Sunday, September 30, 2007

Daniel Gross is Scratching His Head...

Mark Thoma and David Altig do a good job explaining why it is appropriate for the Fed to look at core measures of inflation when conducting monetary policy. Their argument is essentially that core inflation (or trimmed-mean PCE) does a better job predicting future overall inflation. Many observers are critical of this approach and say that it runs against reality. Here is one such observer:

Gross: There's No Inflation (If You Ignore Facts)
By Daniel Gross

Oct. 8, 2007 issue - Imagine that a cardiologist told you that aside from the irregular heartbeat, the stratospheric cholesterol count and a little blockage in your aorta, your core heart functions are just fine. That's precisely what the government's cardiologist—Ben Bernanke, chairman of the Federal Reserve—has just done. The central bank is supposed to make sure the economy grows fast enough to create jobs and make everybody richer, but not so fast that it produces inflation, which makes everybody poorer. "Readings on core inflation have improved modestly this year," the Federal Open Market Committee said in justifying its 50-basis-point interest-rate cut last month, while conceding that "some inflation risks remain."

Catch that bit about "core inflation"? That's Fedspeak for: inflation is under control, unless you look at the costs of things that are going up. The core rate excludes the prices of food and energy, which can be volatile from month to month. Factor them in, and inflation is about as moderate as Newt Gingrich. In the first eight months of 2007, the consumer price index—the main gauge of inflation—rose at a 3.7 percent annual rate. That's more than 50 percent higher than the mild 2.3 percent core rate. The prices of energy and food are soaring, at 12.7 percent and 5.6 percent annual rates, respectively, and have been doing so for years. As a result, the CPI—including food and energy—has risen 12.6 percent since July 2003, for a compound rate of about 3 percent.

Signs of inflation are evident throughout the economy. When investors fear a rising inflationary tide, they latch onto the driftwood of gold. The day Bernanke cut rates, the price of the precious metal soared to heights not seen since 1980, when inflation ran at nearly 12 percent! I read about this in The Wall Street Journal (whose newsstand price rose 50 percent in July), which I picked up in the lobby of a New York hotel (where the average nightly rate soared 12.5 percent in the first seven months of 2007 from 2006, according to PKF Consulting) while sipping on a Starbucks Frappuccino (whose price has risen twice since last October).

There are sound macro-economic reasons to believe higher inflation may be a fact of economic life, according to former Federal Reserve chairman Alan Greenspan, who discusses the topic in his new memoir, "The Age of Turbulence." (Apparently, the editors killed the original title: "The Dotcom Bubble Wasn't My Fault. Nor Was the Housing Bubble.") Greenspan notes that vast anti-inflationary forces in the 1990s—especially China's emergence as a low-cost producer of goods—helped tamp down prices. But China's rampant growth and rising living standards could encourage inflation. "China's wage-rate growth should mount, as should its rate of inflation," he writes.

In a recent paper, Albert Keidel of the Carnegie Endowment for International Peace warns of China's "gathering inflation storm," powered in part by "explosive price increases in key consumer categories" like noodles and pork... China is bound to export its inflation—it exports everything else, after all—either in the form of higher prices for toys, or in the form of higher global prices for the commodities it consumes in increasingly huge gulps.

In the United States, companies are passing along high-er commodity and fuel costs by boosting prices, slashing portions and tacking fuel surcharges onto things ranging from deliveries to lawn service. And because food and energy prices are so visible—the prices are posted in public, and consumers buy these goods frequently—price increases have a disproportionate impact on perceptions of inflation.

China's government is trying to deal with its inflation in predictably Orwellian fashion. "Beijing has instructed local provincial and urban statistical bureaus in a subtle form of denial—they are not to use the word 'inflation' to describe what is happening," notes Keidel. It's easy to mock Beijing's clumsy bureaucrats. But by focusing on core inflation, the Federal Reserve—along with the legions of investors who reacted ecstatically to the interest-rate cut—is practicing its own subtle form of denial.

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