Caroline Baum hit the nail smack on the head with her article Fed’s Inflation Analysis Ranks With Zimbabwe’s. I intended to do a supportive blog on it when it first came out but was delayed by some breaking news on housing. As it turns out I find that I am in a very small minority as reported in her followup piece From Pluto, U.S. Inflation Is Near 10%. Let’s take a look at both articles.
Fed’s Inflation Analysis Ranks with Zimbabwe’s
There’s a big difference between an inflation measure and the inflation process. Policy makers — Bernanke, Alan Greenspan before him, the Fed governors and bank presidents — talk about the effect oil prices or imputed rental costs have on inflation gauges, such as the consumer price index. That’s not the same as the inflation process, which is always and everywhere a monetary phenomenon.
If oil prices rise because cold weather boosts demand, the relative price increase may manifest itself as a rise in the CPI in the short run. But with appropriate growth in the money stock, the demand for, and price of, something else should fall.
Cause and Effect
So when Bernanke talks about temporary “factors” boosting inflation, he is really talking about temporary “effects” of higher oil prices on the CPI. Oil prices don’t cause inflation. Nor do wages, even though you’d never know it from discussions on the subject. The Fed causes inflation all by itself, creating too much money relative to the supply of goods and services.
If the inflation-as-effect posture is just a shorthand way of communicating with Congress, that’s one thing. If it’s the Fed’s analytical framework for inflation, then we’re in trouble. The tenor of the discussion of inflation in the minutes of the Fed’s policy meetings, which are in line with the comments in the testimony, makes me wonder.
Caroline Baum seems to grasp what far too few others do: “the inflation process is always and everywhere a monetary phenomenon“. From an Austrian viewpoint, inflation is the expansion of money and credit. Of those two, the Fed is only in control of base money supply. The Fed is not directly in control of credit. (This issue will come up again shortly).
The expansion of credit, however, is so far out of control and has been for so long now that for all practical purposes the Fed is not really in control of anything. This is one of the things that happens when sweeps effectively cut bank reserves to zero and fractional reserve lending allows infinite (in theory) lending of the same money over and over and over again. Rather than being in control, the Fed is in an ever tightening box praying for a miracle soft landing that is not going to happen. This was discussed in Counterfeiting Money – Crime or Good Economics?
Money itself (however one defines it) is a claim on real savings (a placeholder for saved goods). For example, a baker makes bread, so what he actually saves is bread. The baker only transforms his savings into money (typically a monetary commodity that has a prior demand for other uses, such as gold) because that’s far more convenient. The baker can not actually save bread, as it would get old.
Therefore money, as such, is a claim on real goods. Credit by contrast, is a claim on money itself, which in turn is a claim on real goods. In our present system, credit claims on money to be paid back in the future masquerade as actual money and can thus be termed “synthetic money”. In addition there is a “multiplier” effect. Someone gets a loan and spends it on goods. That money is deposited and is treated as money regardless of whether or not it is backed by real goods. Via sweeps and still more lending (see Money Supply and Recessions), the same money is lent out time and time again (the multiplier effect). This is the failure of the central bank administered fiat system: monetary claims proliferate beyond actual production of goods to back them up. In a honest system, only actual savings would be transferred from savers to borrowers (with banks acting as middlemen).
This “credit inflation” is thus fundamentally different from the “Weimarian printing press inflation”. The Weimar situation brings about hyperinflation as the monetary unit itself is inflated in its physical form, as banknotes. By contrast, a credit inflation that creates claims that masquerade as money is prone to deflation because the money needed to pay back the credit is in a shortage (relatively speaking) compared to the outstanding credit claims.
My main quibble with the first article is Baum’s statement “The Fed causes inflation all by itself, creating too much money relative to the supply of goods and services“. The source of the quibble is that credit is not directly controlled by the Fed, and a second point is the idea that inflation is “too much money relative to the supply of goods and services“. The problem with latter idea is that it ignores asset prices and it also ignores productivity improvements. From an Austrian perspective inflation is an expansion of money and credit whether or not prices are held in check by increases in productivity.
Regular readers know what is coming up. Here it is: An Interview with Paul Kasriel.
Mish: Do you have any comments regarding Greenspan?
Kasriel: Greenspan is a fascinating study. Some day I hope to write a book about him. Right now I willing to say he is the luckiest Fed chairman in history.
