The Fed's Altimeter may be Broken

The Federal Reserve has conducted our nation's monetary policy for 99 years without a formal inflation target. During those years, inflation was among the variables considered by the Federal Open Market Committee when conducting monetary policy, but the committee did not target a specific rate, according to a paper published by the San Francisco Fed. Inflation targeting crept into the FOMC's modus operandi in 2000 with their informal adoption of 1.5%, elevated to 2% in 2007, and formalized and officially published at 2% as measured by the core personal consumption expenditures index (PCE) in 2012. Inflation has hovered below that level since onset of the subprime crisis in 2007 and the lingering question is, why? Despite the Trump tax cut, increases in employment not seen in years, and substantial wage growth -- any one of which in the past has been sufficient to trigger inflationary pressures --  it has remained stubbornly dormant. Let's review how we got here. 

In the 1970s under former Fed Chairs Arthur Burns and G. William Miller, inflation moved steadily upward, reaching a high of 11.3% in 1979 when, shortly thereafter, President Jimmy Carter selected Paul Volcker as his inflation assassin. Volcker's punishing monetary policy, accompanied by nationwide protests against his sky-high interest rates, painfully brought inflation down to 1.9% by 1986. Upon Volcker's resignation in 1987, former President Ronald Reagan appointed Alan Greenspan to replace him and for most of his 18-year tenure under four different presidents, inflation remained in a range conducive to economic growth, that is, more than 2% and less than 4%. When Greenspan resigned in 2006, he was about to be coronated the greatest Fed chair ever when the subprime crisis materialized in 2007 and he reported, "we didn't see it coming." With but few exceptions, our inflation rate has since been under 2%. 

Fed Chairman Jerome Powell's recent response to this dilemma was reported by the Wall Street Journal's  May 4th front-page story, 'White House Escalates Feud with Fed'.  He stated, "the March inflation factor could have been held down by temporary numbers." 

Such a response is problematic for two reasons. First, economics, upon which monetary policy relies for its assumptions, theories, and models, is a soft science, unlike a hard science like physics. When an object is dropped, gravity ensures its progression downward at a given rate of speed, whereas the effects of the Fed's monetary policy decisions upon the economy historically have been hit or miss propositions, and everything in between. Second, about 17% of the Fed's annual operating expenses of $5 billion and 10% of its nationwide staffing of 22,000 are directed to monetary policy. Given the uncertainty underlying a soft science and the Fed's 2007 slumber on subprime, such a magnitude of resources calls for a much more definitive prognosis than "maybe inflation is being held down by temporary numbers."

To be fair, let’s give credit to the Fed for doing yeoman’s work after becoming aware of the 2007 crisis, whose countermeasures prevented our plunging into financial Armageddon. Among other matters, it avoided use of negative interest rates that have plagued Japan, Europe, and the other nations whose central banks pursued that strategy. Although having drawbacks, use of quantitative easing was a much better choice than submarining the economy. Moreover, our nation's debt of $22 trillion would have been $800 billion larger without it, due solely to the Fed's increased earning transfers to Treasury emanating from its inflated security portfolio. 

Now President Trump and his economic advisers are encouraging the Fed to lower interest rates by another percentage point and to resume bond purchases to further stimulate economic growth on the premise that the tax cut is holding down inflationary pressures. Fed Chairman Powell recently put the possibility of one or more interest rate cuts on the table in the near term. On the other hand, Greenspan among others has suggested that the problem with inflation is how we measure it, stating "there is a bias in the statistic. You're getting statistics which are not correct" -- thus impugning the Fed's use of the PCE as well as all other current measures of inflation. There is also the possibility that technological improvements could be masking inflation.

But the only known factor that can be linked directly to the absence of inflationary pressures is the arrival of the subprime crisis and the Fed's reaction to it -- when the fed funds market collapsed and the FOMC redefined the fed funds rate from being the price banks paid to purchase required liquidity in the market to being the interest rate that the Fed pays banks to retain excess reserves. (About 20% of the pre-crisis fed funds market remains, in which reserve holding banks purchase funds for arbitrage in their reserve accounts.) Among the many consequences of the redefined fed funds rate is that the FOMCs interest-rate changes have not reverberated through the economy like they once did. For example, since onset of the crisis, there have been nine 25 basis point increases in the fed funds rate driving it up to a range of 2.25-2.5%, but the average 5-year CD is yielding 1.38% according to Bankrate and inflation has remained mired below 2% except for 2012, when it bumped up slightly above it for a short period of time.

Our planet already houses five countries with deflationary economies and 14 more with an inflation rate of just a positive half percent, or less. Included among these is Japan at .47% (and Switzerland's is at just .53%.) The bottom line is it's time for the Fed to unravel this mystery -- if for no other reason than to provide peace of mind that negative interest rates, and even worse, a deflationary economy are not in our future. Until then, our central bank will be much like a pilot flying an airplane with a suspect broken altimeter, which professional pilots do not do.  

Jim Kudlinski, PhD, former Federal Reserve Board Official, author of the "Tarnished Fed", (2014)

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