. The basket of goods that people buy changes over time. What do you do then? No one can agree.

    Quite so. That’s the heart of the problem. I nearly think we actually agree.

    Lets revisit Bernanke’s remarks:

    Let me make a few points. First, those on the Street and elsewhere who lately have been worrying about inflation have tended to point primarily to raw materials prices, which have been rising, and to the dollar, which has been falling… The Board staff’s Monday briefing, which I believe has been posted electronically, debunked the importance of the raw materials argument quite convincingly in my view.

    Then without a hint of irony he remarks:

    The briefing includes a graph of the historical data, which shows that even very large movements of raw materials prices … appear to have … no discernible effects at all on final goods inflation. Presumably this lack of inflationary impact reflects the fact that raw materials are only a small part of total costs. …unit labor costs… are far more important in inflation determination than are materials prices.

    And that’s the rub. The study draws upon BLS CPI-U data to support its conclusion, but BLS CPI-U is constructed to gradually exclude goods affected by commodity price inflation, but that’s precisely the hypothesis for which the data is being drawn upon to test.

  36. Gravatar of ssumner ssumner
    30. June 2009 at 11:32

    Jon, Sorry, I missed your argument the first time around. It makes sense, if you are refering to the core rate, which excludes food and energy. Obviously commodities do affect the regular CPI. So which CPI was Bernanke refering to? If it was the core rate you have a good point. But was it the regular CPI?

    I suppose Bernake’s defense would be that he only cares about the inflation index he is looking at, so if commodities don’t affect the only index he cares about, then I see his logic. Then the question is whether he should care about a different index. As you know I favor NGDP, which is different from any index, but tends to pick up bubbles better than the CPI.

  37. Gravatar of Alex Alex
    30. June 2009 at 12:56

    Scott,

    “There is no one “right” way to measure prices.” That was more or less what I wanted to say. If workers look at CPI or not, I would say no in the US. You all know how much your rent, insurance, services, gas, tuition. etc are going up by. Other items like food might be more difficult to estimate because of the wide variety of goods but overall people know how much prices are increasing by. Now in Argentina things are different. When we need to renegotiate wages and rents it is important to have a good estimate of inflation. Unfortunately our government changed the way CPI was computed because rising food and energy prices were making inflation look even worst than what it was, so they changed the basket of goods instead of looking at another index. Now we have a hybrid index which no one knows how it is computed and since the raw data is not available we cannot recalculate the original series.

  38. Gravatar of Jon Jon
    30. June 2009 at 19:15

    I suppose Bernake’s defense would be that he only cares about the inflation index he is looking at, so if commodities don’t affect the only index he cares about, then I see his logic.

    Yes, its certainly fair to pick your index, but I don’t think that makes his position logical… These are scripted remarks so I think it fair to hold him to a high-standard.

    I wonder how ‘political’ the Board is.

  39. Gravatar of ssumner ssumner
    1. July 2009 at 05:07

    Alex, i see your point about Argentina.

    Jon, Some economists really believe the core CPI is the best one (and it excludes many commodities.) And these economists aren’t all political appointees, some are academics. So I am not willing to call him corrupt, but I agree with you that the core CPI has real problems, and misses a lot.

  40. Gravatar of Jon Jon
    1. July 2009 at 19:11

    Sorry, I didn’t mean political in that sense. I mean whether the board is highly technocratic or is there a lot of deal making and grand-standing.

Leave a Reply