Mish: Greenspan is the luckiest Fed chair in history? How so?
Kasriel: He was fortunate in two very big ways. First off, he was fortunate to preside over the economy at a time when productivity was soaring and the global supply of goods was expanding rapidly because China had entered the world trading arena. In that environment the Fed could create large amounts of money and credit without causing inflation other than in asset prices.
Mish: Does that mean you believe that inflation is a monetary phenomenon related to increases in money supply and credit as opposed to rising prices?
Kasriel: Yes, and that is exactly why Greenspan was so lucky. Inflation was masked by the factors we just mentioned.
But on the main issue it is clear that Caroline is correct: “If oil prices rise because cold weather boosts demand, the relative price increase may manifest itself as a rise in the CPI in the short run. But with appropriate growth in the money stock, the demand for, and price of, something else should fall.” Bingo. In this regard, Caroline hits the nail on the head again by suggesting the Fed’s inflation analysis ranks with Zimbabwe’s.
This is THE critical point: Peak Oil, hurricanes, weather, and crop shortages do not cause inflation (see Inflation: What the heck is it?). Silly government policies such as subsidies that promote ineffective use of corn for production of ethanol do not cause inflation either. Nor do obscenely bad medical practices such as not allowing importation of drugs from Canada.
For those that disagree, please tell me how jacking up interest rates will fix problems associated with peak oil, hurricanes, global warming, government policies on ethanol, or anything else. A focus on prices (with the cure supposedly being interest rates) simply puts the cart before the horse while ignoring pent up pressures of asset bubbles.
From Pluto With Love
Reader reactions to Caroline’s first article can be found in From Pluto, U.S. Inflation Is Near 10%. I will score the debate.
Earlier this week, a column on inflation — what it is (a monetary phenomenon) versus how the Federal Reserve talks about it (seemingly exogenous price increases) — prompted the “regulars” to check in.
This select all-male club (women, no doubt, have better things to do with their time) can best be described by the shared belief system of its members: a fixation with all things gold; an ingrained distrust of any statistic published by the government; and a firm belief that the Federal Reserve’s discontinuance of weekly publication of the M3 monetary aggregate last year was just another sign the U.S. is headed down the road of Weimar Germany.
My feedback tends to fall into some broad general categories:
The Close-But-No-Cigar Department
“Precisely why did the Fed discontinue reporting M3?” writes one reader, echoing a burning question among conspiracy theorists.
The M3 conspiracy theorists (CTs) seem to ignore the monetary base (currency and bank reserves), which is the only instrument the Fed controls. Annual base growth slowed to 2.7 percent in January from 10 percent four years ago.
[Mish scoring: Baum 1 – CTs 0 – The subject of M3, however, brings us back to a sentence from the first article …. “The Fed causes inflation all by itself“. If the Fed is not in control of M3 (and I agree with Caroline that the Fed is not) then how did the Fed cause inflation “all by itself“? Yes, on one hand I am suggesting the Fed is not in control and on the other hand I am blaming the Fed just as Caroline is doing. The answer is that the system is now so totally messed up and credit lending is so out of hand caused by imbalances stemming from Bretton Woods II, fractional reserve lending, and Fed bubble blowing policies over decades, that the current mess is simply not repairable until there is a complete collapse in credit that forces another look at said policies. The real question at this point is not whether or not the Fed is in control of money supply but rather: Is the Fed really in control of anything at this point? In the meantime, from a technical point of view, I am tired of all the statements I hear day in and day out that “The Fed is pumping M3” or other such nonsense. The Fed is simply not pumping M3. The Fed is defending an interest rate target as if they knew what that rate should be. The problem is the Fed and other central bankers have no idea what interest rates should be and that is a huge part of the problem. In addition, even IF the Fed knew what Japan’s rate should be, the Fed is powerless to set it. Thus the Fed is not in any position to stop the carry trade in Yen. The whole system is a mess and will eventually have to be replaced.]
The Finger-to-the-Wind Department
“Dear Ms. Baum,” another reader writes. (They start out politely to get my attention.) “Do you really believe that nonsense about the ‘core inflation rate?’ Inflation is actually running 8-10 percent per annum and getting worse.”
This is the consensus forecast among CTs, who rely for their stats on John Williams’s Shadow Government Statistics Web site.
