Friday, January 15, 2010

Where Was the Inflation? Right In Front of Your Nose!

I think we need to seriously reconsider the basket of goods used to measure inflation. Intermediate and manufactured goods are becoming cheaper thanks to emerging countries like China and Vietnam. We are in an era of greater manufacturing productivity being passed on in the form of lower costs for manufactured items. So we will not see inflation in this era as long as we measure inflation primarily through manufactured goods.

Commodity, energy, and asset prices, on the other hand, don't benefit from lower cost manufacturing. If the Fed is using inflation as an indicator of whether monetary policy is too tight or too loose, they must understand that the manufactured item category will give them a lower inflation rate than normal thus fooling them into thinking monetary policy is tighter than it is. The Fed should look at inflation ex manufactured items or at least adjust for the China effect that skews the inflation numbers. They are treating current CPI numbers as if they were the same as CPI in the 1980's or 1990's, but the era has changed.

I believe this is why the Fed has adopted a monetary policy far far too loose, because they are being tricked by a natural deflation in manufactured goods due to the entry of China and other emerging markets. If they adjust for these factors, they would see that inflation was out of control in the 2000's, but unfortunately, they did the opposite. Instead of paying attention to food, energy, and asset price inflation and ignoring manufactured goods, they used the CPI ex food and energy as their main measure of inflation. How stupid! Furthermore, a change in the housing component of CPI to owner equivalent rent removed housing asset prices from CPI and replaced it with a non-asset alternative. No wonder they haven't been able to pick up inflation, they've removed everything that can rise in price from the CPI!

Now if someone like me can see this, why are Fed members still scratching their heads over the lack of inflation? It should be obvious by now, and I'm going to give Bernanke the benefit of doubt when he says that he will be alert to inflation and raise rates quicker than the Fed did in the past. So the real key is how commodity, energy, and asset prices behave. Oil and gold are already at elevated levels, the stock market has recovered. Should we see food prices skyrocket as they did during the bubble and oil go back to 100, we will know that inflation is back and out of control again. But should the Fed continue to be clueless and look at CPI ex food and energy, then they will never see the signs of loose credit and they'll never get why their policies are causing bubble after bubble.

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