The Fed is Wrong on Core Inflation
The release of Fed Minutes showed greater unaminity than was previously hinted at. That was the excuse for the intraday reversal yesterday.
A sharp-eyed observer noted:
"Volume had been barely pacing Monday. Until 2:00 p.m. when it started to crank. As a matter of fact, there was a boatload shoved thru as the clock struck 2 and for the next ~30 minutes. Local lore is attributing this jump in volume and in price to the good news of the FOMC minutes. The only question that remains is what kind of a speed reader could actually scan and digest the above-referenced 7 pages, 276 lines, 34 paragraphs and 3,336 words and start to act on it before the red headline ink was even dry. (emphasis added)
I'll say. The ramp started the instant the Fed minutes hit -- certainly not enough time for any mortal to have read and comprehended that much data. This looked like it was simply a large macro-player pushing indices around in a very thin tape.
This is not me "talking my book." As I said in early August, I am contructive on the market for the next few weeks, but not much more beyond that.
The more interesting Fed related story the past few days was out of merry ole England, by way of Jackson Hole. Its seems that Charles Bean, the Bank of England's chief economist, is aghast at the absurd focus on the Core Rate of inflation by the U.S. Central Bank.
Dan Gross has the details:
"The US Federal Reserve is wrong to focus on core measures of inflation that exclude energy prices, Charles Bean, chief economist at the Bank of England, has suggested.
It should focus instead on headline inflation, which is much higher, he argued. Including energy and food costs, US consumer price inflation is running at an annual rate of 4.1 per cent, against 2.7 per cent for core inflation.
Mr Bean told the Fed's annual Jackson Hole symposium at the weekend that energy prices were rising for the same reason the price of many manufactured goods were falling: the rise of China and other emerging market economies. Since both price trends had a common cause, he said it makes little sense to focus "on measures of core inflation that strip out energy prices while not stripping out falling goods prices as well."
Mr. Bean did not mention the Fed by name but his implication was clear. Fed officials, including chairman Ben Bernanke, typically talk about measures of core inflation excluding volatile food and energy prices, which they say better predict future headline inflation.
Central bankers in Europe take a sharply different approach. Both the Bank of England and the European Central Bank put greater emphasis on talk of headline inflation, which includes the immediate "first round" effect of rising energy prices.
I find it rather discouraging that so obvious a statement needed to be publicly pointed out by an overseas observer, albeit a well placed one.
Inflation (ex-inflation) has now risen to the level of a national embarrassment.
>
Source:
BoE chief economist hits at US inflation measure
By Krishna Guhain Jackson Hole
Published: August 28 2006 03:00 | Last updated: August 28 2006 03:00
http://www.ft.com/cms/s/0dea0906-3631-11db-b249-0000779e2340.html
http://www.danielgross.net/archives/2006/08/27-week/index.html#a001090
Wednesday, August 30, 2006 | 10:22 AM | Permalink
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» Pre-meditated Rally from At These Levels
About that rally yesterday. I read the minutes and I did not see what the market saw, so it does look pre-meditated. [Read More]
Tracked on Aug 30, 2006 11:01:04 AM
Comments
Hey Barry- Ignoring inflation (or, at best, failing to adapt outdated measures to the modern world) seems to be an operational philosophy that the Fed and U. S. government will keep for a while. So the natural question is: How do you think this situation can be exploited for financial gain? I'll take f--ked up perspective all the way to the bank if I can...
Posted by: Sherman McCoy | Aug 30, 2006 10:58:09 AM
I have a prediction. The inflation rate will soon go steadily down. My reasoning is that I believe we are headed for a serious recession, on par of the early nineties....
Posted by: Lyon | Aug 30, 2006 11:00:33 AM
I still think this bogus rally gets whacked after Labor Day.
Posted by: jim | Aug 30, 2006 11:01:06 AM
Jim is right......ride it hard until the first stringers return.
Posted by: Craig | Aug 30, 2006 11:14:10 AM
OK, let's all agree inflation due to gas/energy prices is running higher than we would all like (Fed included). Now, let's look at WHY the oil prices are high - Geopolitical risks, Hurricane concerns, increased worldwide demand, lack of new refining, etc. (although, to be fair, prices have come down fairly signifcantly lately).
Now, if you are the FED and you have raised rates 17 straight times, and you are starting to see commodities/energy retreat and Core inflation is holding fairly steady, and most importantly to this site, housing is in a semi free-fall, why would you raise rates? Answer is you wouldn't/won't. You won't raise them in Sept. either. The economy will naturally slow (as it is doing), and guess what energy/commodities are coming down.
If we get GDP under 2 for Q3, they will then start to cut rates and market will take off. Soft landing will be achieved. Maybe it's because I am in the Midwest, but I really think this housing situation is over-rated as far as brining on a recession. People still have money, real wages are going up (slightly yes, but still up) and the consumer is one resilient MF'er. Don't bet against them guys.
