Deflation Accelerates

For someone who has criticized monetary policy as being too easy for the last several years, it feels strange to say this.  Monetary policy is now too tight.  

The BLS just released the latest CPI for October, and it’s up 2.5% versus the year earlier.  Considering that the CPI is heavily doctored to understate the rate of consumer price increases, you must think I’ve taken leave of my senses.  How is inflation over 2.5% deflation?  

The problems here are manifold.  First, as I’ve said before, CPI stands for Consumer Price Index.  The word “inflation” appears nowhere in there and that’s for good reason.  It’s not an index of inflation.  Besides the problem of statistically understating in magnitude, it also lags in time.  That means despite most of the time yielding misleadingly low readings, during periods of falling inflation, it can be misleadingly high.  

Now is one of those times.  Inflation is now not only lower than 2.5%, it’s lower than zero.  

This is based on Financology’s own index of the dollar, the FDI.  But a survey of the universe of prices that respond in real time to changes in the real value of the dollar tells the same story.  Across both the financial and real.  Stock prices are down.  Commodity prices are down.  Foreign currencies are down.  Even slower moving real estate prices are beginning to roll over.  We saw this first in foreign exchange, non-US stock markets, then gold prices, copper prices, and more recently oil prices.  Unless this soon changes, the CPI will follow.  

The good news is that Jerome Powell is so far the best leader of the Federal Reserve since Paul Volcker.  The bad news is massive institutional inertia.  Where is it written that monetary policy must adhere to badly lagging indicators?  That it must move exclusively in sweeping multi-year cycles unresponsive to a real world that moves in real time?  The economy and markets need small frequent changes in the direction of rates, not years of unidirectional policy that encourage the buildup of dangerous imbalances and inflate bubbles.  The FOMC meets eight times a year.  Why shouldn’t short term interest rates be able to move at least as often?  I can’t think of any reason why they shouldn’t be able to fluctuate daily, if not in real time like any other market.

Up or down, regardless of the prevailing trend.  Anyone looking at a chart of market interest rates or bond prices and then looking at a chart of the Fed’s policy rate is immediately struck by a singular fact: the latter is composed of straight lines.  Compared to real live markets, it looks dead.  Why?  Do some of our most highly educated and accomplished economists actually believe that a policy lacking volatility will lead to less volatility in the financial markets and economy?  That a predictable policy is conducive to a predictable economy?  

If anything, experience is the opposite.  In purging short term interest rates of short term volatility, the Fed has pushed volatility out to other markets and amplified it in the economy.  Because we aren’t willing to tolerate benign volatility in short term rates, we get malign volatility in stocks, bonds, commodities and massive boom and bust cycles.  

There is much ado about the neutral rate of interest.  But this neutral rate is a hypothesis, not an observable reality, and to the extent it even exists it can turn on a dime.  In 2008, for example, the abrupt change in the trend of the FDI indicates that it fell several percentage points in a mere few weeks that summer.  A fed funds rate that was too low in June was too high in July.  But due to institutional inertia the policy rate did not move far enough fast enough.  

It would have violated the rule that says monetary policy must move exclusively in sweeping multi-year cycles unresponsive to a world that moves in real time.  

Make no mistake, the resistance is even worse on the tightening side.  Our main difficulty now is that the Fed failed to start rate normalization when it should have back in 2013 as the current financial market bubble was being born.  And there is no escaping consequences of such a big policy mistake.  But that doesn’t mean the Fed has no damage control options.  It can abandon another inexplicable and arbitrary rule: that its interest rate target must be pushing the zero bound in order for quantitative easing to be considered.  The Fed should continue selling off its mortgage bonds since allocating money encroaches into fiscal policy, the proper province of Congress.  But there’s no reason it can’t slow or stop selling Treasurys at any time, and Chairman Powell should state now that such an option is on the table for its next meeting.