The Fed’s supine subservience to Wall Street is enabled foremostly by its risible, mechanical and nearly fanatical pursuit of 2.00% inflation. Yet the latter is the single Biggest Lie ever to arise in the annals of central banking.
That is, the Fed’s inflation target is singularly bereft of the three essential ingredients that are implicit in its obsessive pre-occupation with mechanical gains in the general price level:
- First, there is no evidence whatsoever that 2.00% inflation is better for prosperity than 0.00%;
- Secondly, the Fed has no tools to achieve 2.00% inflation to the second decimal point in today’s globally-integrated economy; and
- Finally, inflation cannot be objectively measured with any precession anyway. The PCE deflator preferred by the Fed has no more merit than numerous other inflation yard sticks that have been consistently posting at or above its magical 2.00% target.
Nevertheless, none of these fatal deficiencies are even acknowledged by the central banker groupthink that infests the Fed and its major counterparts arounds the planet. Thus, Powell recently averred that,
“I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” – Jerome Powell 10/30/2019
Nothing could be more wrong-headed than the notion that “rates” can be virtually extinguished by the central bank so long as there is no significant “move up” in inflation as they define it. But “rates” are the price of short-term speculative credit—meaning that what’s relevant is not CPI inflation in the abstract, but the after inflation (real) cost of money market borrowings.
Needless to say, real money market rates are crazy low and, more importantly, they have no benefit except to heavily subsidize financial speculators and carry traders. And, as per the rule of markets, the more you subsidize something, the more you get of it.
As is evident in the chart below, the Fed’s policy rate has been well below inflation for the entirety of the nearly eight years which have elapsed since the Fed adopted its formal 2.00% inflation target in January 2012.
There is literally nothing like it in the annals of modern financial history.It means the cost of carry has been deeply negative in real terms as an explicit matter of policy, whether intended or acknowledged by the Fed or not, for the better part of a decade running.
Yet negative carry is the mother’s milk of speculation. That’s because speculators operate on extreme leverage—often funding their asset positions with upwards of 90% debt in the form of repo or other short-term secured credit. So when carry is negligible or negative, it amounts to zero cost of goods—meaning that any asset position with a positive yield or prospects for even modest price appreciation can produce prodigious profits.
For the reasons explained below, we use the 16% trimmed mean CPI as the best, serviceable proxy for inflation. So for the first four years of the Fed’s inflation-targeting policy, the real cost of Fed funds and related money market borrowings was an astounding -1.5% to -2.0%; and even after the Fed began tepidly raising “rates” in December 2015 it did not obtain even a sliver of positive real yield until December 2018.
And we do mean sliver. When the Fed nudged the funds rate up to 2.25% in December 2018, the 12 month trimmed mean CPI stood at 2.24%, implying that the real rate amounted to the grand sum of 1 (one) basis point!
Yet all hell broke loose on Wall Street, culminating in the Christmas Eve massacre. At that point, the S&P 500 tagged 238o, representing a 20% plunge from the 2940 peak achieved in late September.
Needless to say, the Powell Fed instantly panicked, paused, pivoted, prevaricated and punted on its rate and balance sheet (QT) normalization campaign. Currently, therefore, the Fed funds rate is hovering around 1.55%, which is once again nearly 75 basis points under the 2.28% trimmed CPI inflation rate posted for September 2019 versus prior year.
So also once again, the carry trade speculators are pinching themselves with delight, believing they have died and gone to punters’ heaven. Indeed, the chart below should be considered the mark of the Monetary Harlot because there could be nothing more irrational than essentially 93 straight months of negative (real) spread.
But here’s the thing. If the Fed were focusing on the true function of interest rates, which is to convey price signals to the financial markets, it could not possibly come up with a justification for the chart below. That’s especially the case coming on the heels of the so-called “financial crisis” of 2008, which was actually just a huge blow-off of accumulated speculative excesses.
But the Fed heads do not see the money market rates as the crucial prices signals that they are or understand that they function as the very mainspring of capitalist financial markets. To the contrary, through the distortions of their Keynesian beer goggles they view interest rates as little more than a macroeconomic pumping valve—the mechanism by which the central bank meters an invisible economic ether called “aggregate demand” into the $21 trillion bathtub of U.S. GDP.