Posted by: JDamon | Aug 30, 2006 11:18:04 AM
The only excuse the Fed gives for core inflation reporting is that headline inflation is "volatile." Gosh and golly, it's not like they don't have any centuries old statistical techniques for smoothing out volatility. Perhaps there's an opportunity to start a respectable series of inflation indicators; iBR1, iBR2, iBR ex energy, etc.
Posted by: Robert Coté | Aug 30, 2006 11:19:50 AM
Once Britain starts talking about it does that mean we are fighting the last war? Barry, JDamon makes some very good points. Do you honestly believe the Fed should be raising rates higher here? Cooked inflation numbers aside, of course. Far aside.
Posted by: doh! | Aug 30, 2006 11:26:51 AM
First of all, cue up “God Bless the USA” and let me say I don’t think monetary policy should depend on import prices at all. To target an index including import prices means that policymakers expect American firms to cut prices (relative to the target trend) when importers raise prices and vice versa. Why should they? Why should a scarcity of imports (like oil) result in a contrived scarcity of money? And why should an abundance of imports (like manufactured goods) result in a contrived abundance of money? The reason to have a target in the first place is to give the Fed credibility so that domestic firms will forbear raising prices in response to temporary shocks. If the objective is to influence the behavior of domestic firms, why should policy be influenced by variables outside the control of domestic firms? The target index should focus on prices that are likely to be sticky, which is not the case for imports under flexible exchange rates.
(For the record, looking at domestic prices only, the GDP deflator is running at about 3.3% for the past 4 quarters – somewhat worse than the core CPI but considerably better than the full CPI.)
But – second point – part of the reason the Fed focuses on core prices is that food and energy prices are volatile. If you’re looking at the last month or 3 months or 6 months or even 12 months, the full CPI gives you only a little bit of information about whether inflation is accelerating, whereas the core gives you more information. If the Fed were to target a full index like the CPI, they would have to take into account its volatility. In that case, the 4.1% number cited by Bean (or was it by the reporter?) is misleading. Rather you should use a smoothed inflation rate that takes into account several years of data. For example, I have a weighted moving average (72 months linear weights declining to zero at the far end) of CPI inflation that is running at about 3%, which is a lot closer to 2.7% than 4.1%.
(Cross-posted from Greg Mankiw's Blog. I don't usually cross-post, but I couldn't help myself this time.)
Posted by: knzn | Aug 30, 2006 11:40:28 AM
Tony Crescenzi on Realmoney.com has been saying today and for some time that commercial construction and loans is booming.
I don't understand why commercial construction would be so strong in light of a weakening economy. Anyone have a clue?
Posted by: Michael C. | Aug 30, 2006 11:42:59 AM
Commercial construction is usually 12-18 months behind the consumer. It's tough to stop building a mall right in the middle of your pour for Dillard's foundation.
Posted by: Mark | Aug 30, 2006 11:56:20 AM
Another criticism foreign central bankers have made is that it's a mistake for the Fed to ignore equity price inflation, but to then lower rates when equity prices fall. The Economist had a lot on this earlier this year.
Given the current indebtedness of average working people, wouldn't inflation actually be good for them? Wages would probably at least keep up with inflation. Even Social Security is indexed now.
Don't get me wrong, I'm not advocating it. But just hypothetically, wouldn't 70-80% of American households be better off with inflation of 5-7%?
Posted by: Bob_in_MA | Aug 30, 2006 12:10:29 PM
mark, Commercial construction is not lagging. They are reacting to the demand for business growth. Corporate profits continue to grow and they need to expand their operations. Do not try to compare big business to the consumer. That is like comparing apples and oranges. Businesses deveolp strategiest to maintian their competative edge. They speculate on the future and capitalize on times of poor and pently. When was the last time you heard of the average consumers hedging his energy needs 5 to 10 years out into the future? Or layoff the kids when they can't afford to kepp them becasue of rising costs? That is why they are called a consumer. They consume. They are a bacl hole for products and services and very few products and services are ever converted up to a higher value product or service that the resell other than the consumers labor hours.
Corporate profits are high not becasue the eocnomy is good but becasue consumers have not figured out the real value of the products they are purchasing. Remember the CRT monitor to LCD monitor convertion. Those CRT monitors dropped from $700 for a 21 inch screen to $250 overnight. So you have to wonder, was the value of those old monitors $700 or $200? People were willing to pay $700 up to the day that they dropped prices. They didn't understand the true value of the product.
Posted by: Ander | Aug 30, 2006 12:24:51 PM
Even the core rate doesn't offer much solace, rising from 2.1% in Q1 to 2.8% in Q2.
But, like fund managers, central bankers aren't averse to talking their own book too. Our European trading partners can't be too happy that a weak dollar discourages their exports to us and would probably like to see the Fed tighten again.
