The Market – The Fed and Buffer Inflation

February 14th, 2007

Here is a conspiracy theory for you.  Perhaps the Fed benefits by not releasing / utilizing the inflation numbers that are often higher than the Consumer Price Index (CPI) measure.  The Dallas Fed tracks inflation with a trimmed mean PCE rate and the Cleveland Fed uses a weighted median CPI, both of which usually show inflation as higher than the standard CPI measure.  By using the officially accepted CPI, which also has the benefit of usually showing a lower inflation amount when food and energy are stripped out (two things a human being really doesn’t need anyway, let alone the American consumer), the Fed is able to quietly let higher inflation flow through the economy and thus not be forced by an inflation-wary market to raise rates to combat inflation.  Raising rates would likely have a negative correlation on asset prices (real estate and the stock market) and also the unemployment rate. 

Ever since the Volker Fed in the 1970s, it has been the Fed’s objective to prevent run-away inflation, or the ‘expectation’ of higher inflation by the market and the average consumer.  But current economic theory suggests that in containing inflation, the Fed may counter economic growth and thus job growth, causing the unemployment rate to rise.  Thus, the Fed somewhat delicately has to choose between containing inflation to foster an economy based on worthless pieces of paper (the dollar) or risk raising the unemployment rate and the resulting ire of politicians.  The important concept here is that as long as the market and consumers believe that inflation is contained around 2%, then inflation will not lead to run-away inflation.  If the Fed could have an official and generally accepted inflation index that the market and the consumer have faith in, and this index just happens to track inflation at a lower rate than the actual inflation pressures in our economy, then I am sure this index would work to their benefit.  The Fed would be able to create the ‘expectation’ that inflation was contained at the unofficial sub-2% rate target, and yet let the true inflation amount act as a support to spur economic growth.  The Fed would not be forced to raise rates on a more hawkish basis because the artificial inflation number gives them some buffer, and thus the Fed prevents higher rates from potentially undermining the economy, asset prices, and job growth.  Of course, the index that helps them do this is the CPI. 

The current economic fundamentals are quite spectacular: the unemployment rate is exceptionally low, market liquidity is exceptionally high, asset prices are still high, high consumer spending is still making my jaw drop, commodity prices are high, and yet all of this is occurring with inflation somewhere around 2.4%?  I have to think that our current economy is not been sustained by 2.4% inflation but a much higher rate, perhaps around 3.0-3.5%.  This higher rate of inflation may be acceptable to the Fed, but so long as only they know it and not the market / consumer, because as I said earlier, inflation expectations can lead to higher inflation.  So perhaps we should name the CPI the “Buffer Index: Helping the Fed keep inflation expectations low when real inflation is actually higher.”

Entry Filed under: The Market

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