Inflation problems depend on where you look for them

This raises an important question: does the central bank think properly about inflation?

The Fed defines its inflation target in terms of consumer prices, such as those we pay for cars, toothpaste and haircuts. But in recent decades, prices have climbed much faster for investment assets, such as homes and equities, and this has twice led to booms and busts followed by recessions.

If the Fed is having problems with the low interest rates it has helped to construct, it may be due to asset prices and not consumer prices.

The Fed’s inflation target comes from a 1977 congressional mandate that requires the central bank to achieve ‘stable prices’ in addition to maximum employment and moderate long-term interest rates. Due to the high consumer price inflation in the 1970s, the price stability mandate received the most attention from the central bank for many years, and the Fed lowered inflation.

Only in 2012 did the Fed adopt a numerical definition of its purpose. The company said it wanted 2% inflation, measured by the trade index’s price index for personal consumption, in the medium term. In other words, the measure was the cost of household goods and services.

Since 2012, this measure has averaged 1.3% annual growth – a long time below the Fed’s target. Critics who have warned the Fed’s easy monetary policy of the 2010s would lead to an inflation surge, a financial bubble and a collapsing dollar appear to be wrong. All the more reason to keep interest rates extremely low today, if the economy is struggling, goes the Fed’s thinking.

Low rates are meant to encourage lending, spending and investment, to support economic growth and rents.

As society became more prosperous, more resources went to assets such as stocks, bonds and second homes. Perhaps not coincidentally, two of the last three recessions in the US were driven by asset price bubbles – a surge in technology stocks in the late 1990s and a training price surge in the 2000s – which caused economic imbalances, although consumer prices barely made a lightning strike.

Cheap imports from abroad, including global powers, may keep US consumer prices in the air as asset prices rise, which could create new risks that could tip the economy in unexpected ways.

It is easy to find reasons for discomfort. Tesla’s share price has risen by more than 300% in the past year. Copper prices rise by 56%. The S&P Case-Shiller price index rose 9.5%. Freight prices rise by 215%; soybeans, 54%, wood, 117%.

Houses are particularly thorny. They provide a service – we live in it – that is measured in official consumer price indices. It is also the most valuable asset in the investment portfolios of many households. The investment portion is not measured in these inflation indices. Instead of tracking actual house prices, the indices estimate housing costs based on rents in large cities.

With Covid-19’s decline in urban trade and people leaving, it’s no wonder the Labor Department’s official measure of rental housing costs has risen by just 2% in the past year, while house prices nationwide have been nearly five times higher. In 2004 and 2005, when a housing bubble grew, the standard of renting rent averaged just over 2% annually on average.

“You have erroneous pricing and policymakers who link their decisions to erroneous pricing,” says Joseph Carson, a former economist at Alliance Bernstein and the Department of Commerce.

While stable consumer prices are the primary focus of monetary policy, asset prices are the judge’s domain.

The Fed and the Treasury Department are counting on monitoring systems they have put in place since the 2007-2009 financial crisis to detect problems in asset prices – such as surges borrowed by investors – that could destabilize the financial system. It is then up to regulators to figure out what they need to do.

“Monetary policy should not be the first line of defense” against the destabilizing rise in asset prices, Fed Chairman Jerome Powell told a news conference last September. The increase in rates for taming assets could, according to him, be a secondary response.

One of the lessons of the last two trainings in asset pricing was that it was difficult to identify the bubble while it was inflating, and even harder to stop it without causing economic damage than collateral.

For now, markets and the people monitoring it do not seem very concerned.

In response to a question at his press conference in January, Mr. Powell said he sees the rise in house prices as a temporary response to the Covid-19 crisis, with people changing from residence to home.

Nancy Davis, founder of Quadratic Capital, a $ 1.5 billion investment management fund, notes that corporate inflation and interest rate risk in exchange markets, where companies protect, price inflation in the two to ten year horizon at about 1% per year. , even further below the Fed’s target.

The market may be complacent, she said. Or one could say that the risk of an increase in inflation is no more serious than the risk of falling consumer prices, known as deflation.

“Nobody knows what’s going to happen, especially the economists,” she said. ‘

Write to Jon Hilsenrath by [email protected]