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Posts tagged ‘inflation’

Current Monetary Policy

American monetary policy is implemented by the independent, a-political (and unelected) Federal Reserve Bank. It’s actions control the money supply primarily by setting targets for the key federal funds rates.  The Fed also controls the money supply and interest rates through open market operations (buying and selling government bonds) and by setting reserve requirements for banks. Theoretically, these actions serve to influence output and inflation, although in reality, the velocity of money changes in response to variables related to risk and return, and often may not respond directly to Fed policy desires.

Long time Fed Chairman Alan Greenspan maintained an implicit inflation target of zero from 1987-2006, which he believed would yield maximum sustainable economic growth. Under his successor Ben Bernanke, the Federal Reserve Board in January 2012 set an explicit inflation target for the first time with a ”longer-run goals and policy strategy” statement.

“The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s mandate for price stability and maximum employment. Over time, a higher inflation rate would reduce the public’s ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling–a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken.”

Inflation targeting steers monetary policy to try to hit the target inflation rate. This approach has for years been the official policy of Britain, Canada, Australia, Sweden, New Zealand, Brazil, and South Korea, among others. The theory is that inflation-targeting policies tend to stabilize their inflation rates while keeping economic growth on an even keel.

Is Inflation Targeting the Right Approach?

The link between inflation rate targets, price stability and full employment is far from a settled issue because many other factors can affect economic growth, from natural disasters, energy policy, fiscal policy and wars. Increases in inflation as measured by the Consumer Price Index (CPI) are not necessarily coupled to any factor internal to a country’s economy and strictly or blindly adjusting interest rates would potentially be ineffectual and restrict economic growth.

Most economists today agree with the Fed that inflation is a necessary evil, and advocate for low, stable levels of inflation.  Deflation is often seen as a worse danger in a modern economy because it increases the real value of debt, may aggravate recessions and has potential to lead to a deflationary spiral. Yet research from the Fed’s own Minneapolis Reserve Bank shows that deflation does not automatically lead to depression and need not be a barrier to economic growth.

Until the 1930s, it was commonly believed by economists that deflation would cure itself. As prices decreased, demand would naturally increase and the economic system would correct itself without outside intervention. This view was challenged during the Great Depression. Keynesian economists argued that the economic system was not self-correcting with respect to deflation and that governments and central banks had to take active measures to boost demand through tax cuts or increases in government spending.  This message was well received by officials who wanted to believe that government actions control the economy instead of the “animal spirits” of a jumble of factors.

For 50 years, monetarism has been the foremost alternative to Keynesian-ism as a means of understanding inflation. Monetarists think that inflation results from too much money chasing too few goods, rather than from interest rates, demand, and the slack or tightness of markets. The matter is far from settled, but the majority of leading economists today are post-Keynesian in thought and almost constantly advocate for active monetary stimulus to induce economic growth, despite the absence of evidence that such stimulus is effective. Even new Fed Chairwoman Janet Yellen recently admitted that the central bank doesn’t have a good model of inflation. (The Fed relies on the Phillips Curve, which charts a tendency for inflation to rise when unemployment is low and to fall when unemployment is high.)

The notion that nobody who expects prices to fall in the future would spend money today is nonsense. It ignores entirely the concept of time preference, and we can see that this is not the case every day in the market for computers or smart phones. These products get cheaper and better every year, yet demand for them is strong and people spend considerable amounts of money on them today. In other areas such as clothing, products are far less expensive today than they were a generation ago, in large part due to less expensive offshore labor, falling trade barriers and Wal-Mart.

Is there a Better Way?

The primary reason inflation is desirable in public policy is because it facilitates use of government debt to accommodate federal fiscal irresponsibility and permanently stimulates home ownership by inflating away the value of mortgages. Inflation is a form of sovereign default. Paying off bonds with currency after ten or twenty years that is worth half as much as it used to be is like defaulting on half of the debt. Government can steal value out of your pocket full of money without you even seeing anything happen.

For nearly 5,000 years, the majority of countries have used money denominated in or backed by metals such as gold or silver. As long as governments have been in power, they have sought to increase their ability to spend money in excess of their receipts. During the Roman Empire, the Emperor Nero debased his currency by reducing the percentage of silver in minted coins. Paper money was first introduced in Medieval times in Italy. Why does paper money have any value at all? In our economy, the basic answer is that it has value because the government accepts dollars, and only dollars, in payment of taxes.

The key problem with fiat money is that governments have the power to arbitrarily produce more of it, debasing it’s value. In the era of metal currency, there was neither inherent long term inflation or deflation. The United States, despite prior episodes of paper money failures (Continentals during and after the Revolutionary war, and Greenbacks during the Civil War), issued the predecessor of today’s paper currency in 1913, revalued it against gold in 1934, and suspended any convertibility into gold in 1971. Meanwhile, the value of the dollar in gold terms has fallen 92% since 1913. As the chart below shows, inflation of the US$ is the norm, and deflation is an unusual phenomenon. 2009 was the most recent year of deflation, and it was 54 years since deflation had occurred. In both 1955 and 2009, the US had positive GDP growth. 

source: US Bureau of Labor Statistics

So what are the alternatives to using paper money and the inflation that inevitably follows? In the internet age, there have been a series of attempts to create a medium of exchange that does not inflate and is not subject to government exchange controls and taxation. These attempts are based on securely exchanging information which is a process made possible by certain principles of cryptography. The first “cryptocurrency” to begin trading was Bitcoin in 2009 although numerous other cryptocurrencies have been created since then. Fundamentally, cryptocurrencies are specifications regarding the use of currency which seek to incorporate principles of cryptography to implement a distributed, decentralized and secure information economy.