Posted by: Craig H | Aug 30, 2006 12:27:12 PM
foreign central bankers will not be voting in our upcoming elections so the odds of the Fed tightening??? thought so...
Posted by: doh! | Aug 30, 2006 12:39:55 PM
For those conspiracy theorists out there, the SP500 futures dropped a point on the release and the mkt didn't start advancing until two minutes after the release, plenty of time for some to find exactly what they were looking for in the report. the speculators see the push and pile in on every pullback. Simultaneously the mkt had a larger time frame divergence which everyone pounced on. just one perspective....
Posted by: mark | Aug 30, 2006 12:42:09 PM
Hey, did anyone notice Robert Shiller's op-ed in the WSJ today?
http://online.wsj.com/article/SB115688653772648766.html
Discussed here by Roubini:
http://www.rgemonitor.com/blog/roubini/143855
Posted by: GRL | Aug 30, 2006 12:44:50 PM
Uh, yes Ander, it is lagging. Lagging demand as such.
Posted by: Cherry | Aug 30, 2006 2:30:01 PM
JDamon wrote:
"real wages are going up"
Yeah, if you're in the top 1% of the wage earners.
It's gone down for the low and middle class wage earners.
Posted by: TSM | Aug 30, 2006 2:40:33 PM
#1: PCE core inflation is rising and hitting new highs based on 4-5 year compounded growth rates.
#2: The last time there was an energy cost bump core inflation steadied. But guess what, when energy costs came down core inflation rose! (Simple economics: Money was syphoned to energy so there was less for core purchases which meant lower demand which meant lower cost pressures. When less money was needed for energy, more was available for core purchases, more demand, more upward price pressure.)
Posted by: Norman | Aug 30, 2006 2:57:48 PM
OK, so here's a comment by the Richmond Fed President. How can he talk about moderating energy prices helping control inflation when all along they have been EXCLUDING energy in their calcuation of inflation?!
Lacker said he did not think that weaker growth "by itself" would bring inflation down. On one side, there is a view at the Fed that hopes flattening energy prices over the near term would reduce upward pressure on core inflation, he said. "I was in the camp of thinking we needed to raise rates to make sure inflation comes down," Lacker said in a television interview.
Posted by: Greg | Aug 30, 2006 3:26:14 PM
Greg:
How can he talk about moderating energy prices helping control inflation when all along they have been EXCLUDING energy in their calcuation of inflation?
They have been excluding direct energy prices from their calculation. Lacker is talking about the indirect effect of energy prices. For example, if fuel gets cheaper, then air fares might go down, because it costs less to run a jet. They have been including air fares all along. (I actually happen to be an extremist who thinks that even the indirect effect of energy should be excluded from target price index, but that is not how it is done today.)
Posted by: knzn | Aug 30, 2006 3:38:00 PM
Ander-
I think we are talking about different things. At least I hope so since I am in the business ( international commercial real estate and economic development consulting). It would be very hard on my ego to think I advanced this far in my profession and I had no idea what I was talking about. (Perhaps it was the throwaway nature of my post.) I see what you are talking about for current demand. I look several years out in my projections for my clients before committing them to projects.
Posted by: Mark | Aug 30, 2006 3:49:10 PM
The bond market is now pricing in an 8% chance of a rate cut at the Jan 31, 2007 meeting.
How bout that.
Amazing how the bond market and stock market are now completely on different pages. In order for the Fed to cut rates in 4 months, the incoming data would have to show rapid deterioration in the economy.
But hey...are we still buying?
Posted by: Michael C. | Aug 30, 2006 4:13:15 PM
On the Shiller index and Roubini's analysis, while I agree fundamentally with the fact that housing is turning from boom to bust, that graph is usually explained away by housing bulls as due to 1997 era tax changes. The capital gains on housing became deductible up to $250k for a single or $500k for married homesellers that year. That started the ball rolling, then historically low interest rates entered the picture, and of course irrational exuberance.
Posted by: Rusty | Aug 30, 2006 4:17:43 PM
>Rather you should use a smoothed inflation rate that takes into account several years of data
Not really disagreeing with you, just pointing out the Control 101 truth that the longer you average your data the slower your response time to a step change is.
So how responsive should the Fed be? I sure don't know. But when you think you have a really good predictor think about when it actually sets the flag, and if that would be soon enough for any use to anybody.
I'm in general pretty comfortable with the normal view that you should watch energy prices thru their second-order effects.
But knzn is going to have to work quite a bit to get me to see his self-labeled "extremist" view. We, especially in America (but you Euros don't get too smug, look around a bit) have built ourselves into such an energy-dependent corner that you can make a lot of good predictions about the economy based on what a btu will cost it.
Posted by: a different chris | Aug 30, 2006 4:33:50 PM
