Why the Federal Reserve Is Looking for Inflation in All the Wrong Places
From Ben Bernanke’s “helicopter money” to Jerome Powell’s “overshooting the target”, the Fed seems to be hunting for that elusive inflation and seems to be determined to do whatever it takes, monetary policy wise, to get it.
However, despite all the dire predictions, all the attempts at Quantitative Easing (QE) in the past (and even the current “not QE but is QE”) have failed to even meet the Fed’s baseline inflation target.
This could be because the Fed is looking for inflation in all the wrong areas!
To start with, let’s take a peek at how the US Department of Labor actually calculates inflation. It starts with the Consumer Price Index (CPI), and any month-on-month or year-on-year increase/decrease of the CPI is inflation/deflation.
So what is the CPI made out of?
Checking out the Consumer Price Index
The actual CPI that the Fed looks at is calculated using some complicated formula, but using the items in the above basket.
So, the Fed’s goal is to cause the CPI to rise, and they do it by pumping more money into the financial markets via QE… Hmmm…
Let’s also recap what QE actually is, and how the Fed did the QE the last time.
Under Bernanke, QE 1, 2 and 3 were mainly conducted by the Fed purchasing mortgage-backed securities, Treasuries, and agency mortgage-backed securities respectively. Of course, the interest rate was near 0% at that time too.
But, who did the money go to?
Oh right, the member banks who carried balances with the Fed.
So let’s look at the CPI chart again. What items would increase if interest rates are low and the banks have more money?
Hmmm… It seems to me that there is no direct impact to most of them, especially since the housing portion doesn’t even consider the actual housing price, but rental and imputed rental.
Where did all the money go? Well, the financial market, where the banks play…
Looking at the Financial Markets
Let’s just take a peek at the effects of QE on one major stock index — the S&P 500.
Wow, that looks like some hyperinflation there! Started out below 100 in 2009, to over 300 in 2020.
But that’s not all…
Bonds had a choppier ride but the price also spiked.
Lastly, we look at the previous standard, i.e. the “gold standard”.
Well, looks like QE worked in deflating the USD against gold all right! If we were still trying to track the “gold standard”, such a spike of gold against USD implies that USD has deflated, which is technically in line with the Fed’s goal to cause inflation.
So, it seems that the Fed did achieve its goal — it created inflation all right, but only in the financial markets.
Based on the CPI figures above, if they really wanted those numbers to go up (for inflation), helicopter money would have been more effective!
Other factors in play
Of course, it is easy to poke fun at the Fed using the lens of hindsight. Let’s also take a peek into this lens to see what other factors were at play that stifled inflation in the way it was supposed to work.
1. The rise of new technology
While Amazon, Facebook, Google etc. did have their beginnings in the early 2000s, it was during the GFC that they really came into their own.
Suddenly, the way that consumers consumed changed significantly. Not only was there a whole new way of doing business, there were totally new products to consume that are not included in the traditional CPI.
It also didn’t help that the business model of such tech companies revolved around providing “free” products and selling ads — the real cost to the consumer is thus hidden compared to a subscription service like Netflix, which can be captured in CPI.
Additionally, e-commerce like Amazon played a significant role in keeping prices low. There is now a whole debate about whether the legal definition of monopoly needs to be changed because of how Amazon works.
Cliffnotes: the traditional definition of “monopoly” contained a key component about whether the consumer is worse off (e.g. because of rising prices). So while Amazon does have significant market share and can be considered a monopoly from other components, the key one of “consumers being worse off” is not fulfilled because they kept undercutting their rivals and thus, kept prices low, and consumers are not “worse off”… for now.
2. The lower risk tolerance of banks
The traditional explanation of why QE didn’t work is because the banks used the extra money from the Fed to enrich themselves (and their shareholders via buybacks and other means) instead of lending the money out to consumers and businesses.
Well, it may or may not be surprising considering the landscape before and after the crisis — but since this has already been debated to death, I’m not going to elaborate too much here.
3. Financial markets are not a factor in CPI
For someone trying to increase inflation, it is interesting that it was done via a manner that is not actually recorded in the inflation calculation.
This would be akin to studying for an exam without reading the course requirements!
Maybe it comes from my background, but I would have thought that the first thing to do would be to view my Key Performance Indicator (KPI) — so if inflation is the KPI, then I would want to drill down into what actually causes inflation and then select the measures to increase those numbers.
The benefit of hindsight
Yes, of course I am now writing this with the benefit of hindsight. It is just interesting to me that the current Fed chair is still trying his “QE but not QE” to try to juice inflation yet again, when we already have this hindsight of what happened during the first rounds of overt QE.
Well then, I guess it’s time that some of us learned from history and made use of hindsight to position ourselves for this new decade in 2020, by doing your own research and coming to a conclusion (with your own advisors) on how to take advantage of this next round of “QE”.
I have a list of things to do this year — if you don’t, start thinking about it!