Bitcoin appears to be a brilliant solution to the problems of fiat currencies and inflation. But it fails on a variety of other key measures, the most important of which is a relatively stable store of value. Bitcoin has been plagued with extreme value volatility. Further, the anonymous nature of its transactions enable it to be easily used for illicit and illegal activities such as drug trafficking. Because  government regulators are not involved in Bitcoin administration, it’s value can be erased by computer viruses or outright fraud. Mt. Gox, a key Bitcoin exchange, collapsed into bankruptcy in February taking $500 million of Bitcoin value with it.

In the history of man, no fiat currency has ever survived as long as the US dollar without the restructuring the American dollar is experiencing. Inflation, and monetary policy by the Fed is effectively defaulting our debt and devaluing our currency every year. This inflation is another form of stealth taxation which promotes and enables profligate federal spending.  Our central bank’s primary mandate is price “stability” (and full employment). One need not be an economics PhD to recognize that a monetary policy of taking 2% of its citizens money annually is simply wrong.

What is the Fed?

The Federal Reserve Bank System is a unique hybrid public-private bank network whose 12 district members are owned by local banks and regulated by a 7-person Board of Governors, each of whom are appointed for one 14-year term by the White House. It was created in 1913 and amended in 1935 primarily to use monetary policy to deal with cyclical bank panics. Congress established three key objectives for monetary policy in the Federal Reserve Act:

  • maximum employment
  • price stability
  • moderate long-term interest rates

The private banks give input to the government officials about their economic situation and these government officials use this input in Federal Reserve Board policy decisions.

How does the Fed employ monetary policy?

Monetary policy should ideally be used in conjunction with fiscal policy as a means to achieve desired national economic objectives. In America monetary and fiscal policies mostly are independent of each other. Congress and our President have led America to the brink of a “fiscal cliff”, and no comprehensive fiscal policy reform seems likely in the near term. This state of affairs has thrust the Federal Reserve Board, and its Chairman Ben Bernanke, to the forefront as the savior/enabler of today’s American macro economic policy.

The primary tools of the Federal Reserve Board are:

  • to set bank reserve requirements
  • to set the discount rate for interest paid by the Fed on bank reserves
  • to conduct Open Market Operations that seek to influence the Fed Funds rate (that is paid by banks to each other for short term borrowings) via open purchases and sales of US Treasury and federal agency securities

Minutes of the regular meetings of the Fed’s Open Market Committee (FOMC) are widely published by the media in order to inform business and banking leaders about probable Fed actions. The Fed has said it doesn’t expect to touch short-term rates until it sees the unemployment rate fall to 6.5% or lower, as long as inflation forecasts remain near its 2% target. That would mean, according to the Fed’s economic projections, that it would keep short-term rates near zero into 2015.

” In case there was any doubt about its resolve, the Fed statement also issued a new implicit annual inflation target: 2.5%. The official target is still 2%. But the Open Market Committee stated that it will keep interest rates near zero, and by implication keep buying bonds, as long as the jobless rate stays above 6.5% and inflation stays no more than a half-percentage point above the Committee’s 2-percent longer-run goal…That is a 2.5% inflation target by any other name, and it’s striking to see a central bank in the post-Paul Volcker era say overtly that it wants more inflation.”  WSJ, 12/12/12 “The Fed’s Contradiction”

Many economists think we have to inflate our way out of the debt crisis. Inflation remains quiescent, but central banks that ask for more inflation likely get it. The Fed is now buying about 70% of new long-term Treasury debt, and when you add “QE3” debt purchases, it appears to be well on its way to monetizing not only the deficit, but also a large chunk of the accumulated federal debt.

Why do the Fed’s policies matter?

Fed policy continues to punish thrift and reward irresponsible debtors. A 2.5% inflation rate and interest rates on deposits near zero compounded diminishes the real value of saving by 1/2 over only 28 years even absent any income or taxes. This is a tax on our middle class. Benefits for those receiving government benefits will be indexed to a CPI. The rich can make investments in hedge funds, private equity and other vehicles that can earn better than inflation adjusted returns after taxes. It is those who have long worked and saved who will pay these penalties.

By keeping interest rates ultra low, central banks including the Federal Reserve may have likely created a ticking time-bomb for investors in the bond market. The risk is that the many retail (middle class) investors who sought safety in bonds don’t fully understand the losses they will face if there is a sustained economic recovery and yields start to rise.

The Fed’s near-zero interest rate policy will continue to disguise the real cost of government borrowing. One reason the Obama Administration can keep running trillion-dollar deficits is because it can borrow the money at bargain rates courtesy of the Fed. Each 1% increase in rates on a $16 trillion federal debt is $160 billion per year, and those increases must begin sooner or later.

For the past four years the Fed has maintained expansionary and unconventional policies and we are told there is still no end in sight. Mr. Bernanke famously failed to predict the 2008 monetary crisis, and then was slow to react (although he did so effectively). Now we are supposed to believe he will know when to pull the ripcord on growing his balance sheet. The Fed and Mr. Bernanke may well be geniuses and get it all just right this time, but Diogenes is not optimistic that this will happen.