“I would argue that the Fed already has reached its 2% inflation target where possible, namely in the service economy. It is unrealistic to expect monetary policy to raise prices as rapidly for goods…

…Because the Fed is using a faulty index to measure inflation, it is not formulating effective monetary policy. The consequences include confused expectations, discord within the Federal Open Market Committee, and a loss of credibility as inflation targets are continually missed—as they have been since the 2% goal was officially adopted in early 2012. Instead of forecasting that the core PCE index will increase to 2% in the “medium term” (2018), the Fed ought to develop a new price index. It should include components whose prices are sensitive to monetary policy and exclude not just food and energy but all goods whose prices are dominated by independent factors of supply.”,Robert F. Stauffer, “The Fed’s Mismeasure of Inflation”, The Wall Street Journal, February 5, 2016

Opinion

The Fed’s Mismeasure of Inflation

The 2% target rate has been reached in services, but monetary policy will do little to raise goods prices.

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The Federal Reserve in Washington, D.C. PHOTO: GETTY IMAGES

By Robert F. Stauffer

While the Federal Reserve approved a small increase in its target interest rate in mid-December, last week the Federal Open Market Committee voted against any further rate hike. The Fed’s press release noted that inflation remained below 2%—and the minutes of the December FOMC meeting indicate that some members are still very concerned over the low rate of inflation. This guarantees that decisions to further hike rates will be contentious and slow.

But concerns about too-low inflation are misguided. The Fed needs to recognize that its power to increase the rate of inflation is significantly limited. Specifically, it needs to carefully consider the factors of supply that are restraining price increases in the markets for goods—as opposed to services, which are more sensitive to monetary policy and where inflation is basically on target.

Consider the price index for durable goods—appliances, consumer electronics, furniture, automobiles and the like. From 2000 to 2015 the average annual change in the index was minus 1.88%, according to the Bureau of Economic Analysis; since 2008 it has been minus 1.65%; and since 2011, minus 1.88%.

Durable goods account for 10.8% of consumer spending and about one-third of all goods. Competition is strong, from imports, domestic discounters and growing online sales. These market forces restrain price increases while providing incentives to reduce costs by increasing productivity. The major macroeconomic result is to lower overall inflation.

The competition restraining these durable-goods prices is clearly beneficial. Yet many monetary economists, including some at the Fed, will nevertheless demand perpetual near-zero interest rates to counter imaginary “bad deflation”—a decline in prices caused by a collapse in aggregate demand.

Hyper-accommodative policies, however, will do little to change price trends in goods markets. Some may argue that continued easy money will weaken the dollar and put upward pressure on the prices of imported goods. This is a valid point, but it will have only limited effects on the prices of goods overall.

The Fed’s preferred yardstick for inflation is the core Personal Consumption Expenditures Index. The PCE does exclude two major categories of goods: food and energy, which account for about 9% of all consumer spending. The usual justification for removing food and energy from the index is their price “instability”—a somewhat vague criterion that seems valid for energy but less obvious for food. Yet durable-goods prices have declined for 15 years due to factors beyond the Fed’s control, and they remain included in the core PCE.

The Fed would be much better served by excluding from its index product groups whose prices are mainly determined by the supply factors discussed above. This would include energy, durable goods, clothing and footwear (under non-durables), and probably most other components of the goods category (accounting for about 32.5% of consumer spending).

On the other hand, the prices of services—a broad group that includes housing and utilities, health care, and finance/insurance—have increased relatively consistently: From 2000 to 2015 the average annual change was 2.61%, versus 0.54% for all goods; since 2008 it has been 1.92%, versus 0.06% for goods; and since 2011 it has been 2.23%, versus minus 0.63% for goods.

Competition in services is limited: many are highly differentiated, and customers often have poor information on prices and quality. Comparison shopping online is more difficult than for goods. The power that sellers of services have over their prices allows monetary policy to have more influence. If the Fed can help engineer increases in demand via easy-money policies while promising future inflation of around 2%, sellers will tend to increase prices consistent with that target.

I would argue that the Fed already has reached its 2% inflation target where possible, namely in the service economy. It is unrealistic to expect monetary policy to raise prices as rapidly for goods.

Because the Fed is using a faulty index to measure inflation, it is not formulating effective monetary policy. The consequences include confused expectations, discord within the Federal Open Market Committee, and a loss of credibility as inflation targets are continually missed—as they have been since the 2% goal was officially adopted in early 2012.

Instead of forecasting that the core PCE index will increase to 2% in the “medium term” (2018), the Fed ought to develop a new price index. It should include components whose prices are sensitive to monetary policy and exclude not just food and energy but all goods whose prices are dominated by independent factors of supply.

Mr. Stauffer is an economics professor emeritus from Roanoke College in Salem, Va.

 

Posted on February 9, 2016, in Postings. Bookmark the permalink. Leave a comment.

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