The Fed Management Of Inflation

The following consideration was initiated by the report of a statement made by Mitt Romney. He is reported to have said, “Mr. Bernanke’s policies have “over-inflated” the currency”.

I don’t know about you but, when someone says “inflation”, I immediately think about price inflation, the amount of money it takes to buy a gallon milk, a tank of gasoline, or a new DVD. And, when someone says “over-inflated”, I first have to ask, “compared to what?”.

There are, two definitions of “inflation”. The current definition, the one that has been used for over two centuries now, is a change in price levels. An older definition, now called “monetary inflation” is an increase in the money supply. These definitions are available on Wikipedia. There is a loose connection between monetary and price inflation. The hypothesis is that an increase in the money supply decreases it’s value, given that the velocity of money remains constant.

Romney’s statement suggest he is talking about “monetary inflation”. And this is an interesting question. This leads to further questions of what the money supply is and has been, in terms of M1, M2, and MZM. And, it begs other questions as there needs to be some reference point of what “not over-inflated” is.

Still, my first and foremost concern is in the current definition of inflations, the price of the stuff I buy. If the money supply has inflated, I hardly care if it has had no effect on the price of goods. That isn’t to say that it isn’t important. Another commenter said, “Since our economic output has been stagnant for 5 years, and the money supply has exploded it is only a matter of time until the price level increases.”. That may or may not be true. But, before we can even address it, we still have to look at the current definition of inflation. We can then compare the historical monetary inflation to price inflation. Lastly, we can make some effort to see if there is any evidence to determine if monetary inflation can be expected to lead to price inflation.

It is well known that the Fed manages the rate of inflation as a method of managing the economy. In a previous post, I suggested that, left to it’s own devices, inflation can go negative. Deflation is a dangerous spiral, so presented some deductive logic as to why management is necessary. I have not found a specific rate that the Fed targets. Never the less, the actual rate is well known and shows up in the consumer price index. There is a rumor that the target rate is 3% per year.

The current method for determining the price level is the consumer price index. The consumer price index is available from the Bureau of Economic Analysis, at http://www.bls.gov/cpi.  The CPI is generally plotted as the given values, which increase with time. The CPI values are essentially, the number of current dollars required to purchase a standard basket of goods.

My previous examination, of why modest inflation is necessary, took the perspective of dollar devaluation. This perspective was the outcome of looking at money as a storage of value. Over time, with inflation, money stores less value. The reciprocal of the CPI, 1/[CPI] ,can then be taken as the number of standard baskets that can be purchased with a given amount of money. As the dollar devalues, the same amount of money purchase less quantity. This gives something similar to an exponential decay. To get a more manageable number the index here will be [CPI base year]/[CPI]. Plotted this way, the average yearly inflation rate is as shown as the devaluation of the dollar. The base year of 2000 is used. The meaning of the exact value isn’t the important point here. It is the nature of the curve that we are interested in. But, for completion, the value means that, in 1970, 4.5 times as many goods could be purchased for a given dollar value than in 2000. Stated this way, it sure seems like a lot.

So, a higher rate of dollar devaluation is a higher rate of price inflation.  The rate of inflation is given by the difference between two years divided by the first year.  This rate is what we are most interested in as it is the value that the Fed targets.  3% a year is about 0.24% a month.  Each month, it costs 1.0024 more for the same amount of stuff. The plot of the rate is shown.  If the price of gasoline were rising at this rate, the $4.00 this month would be about $4.01 next month.  This is, though, an average.  Everyone has surely seen the price of gasoline fluctuate by more than this in a day.  And, on a monthly basis, prices do fluctuate by far more than this amount.

In my previous examination,  I concluded that the rate of inflation should be as low as possible. This makes sense, we would like the dollar to store value as long as possible.  We would like the rate of dollar devaluation to be as low as possible.  We would like the rate of inflation to be as low as possible.  And, if it goes below zero, we risk a deflationary spiral.