But there is no self-contained and sequestered bathtub of domestic GDP—just a North America based integral component of a thoroughly integrated $85 trillion global economy.
Likewise, “aggregate demand” is not something central banks can conjure anyway—unless they can layer incremental credit-based spending on top of business and household outlays derived from already produced goods and services.
But today they can’t goose GDP via credit expansion because main street has already passed the point of Peak Debt in the household and business sectors alike, as we will document in subsequent installments. So all the alleged “stimulus” represented by the utterly irrational and destructive policy rate (purple line) shown in the chart below never really leaves the canyons of Wall Street.
Stated differently, the Keynesian fools who run the central banks think they are deftly feeding main street with added spending oomph. What they are actually fueling is speculative greed, delusions and recklessness in the financial markets. These are the inherit result of sustained negative carry and have virtually no precedent in terms of their virulence in modern economic history.
The cumulative inflation represented by the blue line in the chart above happens to compute to a CAGR (compound annual growth rate) of 1.90% during the 7.67 years since inflation targeting was embraced by the Eccles Building. If any Fed heads wants to argue that this is a material shortfall from their 2.00% target, we welcome them to also ruminate on the number of angels that can sit on the head of a pin.
But, of course, the Fed has conveniently adopted the shortest inflation ruler it can find—which happens to be the PCE deflator. The CAGR for the latter since January 2012 is 1.30%, thereby providing the basis for the constant jabber from the Fed about low-flation (and the Donald’s claim that there isn’t actually any inflation at all).
As a technical natter, however, the PCE deflator is not really a general price level index based on a fixed basked of goods and services. Instead, it is a statistical device invented by Keynesian academics to deflate the shifting mix of nominal GDP.
Accordingly, if the economy hit the skids and people were forced to eat spam and carp rather than steak and lobster, inflation would go down owing to the substitution effect in the PCE deflator. But no one caught up in such impoverishment would cheer a decline in the cost of living—because it would be merely statistical.
Moreover, beyond this theoretical point, the empirical fact is the above 70 basis point gap between the CAGRs for the PCE deflator and the 16% trimmed mean CPI since 2012 is an artifact of unique developments in the global economy and commodity markets, not an enduring difference over time.
As shown in the chart below, 2012 is actually a pivot point.
During the first 12 years of this century, the CAGRs were 2.09% and 2.21% for the PCE deflator and the 16% trimmed mean CPI, respectively. You truly do need a magnifying class to see the difference in the chart; and also a warped need to prove a point if you think 12 basis points of difference over 12 years actually makes any difference.
The reason for the widening gap after 2012, however, is the smoking gun. It belies the Fed’s power to manipulate the general rate of inflation over any short-run time frame–at least in interval which match the macroeconomic policy chatter emanating from the Eccles Building.
For instance, the PCE deflator was running above the 2.00% target during mid-2018 and has now fallen back to 1.5% on a year-over-year basis, thereby promoting the above referenced tame inflation remarks by Powell. But the point is, the Fed’s rate cuts and open-mouth policy machinations can have no impact whatsoever on such short-run oscillations.
The chart below, in fact, further reveals why the PCE deflator has become a sawed-off measuring stick since 2012.
As it happened, commodity inflation was virulent between 2000 and 2012 because it encompassed the period when the Red Ponzi of China was growing at booming, near double-digit rates and sucking into its great industrial maw massive amounts of energy, coal, iron ore and other raw materials, and at far faster rates than the global supply system could deliver them from existing capacity.
So prices and margins boomed—reflecting the fundamental supply/demand imbalance, and also functioned per economics 101 to attract massive amounts of new capital and capacity expansion. Nevertheless, during this 12 year ramp of the Red Ponzi and its global supply chain, commodity prices grew faster than services prices both here and abroad.
In the case of the U.S. economy shown in the chart below, the 12-year CAGR for producer commodity prices was 3.80%—a level well above 2.85% annual gain clocked in by the CPI for services.
