Inflation and Deflation - The Federal Reserve's Great Dilemma

Janet Yellen's recent admission at a meeting of the National Association for Business Economics is a bit of an eye-opener for a central banker.  Rarely do central bankers admit that they are wrong on anything, particularly one of the two aspects of the economy that they are responsible.  Here's what she had to say:

"Today I will discuss uncertainty and monetary policy, particularly as it relates to recent inflation developments. Because changes in interest rates influence economic activity and inflation with a substantial lag, the Federal Open Market Committee (FOMC) sets monetary policy with an eye to its effects on the outlook for the economy. But the outlook is subject to considerable uncertainty from multiple sources, and dealing with these uncertainties is an important feature of policymaking. Key among current uncertainties are the forces driving inflation, which has remained low in recent years despite substantial improvement in labor market conditions. As I will discuss, this low inflation likely reflects factors whose influence should fade over time. But as I will also discuss, many uncertainties attend this assessment, and downward pressures on inflation could prove to be unexpectedly persistent. My colleagues and I may have misjudged the strength of the labor market, the degree to which longer-run inflation expectations are consistent with our inflation objective, or even the fundamental forces driving inflation. In interpreting incoming data, we will need to stay alert to these possibilities and, in light of incoming information, adjust our views about inflation, the overall economy, and the stance of monetary policy best suited to promoting maximum employment and price stability." (my bold)

From her presentation, here is a graphic showing how both core inflation (inflation which strips out volatile food and energy prices) and inflation as measured using the personal consumption expenditures (PCE) are falling well below the Fed's rather randomly selected 2 percent level:

Here is a graphic showing which components of PCE inflation have been running lower than the 2 percent level:

As I have posted previously, central bankers hate low inflation and particularly deflation as much as they hate unemployment.  As we all know, the Bank of Japan has had a decades-long economic nightmare largely because of deflation as shown here:

While the Federal Reserve is not meeting its inflation target according to the definition used by the Bureau of Labor Statistics, the keeper of American price data, a measure of inflation used by the New York Federal Reserve Bank may actually be showing a building up of inflationary pressures. 

Let's start by looking at how the BLS calculates the Consumer Price Index, the headline inflation rate that is reported by the mainstream media.  Here is how the CPI is calculated:

"The CPI market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. For the current CPI, this information was collected from the Consumer Expenditure Surveys for 2013 and 2014. In each of those years, about 7,000 families from around the country provided information each quarter on their spending habits in the interview survey. To collect information on frequently purchased items, such as food and personal care products, another 7,000 families in each of these years kept diaries listing everything they bought during a 2-week period.

Over the 2 year period, then, expenditure information came from approximately 28,000 weekly diaries and 60,000 quarterly interviews used to determine the importance, or weight, of the more than 200 item categories in the CPI index structure.

The CPI represents all goods and services purchased for consumption by the reference population (U or W) BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups. Major groups and examples of categories in each are as follows:

FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)

HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)

APPAREL (men's shirts and sweaters, women's dresses, jewelry)

TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)

MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses and eye care, hospital services)

RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);

EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);

OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Also included within these major groups are various government-charged user fees, such as water and sewerage charges, auto registration fees, and vehicle tolls. In addition, the CPI includes taxes (such as sales and excise taxes) that are directly associated with the prices of specific goods and services. However, the CPI excludes taxes (such as income and Social Security taxes) not directly associated with the purchase of consumer goods and services.

The CPI does not include investment items, such as stocks, bonds, real estate, and life insurance. (These items relate to savings and not to day-to-day consumption expenses.)

For each of the more than 200 item categories, using scientific statistical procedures, the Bureau has chosen samples of several hundred specific items within selected business establishments frequented by consumers to represent the thousands of varieties available in the marketplace. For example, in a given supermarket, the Bureau may choose a plastic bag of golden delicious apples, U.S. extra fancy grade, weighing 4.4 pounds to represent the Apples category."

As you can imagine, with a wide range of goods in the BLS market basket, some goods are seeing their prices rise while others are seeing their prices fall.  Currently, more than 25 percent of the components that make up the CPI are experiencing deflation as shown on this graphic:

A graphic like this must give the braintrust at the Federal Reserve a massive headache!

In contrast to the CPI, the New York Federal Reserve Bank uses another measure that they call the Underlying Inflation Gauge (UIG).  There are two UIG measures used:

1.) the prices-only measure which is derived from the large number of disaggregated price series in the Consumer Price Index

2.) the full data set measure which uses the above data along with additional macroeconomic and financial variables" including the Producer Price Index, data from the Institute for Supply Management, various labour statistics including unemployment, the employment-to-population ratio and various financial measures as shown on this list:

Here's what both UIG measures look like compared to CPI inflation going back to 1995:

As you can see, the full data set UIG shows significant inflationary pressure, hitting 2.74 percent in August 2017 while the prices-only measure was 2.17 percent.  These measures suggest that trend CPI inflation is in the 2.2 percent to 2.7 percent range, above the Federal Reserve's 2 percent comfort zone.

While the New York Fed's Underlying Inflation Gauge may suggest that the economy looks set to reflate, the yield on 10-year inflation-indexed Treasuries would suggest that investors feel that there is little risk of growing inflation as shown here:

When all things are considered, it is becoming increasingly apparent that the Federal Reserve has no idea why the economy is not showing signs of inflationary pressures, particularly given that unemployment is at or around the levels normally experienced when the economy is “hot”.  From Japan’s experience, we can see that their deflationary pressures rose thanks to the nation’s aging demographic.  Perhaps the aging population in the United States is key to the Federal Reserve’s inflation dilemma, an issue that they can do very little about.