So, the question then is if it is as low as possible without going negative. The yearly average data shown above appears fairly smooth.  The value of the dollar continues to go down.  Comparing the period before 1980 to the time after 1980, it went down more quickly before 1980 then it has since 1980.  It doesn’t appear to have gone up.

The CPI is measured on a monthly basis and it is on this monthly basis that it is varies considerably.  What we are most interested in is the rate. This monthly plot is shown below.

The rate is shown as the blue line.  The 3% target rate is also shown.  On a monthly basis, the national and general rate of inflation varies considerably about the target rate.  In fact, from 2000 to 2010, it goes negative fairly often.  That spike of nearly -2% in one month amounts to a -26% yearly change.

Without getting down to doing any mathematics, by inspection it appears to vary about the target nicely, after about 1985.  The tools that the Fed has, to manage inflation, are very blunt instruments considering an economy of more than seven million businesses and over 160 million working consumers, from sea to shining sea.  If this period of 2000 to 2010 is an indication of the Fed managing inflation as close to zero as possible, then it appears reasonable.  One has to wonder what happened during the period from about 1973 through 1983.  Still, by comparison, this last decade is better than the previous decade.

This question, of exactly what the rate is, on a monthly basis, arose out of comments that suggested the Bernanke has over inflated our currency. The transition if the position of Fed Chairman, from Greenspan to Bernanke.  Bernanke took office in Feb 2006. So, let’s see if Bernanke has done better than Greenspan.

From 2000 thru 2005 the average monthly percent change in the CPI was 0.22%. The monthly inflation is shown below. The blue line is the inflation rate, the pink line is the target of .24% and the black line is the actual trend.  The average rate is about the midpoint of the graph, on the trend line, at about January of 2002.  So the monthly trend has gone from .24% to .20% over the span of five years.  And, for some months, it has dipped to deflation.

From 2006 through 2010, the rate of inflation averaged 0.18% per month.  This monthly inflation is shown below.  The target rate, of 3% per year or 0.24 per month, The trend line begins near the target rate of 0.24% and ends at nearly 0.06%.

So, according to Mitt Romney, Bernanke has “dangerously over-inflated our currency.”    Monetary inflation is the amount of currency that is in the economy.  The hypothesis is that price inflation is related to monetary inflation such that the more money is in the economy, the more things cost, more money, more inflation.  My first interest then is with regard to price inflation.  It is not true, that less currency means less price inflation.  There is a connection that suggests that more currency means more inflation.  So, in determining if there has been a dangerous over-inflation of our currency, I first look at if we have high price inflation.  In order to determine if price inflation is high, we have to compare it to something.  So, I have compared the inflation from 2006 through 2010 to the inflation from 2000 through 2005.

An obvious thing is that the beginning and end of the two trend lines don’t match because that isn’t how trend lines work.  I  point that out because it is the first thing I notice and it deserves some explanation.    The explanation is simply that it is not how trend lines work.   One is for one set of data, the other for the other set of data.

So, under Greenspan, the inflation rate for 2000 through 2005 was .24% to .20% over the span of five years, averaging 0.22%. Under Bernanke, the inflation rate from 2006 through 2010 began at 0.24% and ended at nearly 0.06%, averaging 0.18%.

This doesn’t fully address Mitt Romney’s comment that the currency is “over-inflated”.  Romney’s point is that The Fed and Bernanke, in attempting to stimulate the economy, has put too much money into the system.   The idea is that, in doing so, the economy would have more money to work with, people would have more money to spend, demand would rise, and the economy would be stimulated.  The danger is that, with more money pent up in the economy but doing nothing, there is a risk that it will suddenly become unstuck and prices will rise rapidly.  To answer this question, we will need to determine how much money there is, how much there can be, where it is, and if there is any evidence to indicate that it can become unstuck.

Neither have we answered the question as to whether inflation is as low as it can be without risking deflation.  Perhaps 0.18% per month is higher than it has to be.  Maybe inflation can be lower.  To answer  this question, we will need to look back in history and show low it has been without entering that deflation spiral.

At least we have a baseline.  If we are talking about price inflation, it looks like Bernanke has done better than Greenspan where price inflation is concerned.

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