Wikinvest Wire

Politics, Wall Street, and the Fed

Thursday, February 28, 2008

In this op-ed piece in today's Wall Street Journal, Allan Meltzer adds to the growing scrutiny of Ben Bernanke and crew at the Federal Reserve since last summer when the wheels started coming off of both the U.S. economy and the global financial system, after which the Fed started slashing interest rates.

According to Wikipedia, Dr. Meltzer is "the author of dozens of academic papers and books on monetary policy and the Federal Reserve Bank, and is considered one of the world's foremost experts on the development and applications of monetary policy", though, he doesn't really photograph well.

He is said to be working on Volume II of his "History of the Federal Reserve Bank", covering the period from 1951 to the present. He probably knows what he's talking about.

That '70s Show

Is the Federal Reserve an independent monetary authority or a handmaiden beholden to political and market players? Has it reverted to its mistaken behavior in the 1970s? Recent actions and public commitments, including Fed Chairman Ben Bernanke's testimony to Congress yesterday -- where he warned of a steeper decline and suggested that more rate cuts lie ahead -- leave little doubt on both counts.

An independent central bank is supposed to maintain the value of the currency and prevent inflation. In the 1970s and again now, Federal Reserve officials repeatedly promised themselves and each other that they would lower inflation. But as soon as the unemployment rate ticked up a bit, the promises were forgotten.

People soon recognized that avoiding possible recession overwhelmed any concern about inflation. Many concluded that inflation would increase over time and that the Fed would do little more than talk. Prices and wages fell very little in recessions. The result was inflation and stagnant growth: stagflation.

It's beginning to happen again. Unlike the response of wages and prices in the low inflation 1990s, expectations of rising inflation now delay or stop price and wage adjustment, inhibiting growth.

One lesson of the inflationary 1970s: A country that will not accept the possibility of a small recession will end up having a big one when the politicians at last respond to the public's complaints about inflation. Instead of paying the relatively small cost of a possible recession, the public pays the much larger cost of sustained inflation and a deeper recession. And enduring the deeper recession is the only way to convince the public that the Fed has at last decided to slow inflation.
It looks like we're going to need another fix to how the Bureau of Labor Statistics calculates inflation, as was done in the 1980s and 1990s. For a few years now various Fed economists, including Ben Bernanke, have indicated that "inflation" is overstated by about one percent.

That seems to be the only reasonable approach to reducing inflation during an election year when the economy is stalling and the unemployment rate is rising.

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Nick said...

The current CPI already allows arbitrary adjustment by the government to suit their needs, that's what they changed circa 1980. The only problem is a perception and confidence issue: it's going to continue to strain credulity to claim inflation at 4% when other stable countries with currencies pegged to the US dollar and less manipulatable inflation statistics are measuring 12% inflation.

At some point, most investors will realize that the US dollar is declining in value ~10% annually, and demand greater returns to buy US bonds and other US investments. When the government needs to offer 15% return on bonds to finance the interest in the national debt, and people start to lose confidence in the long-term viability of the US currency, stuff gets dicey. Everybody knows what happens after that, but like the housing bubble burst, nobody is willing to acknowledge it until it actually has happened, because it's too scary of a thought to even think/mention.

Tim said...

It's my understanding that the BLS staff that collects the data and calculates the official inflation rates have fairly strict guidelines as to what they can and can't do and they do their job exceedingly well.

It is only when the major changes to the "process" come along (e.g., 1983 OER for housing costs and the Boskin commission in the 1990s) that major changes to the calculation occur. If memory serves, the most recent change has something to do with chain-weighting and is currently being kept in parallel with the existing measure until such time that there is a need to reduce inflation by about one percent per year.

Seriously, that's about how it works.

Nick said...

The big thing they changed to be able to manipulate the CPI is called Hedonic Quality Adjustment; you can find some documentation about it on the CPI info pages ( or through google searches. It is based on the theory that items in the CPI should be based on only the feature set when the item was added to the CPI, and future versions of the item are calculated as an arbitrary percentage of the actual future item, based on what percentage would constitute the identical feature set to the item originally added to the CPI. A page on the general idea is:

By adjusting the price of items to match the arbitrary percentage of the original item which exists in the new item, the CPI can (and is) set arbitrarily lower. For example, a new car might be considered to have 5x the features of a car which was added to the CPI 20 years ago; therefore if the car is $25,000, it's only $5000 for purposes of the CPI (even though it's obviously impossible to buy the $5000 version of the car). Basically, hedonic regression allows the CPI to be essentially constant while actual prices inflate without bound, since manufacturers are always adding new "features" as they produce new versions of products.

Seriously, the CPI is 100% bogus as a measure of consumer price change. On the other hand, it's a great way to claim inflation in under control while increasing the monetary supply by 10-15% annually, with essentially flat real GDP.

jag said...

Most of the individual price components are quite good. Never before has a government collected so much useful data on consumer prices and it is all there for anyone to look through. Unfortunately, the problem is that the end product - "annual inflation" - has been so corrupted with all of these changes over the years to serve the political purpose of extending the fiat money system for as long as possible while having the effect of inflicting much pain on the underclasses. Maybe it's time for another "free cheese" program.

Flow5 said...

Nominal GDP is measured by monetary flows (MVt). It is mathematically impossible to miss an economic forecasts. (MVt) encompasses everything - including the most comprehensive and accurate measure of inflation. So there was no excuse for the ignorance concerning the impact of administering a low federal funds rate, for an excessive period of time.

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