Why the Fed Can’t Stop Deflation in the U.S.
Does increasing inflation boost economic growth? And do dropping prices hurt growth prospects? No and no. But to hear the Federal Reserve tell it, that’s the way the world works.
The Fed doesn’t have a good track record on this front, so its credibility is suspect. The central bank spent six years expanding its bond portfolio to $4 trillion, in an effort to boost the inflation rate to 2%. That did not go so well.
Recently, the U.S. Bureau of Labor Statistics (BLS) reported that the Consumer Price Index for All Urban Consumers (CPI-U) declined 0.7% in January on a seasonally adjusted basis. It was the third consecutive month of decline. Over the past year, this measure – also called the all-items index, as it includes volatile food and energy – decreased 0.1% before seasonal adjustment.
In other words, the U.S. has joined Europe in deflation mode. It’s the first time the CPI hit negative territory for the year since October 2009, right after the official end of the recession. Imagine how low prices would be if the Fed didn’t buy all those bonds, known as quantitative easing.
That dropping oil prices caused U.S. deflation underscores the foolishness of the Fed fantasy about a 2% inflation rate.
As David Stockman’s Contra Corner put it, “the CPI measure of inflation is so distorted by imputations, geometric means, hedonic adjustments and numerous other artifices, that targeting to 2% versus 1% or even a zero rate of short-term measured consumer price inflation is a completely arbitrary, unreliable and unachievable undertaking. Yet [Fed Chair Janet] Yellen’s latest exercise in monetary pettifoggery is apparently driven by just that purpose.”
We might have stopped short of calling Yellen a pettifogger, but when she says weak inflation is the result of the “transitory effects of lower energy prices,” as she did in her testimony before Congress, she’s asking for some serious name calling.
The implication of “transitory effects” is that today’s deflation is just a blip that will disappear like the snow in your backyard, and when it does, the sun will shine and the Fed’s efforts to boost inflation will flower.
But inflation is just a straw man.
Inflation is a symptom, not a cause. When the economy improves, inflation typically increases. When the economy deteriorates, prices often drop. What doesn’t follow, though, that boosting inflation causes the economy to improve or reducing inflation causes the economy to deteriorate.
Consider the stagflation of the 1970s, when prices were rising and the economy remained in miserable shape. There are also plenty of examples of hyperinflation in some of the world’s most dysfunctional economies.
The reasons behind price changes are more important than whether prices are rising or falling. So deflation in Japan and Europe is a problem, given their long-time economic weaknesses. But in the U.S., deflation may be helping the economy more than the Fed’s multi-trillion-dollar bond buying program.
As bond buying tapered off, the dollar strengthened. Meanwhile, other countries have been weakening their currencies with their own versions of quantitative easing. As a result, goods imported into the U.S. – including oil – cost less, while U.S. companies are holding their own prices down to remain competitive.
American consumers have benefited from the windfall, as they now have more discretionary income, which they are spending.
Meanwhile, deflation gives the Fed yet another reason to keep ZIRP-ing along, meaning zero interest rate policy. At the same time, the Fed can claim that the American economy is booming, even though it’s a pretty weak boom.
The other key BLS statistic reported was the revised gross domestic product number for the fourth quarter of 2014. While the BLS initially estimated growth at 2.6% (historically modest, but a boom for the post-financial crisis Obama years), it now has reduced its estimate to 2.2%.
Growth of 2.2% is not much better than the 2% growth the economy has experienced throughout the post-crisis recovery, and it’s much lower than the 3.3% average growth the U.S. enjoyed in the period from World War II until the financial crisis.
Of course, the U.S. economy looks like it’s booming when compared with the global economy. As former Fed Chair Alan Greenspan told CNBC, “global effective demand is extraordinarily weak – tantamount to the late stages of the Great Depression.”
There are plenty of other reasons why the Fed’s ZIRP is likely to continue:
- An increase in the consumer savings rates
- Lower commodity prices
- Global currency volatility
- High levels of debt worldwide
- Quantitative easing by foreign central banks
- Increasing federal debt, which will be more expensive to service if interest rates increase
But why not blame deflation?
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Brenda P. Wenning is president of Wenning Investments LLC in Newton, Mass.
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