Wednesday, October 19, 2005
The Feds 'One Way' Inflationary Error
Caroline Baum at Bloomberg is surprised at how the US dollar has lost value. "Given all the talk about price stability these last few years, I bet you'd be surprised to learn that the price level in the U.S. has doubled in a little more than 20 years. I sure was. Perusing last week's report on the Consumer Price Index for September, I was struck by an entry at the very bottom of Table 1 that, I'm embarrassed to say, I'd never noticed before: 'Purchasing power of the consumer dollar (1982- 84=$1.00).'"
"I followed the dotted line across the page to the figure in the column for the September 2005 unadjusted index, which read $.503. In other words, the dollar today buys half of what it bought in the early 1980s."
"Annual inflation was running at 8.4 percent at the start of 1982, falling to 3.9 percent by the end of 1984, the base period the Bureau of Labor Statistics uses for comparison. Still, the realization that the dollar buys only half as much today as it did in 1982-1984 made me think about how 2 percent inflation, which is well within the Fed's comfort zone using the CPI, would play out over time."
"If the CPI averaged 2 percent a year for the next 20 years, the price level would rise 48.6 percent. In 35 years, it would double. Even if we use the average annual CPI increase over the last 20 years (3 percent) to project forward to the next 20, the price level would be 80.6 percent higher in 2025."
"So what looks like price stability in the short run is hardly price stability in the long run."
"'When you have an inflation target and overshoot and don't insist on a period of deflation to resolve the purchasing power of money to the path you initially specified, it doesn't result in price stability,' says Neal Soss, chief economist at Credit Suisse First Boston. 'That's the flaw in an inflation target.'"
"Because the Fed has decided that a period of deflation, or a decline in the price level, is verboten, it implies a 'tolerance of a persistent, inconsistent depreciation in the value of money,' says Michael Darda, chief economist at MKM Partners in Greenwich, Connecticut. In contrast to today's stated target of price stability, 'under the gold standard, over time there was price stability in the unit of account,' Darda says."
"Former Fed governor Larry Meyer says there are 'consequences of targeting zero inflation.'" Because nominal interest rates can't go below zero, deflation would hamper the ability of the central bank to push the real overnight rate into negative territory, Meyer says. (If short-rates don't matter, which is what Fed policy makers always claim, why do they care about the inability to push the real overnight rate into negative territory?)"
"The Fed's response to the 2003 deflation scare supports the premise that policy makers won't tolerate any offset to inflation surprises. 'When the central bank overshoots its target, because of an oil shock, for instance, it forgives that error,' Soss says. 'Most of the errors, regrettably, are in a single direction.'"
"The result over time is that 'half of the dollar's purchasing power is gone in a period shorter than the time you'd expect to spend in retirement,' he says. 'The phrase `sound as a dollar' ought to mean that.'"
"I followed the dotted line across the page to the figure in the column for the September 2005 unadjusted index, which read $.503. In other words, the dollar today buys half of what it bought in the early 1980s."
"Annual inflation was running at 8.4 percent at the start of 1982, falling to 3.9 percent by the end of 1984, the base period the Bureau of Labor Statistics uses for comparison. Still, the realization that the dollar buys only half as much today as it did in 1982-1984 made me think about how 2 percent inflation, which is well within the Fed's comfort zone using the CPI, would play out over time."
"If the CPI averaged 2 percent a year for the next 20 years, the price level would rise 48.6 percent. In 35 years, it would double. Even if we use the average annual CPI increase over the last 20 years (3 percent) to project forward to the next 20, the price level would be 80.6 percent higher in 2025."
"So what looks like price stability in the short run is hardly price stability in the long run."
"'When you have an inflation target and overshoot and don't insist on a period of deflation to resolve the purchasing power of money to the path you initially specified, it doesn't result in price stability,' says Neal Soss, chief economist at Credit Suisse First Boston. 'That's the flaw in an inflation target.'"
"Because the Fed has decided that a period of deflation, or a decline in the price level, is verboten, it implies a 'tolerance of a persistent, inconsistent depreciation in the value of money,' says Michael Darda, chief economist at MKM Partners in Greenwich, Connecticut. In contrast to today's stated target of price stability, 'under the gold standard, over time there was price stability in the unit of account,' Darda says."
"Former Fed governor Larry Meyer says there are 'consequences of targeting zero inflation.'" Because nominal interest rates can't go below zero, deflation would hamper the ability of the central bank to push the real overnight rate into negative territory, Meyer says. (If short-rates don't matter, which is what Fed policy makers always claim, why do they care about the inability to push the real overnight rate into negative territory?)"
"The Fed's response to the 2003 deflation scare supports the premise that policy makers won't tolerate any offset to inflation surprises. 'When the central bank overshoots its target, because of an oil shock, for instance, it forgives that error,' Soss says. 'Most of the errors, regrettably, are in a single direction.'"
"The result over time is that 'half of the dollar's purchasing power is gone in a period shorter than the time you'd expect to spend in retirement,' he says. 'The phrase `sound as a dollar' ought to mean that.'"
# posted by Ben Jones @ 9:15 AM 
