Fed Turns a Blind Eye to Energy Inflation

This article originally appeared on Frumforum.com on April 29th, 2011

http://www.frumforum.com/fed-turns-a-blind-eye-to-energy-inflation

When New York Fed chairman and QE2 cheerleader William Dudley recently offered the fact that an iPad 2 is the same price as an iPad but with many more bells and whistles as an illustration that inflation is indeed tame, someone fired back the obvious: “I can’t eat an iPad.”

David Frum asks why, if inflation is such a real looming issue, are investors putting their money in China?  But I think his very definition of “inflation” is off.  Inflation is not caused by rising prices per se, rather rising prices are caused by inflation which is the decreased purchasing power of one’s currency. There is no better way to devalue a dollar than for the Fed to expand its balance sheet, which it has done at heretofore unheard of levels in an effort to: a) prevent deflation (done, but never necessary); b) promote price stability (fail); c) increase employment (fail).

Without recognizing the contradiction of his own previous arguments that commodities price increases are not inflation, Frum poses the following:  “China is in the grip of actual, current, existing inflation. Not inflation fears. Inflation. Prices of basic items like milk rising by 25%, apartments soaring to unprecedented multiples of annual household income, etc. Yet there seems no reluctance to invest in China. Why not?”

One answer can be found in how the Chinese measure inflation in the first place.  The inflation that Frum is talking about in China is based on a measure that includes a healthy weighting of food and energy in their calculations.  The Chinese do not look solely at “core inflation” as the Fed does when deciding monetary policy.    Frum in fact cites food rises such as: “prices of basic items like milk rising by 25%” as evidence of Chinese inflation.  Yet for some reason these same measures are irrelevant when mentioning US inflation… why again?  Because the Fed says so?  (Keep in mind that same Fed also offered in May 2007: “we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited.”  But I digress.)    One can have the discussion as to whether or not core inflation is valid as a measure of real costs to consumers, but you cannot compare one economy to another while applying a different general CPI formula to each and then make your case accordingly.

Until the Boskin concept of weighted measures of prices for the CPI surfaced in the early 1990s, the CPI was measured using the costs of a fixed basket of goods, a fairly simple and straightforward concept. The identical basket of goods would be priced at prevailing market costs for each period, and the period-to-period change in the cost of that market basket represented the rate of inflation in terms of maintaining a constant standard of living.  Over a period of several years though, straight arithmetic weighting of the CPI components was shifted to a geometric weighting.  The benefit of a geometric weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price.  Obviously then stripping out food and fuel completely to create “core CPI” only adds to the muting effect it will have on measuring real inflation.

Once the system had been shifted to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology.

The point being, if we are going to talk about Chinese inflation being high while US inflation remains low (and yet paradoxically the Renminbi’s value against the dollar has risen) I think it behooves us to first use the same measures of CPI for each economy and then go from there.  When you do that, suddenly the Red Dragon—with its economy poised to be the world’s largest by decade’s end and a discipline that comes from being unbeholden to a failing/collapsing welfare ponzi state,  allowing it effectively tackle its
M2 surge—looks much more appealing than does the sick, heavily debt-laden, service-based, entitled and politically feckless eagle.

In fact, some argue that if the United States measured its inflation using pre-1980s methodologies it would be closer to 10%.  This figure anecdotally equates with what the average American is feeling when they go about their daily lives as well.  As anyone familiar with William of Occam will attest, sometimes the simplest answers are the correct ones.

I remind Frum that food and energy were at the forefront of Reagan’s inflation fears when he took office in 1980.  I also remind him that Social Security and other retirement benefits’ cost of living increases are pegged to the CPI as currently measured and as such there is a very powerful incentive, one could even argue sinister motivation given the social compact of the program, for the Federal government to understate inflation.  I ask any Social Security recipients reading this: have your increases kept up with your cost of living?  I didn’t think so.  In my humble opinion, you are being skinned.  Some call this conspiracy theory.  I just call it a logical conclusion.  This is a discussion for another day however.

Inflation across the globe is now on the rise, from Germany to Brazil to Vietnam and is spilling into US markets beyond food and energy.  We just renewed our healthcare plan here to the tune of a 16% annual increase in premiums.  Wal-Mart CEO Bill Simon warned last month: “We’re seeing cost increases starting to come through at a pretty rapid rate.” As of two days ago, consumer products giant Kimberly Clark announced that it is increasing the cost of its Huggies and Kleenex brand and other products 5%, citing lower earnings due to higher costs of raw materials.  I suppose these will be the next products stripped out of any inflation discussions we have going forward, just to keep things clean… and that includes the Fed’s hands and those of administration academics who have supported its policies.