For the record, I don’t believe in excluding all the prices that rise in any given month to portray inflation in the best possible light. And I agree that some series in the consumer price index, such as imputed rents, are fundamentally flawed.
But the numbers aren’t cooked up in the BLS basement, as the CTs think.
“All the wonks in the federal government spin the numbers for the best possible outcome,” he writes. “Of course, they can’t give us glowing reports every month, so they have to `spice’ them with a little `bad news’ now and then. Otherwise they’d lose total credibility.”
Ah, good to know. The numbers are all rigged, but they’re rigged in both directions.
“I think my estimate (of 10 percent inflation) is a LOT closer than what the fed wants us all to believe,” writes a reader whose handle is “PlutoDave.”
Pluto may no longer be a planet, but it’s still far out.
[Mish scoring: Baum 3 – Fingers in the Wind 0 – Baum’s use of sarcasm was impressive. However she missed a good chance to point out how understated housing was in the CPI when housing prices were soaring and how overstated housing now is on the way down. Also any sane person knows that medical expense have risen far more than the CPI suggests. But with falling energy prices since last summer and falling housing prices for 18 months, inflation (as measured by prices) is probably a lot closer to the 2.5% to 3.5% range this year, by my “Finger to the Wind Measurement” than any measurements pegging price inflation at 10%. Inflation as measured by growth in M3, however, is a huge problem.]
The Tin-Foil-Hats Department
“The truth, Caroyn (sic), again?” a Plunge Protection Team alumni writes. “What’s gotten into you? Next thing you’ll be calling for an investigation into market manipulation by the government. Especially the gold market.”
Where was the PPT during the precipitous plunge in the stock market from 2000 through 2002? Never mind. I can’t prove the markets aren’t rigged, and they can’t prove they are. Ergo, I’m the one who’s naive.
[Mish scoring: Baum 1 – Tin Hats 0 – Baum’s reply was infallible.]
The Out-of-Nowhere Department
Many of the e-mails I receive have only the slenderest connection to what I wrote — and to reality.
“There is no rebalancing or inflationary outlet. If there was, it would have happened by now and people would no longer be debating the issue of imbalances. The only person I’ve seen touch on this issue is Mr Stephen Roach at JP Morgan in his weekly commentary.”
Who’s on first? What’s on second? I don’t know who’s at JPMorgan, but Roach is at Morgan Stanley and has a solid following among Armageddon types.
[Mish scoring: Baum 1/2 – Rebalancers 0 – The rebalancing comment can best be described as totally bizarre. But the response certainly could have been better. An answer like “What the H are you talking about?” would have gotten a full point]
The Kill-‘Em-With-Sarcasm Department
“Caroline, if fixing inflation according to you is such a simple exercise then, perhaps, you should get in touch with the Zimbabwe government and give them a quick lecture to pull them out of the misery.”
Zimbabwe has lots of other problems, but as my late friend Bob Laurent used to say, inflation isn’t the toughest one for a central bank. A Chicago-schooled monetarist, Bob meant that the central bank was up to the task of controlling the growth in the money stock.
Yes, there will be short-term pain (back-to-back recessions in the early 1980s in the U.S.), but hyperinflation has only one cause and one cure.
[Mish scoring: Baum 1/2 – Sarcasm Depratment 0 – Yes, hyperinflation has one cause and one cure. But I disagree with the implied idea that “deflation is the toughest problem for a central bank”. Deflation is only a problem because banks try to defeat it by throwing money at it when in fact deflations and recessions are a very necessary force needed to cure excesses in monetary expansion. This is what Bernanke fails to understand. Deflations occur because there was an excess expansion of credit and asset speculation. The cure is NOT as Bernanke thinks: throwing more money at it out of helicopters. Such actions only prolong the agony and create bigger imbalances like the housing bubble we are now in.]
The Pseudo-Philosopher Department
“I’m no theoretical economist,” writes a reader, “but I do believe that empirically consistent descriptions of reality are attractive, in that regard monetarism doesn’t bode too well as a variable which drives inflation.”
[Mish scoring: Baum 1 – Philosopher 0 – A layup]
The grand total was Baum 7 – Everyone else 0
Note to Caroline:
All we need now is to get you firmly in the Austrian camp.
Lunch with Paul Kasriel just may cure those lingering “monetarist blues” that you seem to have. Can I try and set that up for you?
Mike Shedlock / Mish/