May 18, 2006

A Monetary Policy Double Standard

This may sound like a naive question from someone who, for better or worse, just doesn't understand things the way most economists do, but why should contemporary U.S. monetary policy deemphasize rising energy prices while at the same time placing so much importance on falling prices of imported goods from Asia?

While Fed policy may affect the demand for these goods, they have virtually no control over the supply side of the price equation, yet one is important in formulating monetary policy while the other is not nearly so.

Rising Energy Prices

Energy prices have been soaring in the last year or so and Herculean efforts have been made by the financial media in general, and economists in particular, to distract attention from the 21 percent rise in the price gasoline and other increasing energy costs by constantly pointing to the "core" CPI which excludes these items.

Phrases like, "there is little evidence that rising energy prices are feeding into core inflation" are often heard as "core inflation" continues to hover around the benign level of two percent. Though this measure has been rising recently, this movement has been widely attributed to a rise in the nefarious owner's equivalent rent component, squashing early speculation that rising energy costs were the culprit.

The theory with the "core rate" is that it is somehow a better indicator of "underlying inflation", whatever that is. Consumers have enough "regular inflation" in their face every time they fill up their tank or write a check to their doctor - they probably don't want to hear about "underlying inflation".

The original purpose of the "core" CPI was to strip out volatile components that caused wild month-to-month fluctuations in the price indices but this could be readily accomplished with something as simple as a moving average. The emphasis on its use as a superior indicator of price trends seems to be more of a statistical slight of hand or misdirection, successfully deceiving the American public who are just now starting to notice higher prices.

But why should monetary policy makers care about energy prices at all?

While interest rates can have some impact on the demand for energy, they certainly don't affect the supply. In the simplest example, if oil prices were to double overnight as a result of some massive supply disruption which was expected to persist for years, why should the Federal Reserve raise interest rates?

Wouldn't that just make a bad situation worse?

It seems that whatever has happened with energy prices lately, the answer has always been the same - "inflation" is benign and the Fed does not have to tighten aggressively.

Falling Prices for Imports

The corollary regarding falling prices on imported goods from Asia is no less perplexing. A few years ago, as home prices began their multi-year double digit increases there was concern of "deflation". There was concern that somehow something bad was going to happen because consumer prices were not rising fast enough.

As it turns out, most of the downward price pressure was the result of companies like Wal-Mart and countries like China - highly efficient companies selling goods from Asian manufacturers where low prices are enabled by high productivity and low labor costs.

Looking within the consumer price index, the Recreation category for example, you find items like televisions and toys declining by twenty or thirty percent over a period of years, while prices for movie tickets and cable service rose by similar amounts.

Consumer goods that were imported from Asia were falling while domestic services were rising, yet the final calculation showed that overall prices in the CPI were rising at only a one percent rate, which was apparently too close to zero, necessitating prompt and heavy-handed action.

This resulted in monetary stimulus, the likes of which the world had never seen before, being applied to the largest economy in the world in the form of ultra-low interest rates. This begat the carry trade, mortgage lending excess, a housing boom, and huge trade imbalances.

But why should monetary policy makers care about falling import prices?

If, for example, a hundred million Chinese workers came down from the countryside and were willing to work for free, and as a result, the price of DVD players fell from 40 dollars to 4 dollars, shouldn't some special consideration be given to this development rather than lowering interest rates in fear of the falling prices resulting in "deflation"?

If money had not been made so loose in response to cheap imported goods in recent years, it is likely that we would not have the distress that is currently developing in the housing market now that rates have moved back toward more normal levels.

It seems that whatever has happened with the price of imported goods, the answer has always been the same - "inflation" must not be allowed to go too low.

A Double Standard

There has clearly been a double standard in monetary policy in recent years. As energy prices rose, interest rates were raised slowly, grudgingly, because "core" inflation was not affected. When prices of imported consumer goods fell, interest rates were lowered sharply to ward off deflation.

The Federal Reserve had little control over either of these changes in price, yet it diverted attention from one while reacting boldly to the other.

Stable prices, as measured by the contorted consumer price indices, are no longer sufficient to formulate effective monetary policy, unless of course the massive debt and huge imbalances that we find today are indeed the desired result.

You don't need a gold standard to limit the supply of money, but when you have a government that continues to spend more than it brings in and monetary policy that is formulated to always err on the side of lower interest rates while masking rising prices, excess money and credit creation and their attendant asset bubbles will result.

It is quite possible that this will go down as the greatest failure in the history of modern central banking.