The Fed’s Inflation Measurement is Questioned

The Federal Reserve Bank’s PRIMARY mission is conducting monetary policy, which is focused on employment, price stability and long-term interest rates. That may catch some as a surprise, given the popular belief that the Fed is primarily focused on steering the economy towards growth, but that is an ancillary outcome of carrying out their primary mission. Directly from the Fed, their mission is described as:
• conducting the nation’s monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates;
• supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers;
• maintaining the stability of the financial system and containing systemic risk that may arise in financial markets; and
• providing financial services to depository institutions, the U.S. government, and foreign official institutions including playing a major role in operating the nation’s payments system
In carrying out their mission, the Fed uses a multitude of economic statistics to gauge their success and survey for potential problem areas before they can negatively impact their mission. Towards price stability, the Fed under Chairman Greenspan focused on the Personal Consumption Expenditures (PCE) Index, away from the CPI, because the PCE was believed to more accurately reflect current-day consumer buying patterns. Things have changed under new Chairman Bernanke who has focused on the traditional CPI reading while injecting his long-standing views that the Fed should identify a targeted inflation rate, discussed as being between 1-2% annually. This is a dramatic departure from Greenspan’s views and the Fed’s primary mission of stable prices, because it accepts a 1-2% inflation rate as being allowable and acceptable. More disturbing is that it redefines the meaning of the word stable. Under Greenspan stable prices meant 0% inflation. Despite this significant shift in views, the bond market still hasn’t caught on to this. If they ever do, one should expect a 1-2% increase in long-term rates to compensate investors for this so-called price stability.

A causal view to this lack of market response is that debt issuers are currently getting an even better deal than they may realize, through a cheap interest rate.

Last week, market controversy did surface, not on the issue of targeted inflation, but on the issue of the Fed’s use of “core” inflation versus the total inflation picture. Core inflation is defined as price changes stemming from every area of consumption except for food and energy categories. In the past, these areas were deemed too volatile on a short-term basis and were heavily impacted by their respective supply chains, such as short-term fluctuations in food prices caused by summer droughts or a winter freeze, or short-term fluctuations in energy prices caused by hurricanes or maintenance shutdowns at gasoline refineries. At issue with the market is that the volatility in these 2 categories is no longer looked upon as being short-term and predominantly caused by supply, but rather by demand issues. The difference in core and total CPI is significant, averaging 0.3% over the past 10 years and currently showing a spread of 0.5%. Investors have recently questioned does the Fed use the lower Core CPI to measure against its targeted inflation rate, or the total CPI rate? The market is currently moving towards using the total CPI figure, given the shift from short to long-term volatility and the shift from supply-generated to demand-generated pricing pressures. In fact the demand-generated move is expected to continue as rising world economies increase the global demand for energy, such as that demand coming from China. Food prices are expected to continue rising due to changing dietary habits of traditionally western foods, as these rising economies become more affluent. Demand for food as an energy source (ethanol) is also viewed as a long-term move.

If the market wins out and the Fed changes its focus from Core to Total CPI, how the market views Fed policy should change as well as the actual CPI would be further out from their targeted level, possibly requiring even higher short-term rates to bring the total CPI inflation into the realm of a “stable” prices.