There’s probably not a consumer in America who worries about prices being too low.
Yet low inflation scares members of the Federal Reserve Board. Then again, they’re professional economists. What do they know?
Not much, based on recent history.
The Fed has been trying for seven years to push inflation up to 2% and has mostly failed. We wrote in November 2018 that the 2% rate had been reached, and, in fact, inflation was above 2% for the entire year. But this year it’s been below 2% except for April, and it has recently been trending between 1.6% and 1.8%.
Woe is me, if you’re a Fed member.
Fear of deflation
The Fed and other economists fear deflation, which is what happens when prices go down instead of up. Lower prices have historically been a sign that manufacturers were losing confidence in their products. And if consumers know that prices are going to be lower tomorrow than they are today, they may wait until tomorrow to make a purchase.
As a result, profits could tank and the economy could plunge into a recession. Never mind that the economy has been booming in spite of low inflation in recent years.
So, even though a rate of 1.6% is much closer to the Fed’s arbitrary 2% target than it is to deflation, the Fed is concerned that inflation isn’t high enough.
Today, though, prices are often driven by technological developments. Large-screen TVs, computers, smartphones and other products have become much cheaper. Fracking has kept energy prices in check, while making the United States the world’s largest producer of oil. Technology has made automobiles more reliable, so we’re spending less on repairs. It has enabled industries to produce goods at a lower cost by increasing efficiency.
Global competition has also kept prices low. China and other emerging markets with lower labor costs than the United States have been able to produce goods and import them to the United States at a lower price. Likewise, U.S. companies need to keep their prices low to remain competitive.
And while many factors are driving prices lower, it may seem as though the rate of inflation is higher. Gas is still approaching $3 a gallon in spite of fracking and food seems increasingly unaffordable – but food and energy are not included in core inflation calculations, because their prices are too volatile.
Even if the Fed were able to increase inflation, it would likely overshoot its target and high inflation would stunt spending, slowing economic growth.
We’ve suggested previously that if the Fed is going to have a target for inflation, it should be 0%, which is what Congress mandated when it passed the Full Employment Act in 1978. That goal was never achieved, but inflation dropped to an acceptable level after rising to double digits in the mid-’70s and again from 1979 through 1981, even as the economy stagnated.
Not only has the Fed failed to reach its arbitrary goal for inflation, but its method for measuring inflation practically ensures that it can’t reach its goal.
The Fed uses the personal-consumption-expenditures price index to measure inflation, but new research by economists James Stock of Harvard University and Mark Watson of Princeton University shows that nearly half of prices in the index don’t respond to changes in economic activity.
Some prices, such as housing prices, typically rise faster when the economy is strong and growing, but others, ranging from durable goods to healthcare, are insensitive to rising or falling demand.
Why the Fed still uses the personal-consumption-expenditures price index as an inflation gauge is a mystery, given that its own economists at the Federal Reserve Bank of San Francisco found in 2017 that “acyclical” goods and services made up 58% of that index.
“The cyclically sensitive components of core inflation, which excludes food and energy, have accelerated to 2.33% in the 12 months through May from 0.41% in mid-2010,” according to the San Francisco Fed, “just as falling unemployment would predict. But that has been offset by falling inflation in acyclical categories — such as health care, financial services and most goods — which has slowed to 1.04% from 2.26% in the same period.”
So is it any wonder that the Fed has been unable to achieve its goal of 2% inflation even after years of trying?
Lowering interest rates
If the Fed lowers interest rates in the hope that increasing economic activity will boost inflation, it will likely continue to be disappointed – especially if it continues to lower them by just 25 basis points. A larger decrease could have an impact, since prices of many goods are still affected by supply and demand.
“For decades, mainstream economists have seen inflation as determined by slack – that is, spare capacity – in labor markets and the broader economy,” according to The Wall Street Journal. “Too much slack should cause lower inflation; too little should drive up prices. This is captured in the Phillips curve, which shows an inverse relationship between unemployment and inflation.”
We’ve previously noted that the Phillips curve hasn’t worked for years. In the 1970s, we had stagflation – high inflation in spite of a stagnant economy and high unemployment.
Today we have low unemployment as well as low inflation. Unemployment is close to its lowest point in half a century and we’re experiencing the longest expansion on record. Last year, American corporations had record profits. So why is the Fed worried that prices aren’t high enough?
Brenda P. Wenning of Newton is president of Wenning Investments LLC in Newton. She can be reached at Brenda@WenningInvestments.com or 617-965-0680. For additional information, visit her blog at www.WenningAdvice.com.