Again, 2012 is a screaming pivot point, and not the least because China booming growth rates peaked out at that point. But also because the delayed response of vastly increased supply side capacity around the world—symbolized by the vast expansion iron ore production in Brazil, aluminum in Australia and shale oil in the U.S—more than caught up with slowing global commodity demand growth.
Consequently, commodity prices have pancaked since 2012, actually falling at a -0.16% annual rate. By contrast, domestic services prices have actually hardly decelerated at all, clocking in at 2.58% per annum since January 2012 or by just a smidgeon under their 2000-2012 CAGR.
Needless to say, the widening gap between the brown line and the purple line in the graph below explains the “low-flation” , which the Fed uses to justify pumping egregious amounts of stimulus into the canyons of Wall Street.
But this so-called low-flation originates in the world economy, not the Fed’s interest rate or QE stimulus valves to the domestic GDP bathtub.
At the same time that commodity prices were deflating after 2012, the China-based deflation of manufactures and durable goods was actually accelerating. That’s because the investment and capacity expansion binge in the Red Ponzi had generated massive amounts of excess factory capacity—even as it sucked hundreds of millions of low-wage workers out of the rice paddies and into the biggest spanking new export factories that cheap credit could buy from the Germans and other advanced capital goods suppliers.
Accordingly, the -0.86% deflation rate for durable goods posted between 2000 and 2012 has actually accelerated to -0.96% since January 2012.
So, yes, there is some “low-flation” pressures in the US inflation rate but these pressures have absolutely nothing to do with how full the domestic bathtub of GDP is relative to the wholly theoretical and un-measureable Potential GDP. And that means, in turn, that the Fed’s persistent “moar inflation” jabbering is just plain nonsense—at best a beard to obfuscate its real function.
What our Keynesian central bankers are actually doing, of course, is servicing the gamblers, whiners and bullies of Wall Street. So when they wave their rhetorical arms in the direction of main street and their obsolete, unobtainable and dangerously destructive Humphrey-Hawkins mandates, it should be taken for the ruse it actually is.
The above gets us to the chart we presented in Part 2 and the complete irrelevance of the short-run inflation fluctuations the Fed constantly stands up to justify its cowardly coddling of Wall Street.
As we indicated, the purple line represents a popular commodity index which is heavily influenced by global energy and other raw material price cycles. As it evident from the right-hand scale, the year-over-year global commodity index swung from negative 30% during the near global recession of 2015-2016 to positive 30% during the 2017-2018 China credit fueled cycle, and then back to zero percent or less in recent months.
During that same seven-year period, the PCE deflator swung from 2.5% (over-shooting the target) to just 0.5% during the 2015-2016 global slowdown. It then sprang back to 2.3% during the mid-2018 sugar high and is now back to 1.5%, which, in turn, has generated calls for more Fed easing owing to an alleged inflation shortfall.
Of course, this is just junk economics and stupid central banking. As we have demonstrated above, the Fed’s interest rate machinations, its stop and go maneuvers on QE/QT and open mouth operations at its post-meeting pressers have virtually nothing to do with the fluctuations in the PCE deflator.
To the contrary, there are due to global forces far more powerful than the Fed’s wet noodle policy maneuvers.
The implications of the chart below cannot be gainsaid. It completely debunks the very idea that the Fed is rationally pursuing higher inflation with its chronic policy of “accommodation”.
What is it “accommodating”, in fact, is the insatiable appetites for cheap money among its clientele on Wall Street.
In any event, the virtue of our preferred 16% trimmed mean CPI is that it takes the large and violent global commodity and trade swings out of the short-run movements of the PCE deflator. And in the version below, we have further smoothed the picture by showing the trimmed mean CPI on a 6-month moving average basis.
That’s about as noise free as you can get an inflation index—while still reflecting the oscillations of prices in the real world economy.
To be sure, there is no virtue whatsoever in 2.00% inflation, as we will address in Part 4. But if that’s the stated goal of the Fed, this is more than close enough for government work.
In fact, when it comes to the Fed’s other so-called mandate for jobs and full-employment output, its machinations are even more irrelevant and impotent.
