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The Fed & 'Data'-Driven Monetary Policy

Wednesday, May 20, 2015

Getty Images from MarketWatch.com
It all sounds so scientific and objective... The Federal Reserve is going to make its monetary decisions based on 'data'.  That would be like hiring police officers based on the width of the cracks in the sidewalks.

Here is what I mean: In a deliberately cheeky attempt to point out what you can do with statistics, a researcher set out to measure the width of the cracks in the sidewalks of a community.  They also tracked the crime rate in the community during the same period of time.  And in an Olympic-caliber display of statistical gymnastics, they showed an indisputable correlation between the two.

As the cracks widened, the crime rate increased.

Now only a fool would try to then argue that the widening of the cracks somehow caused the crime rate to increase.  But that wasn't the point of the research.  That point was to drive home the dictum known to all who have even taken a high school science class - correlation does not prove causation.

Thus, when the Fed claims to be relying on 'data', we need to be asking: Whose data? And then, when we find out, we need to be examining the data itself for gimmicks.  And we need to start with the rate of inflation, as this is clearly the most important among the 'data' the Fed is using.

The Bureau of Labor Statistics, or BLS, is a little known arm of the Department of Labor.  This is where the CPI is calculated.  It is also, of course, part of the Executive Branch.

The basic idea behind the Consumer Price Index until the 1990's was to measure what it took to maintain a constant standard of living.  Thus, if the CPI increased by 5% over the course of a year, incomes would also have to increase by 5% for the consumer to be able to maintain their standard of living.  At the heart of this purpose is an understanding of money: right now $2 is roughly 100% of the purchasing power needed buy that 16 oz. bottle of Coke in the break room.  If that price doubles to $4, $2 are then only 50% of the needed purchasing power.  If the price of the bottle of Coke doubles, the purchasing power of your '16 oz. bottle of Coke' dollar is halved.

This, then, is the measure used to determine a wide range of benefits provided by government, as well as many labor contracts with respect to wages.  In the late 1990's there was a push by the Clinton administration and the Republicans under Newt Gingrich to change the methodology for calculating the CPI.  If benefits have to be calibrated by 6% each year, this affects budget calculations.  So if those benefits can be calibrated by 3% each year instead, the government has halved the amount paid out to recipients. Tax brackets are also affected, so understating CPI can result in more tax revenue.

As reported by the San Francisco Chronicle (May 2, 2008), the Clinton era BLS Commissioner recalls Ginrich saying this about the CPI changes: "He said to me, ‘If you could see your way clear to doing these things, we might have more money for BLS programs.’" And then they tooted their horn about a 'balanced' budget (remember that?)

So instead of tracking a stable, year-to-year out-of-pocket-to-maintain-your-standard-of-living, substitutions were introduced.  Essentially, if the price of steak were to rise above a family's budget, they might buy hamburger instead.  So if steak had been in the CPI 'basket' and had gone up by 6%, and it was discovered less steak was bought and more hamburger - it having only increased by 3% - hamburger would replace steak in the CPI basket.  This would conveniently substitute a 3% increase for a 6% increase.

Anyone who has to substitute a hamburger dinner for steak, of course, knows full well that the substitution was not by choice but rather forced by true inflation.  But the government gets a pass because it publishes a 'headline' rate that is no longer designed to report gain or loss to our standard of living.  It is, rather, designed first to prop up government borrowing by suppressing interest rates.

The impact of the CPI on the federal budget, and especially Social Security, was stated in February of 1997 by Alan Greenspan and the Senate Banking Committee Chairman. (Advance the video at the link to a bit before 35:00.)

At 43:00 on this video (which was before the CPI was changed) the late Senator Daniel Patrick Moynihan notes that opponents to changing it argued that to do so would be "political."  He reprises Greenspan's earlier comment in the video that not changing it to be more "accurate" by reflecting these "substitutions" would be "political" and that changing it to be more "accurate" would be "non-partisan."

What is laughable is how they conveniently ignored what became a $161B dollar deficit that particular year, which ended with a gross debt of $5.4T. (That this is less than ten years ago and that debt now stands at $18.4T should shock anyone of any political persuasion.)  The argument that it was "political" to change the CPI calculation hinges on the simple mathematical fact that - as the Committee Chairman states openly - not to do so would ruin Social Security - a reality which only existed as a result of the larger deficit.

But much more to the point and more relevant to today: "Accurate" is a judgment call on the CPI that is based on two related assumptions: 1) Money is first a tool of the state for political purposes rather than first a utility contrived by private individuals to facilitate commerce; and 2) Deficit spending is somehow assumed to be the political norm, and it is proper to use the money supply (as a result of #1) to prop up this deficit spending.

Take a look at the graphic below from ShadowStats.com.  The red series is the 'headline' rate.  The blue series is the rate were the original 1980's and 90's methodology applied today.

From ExpliStats.com via ShadowStats.com

It is important at this point to understand what this difference means.  When money is lent - whether to you and I or to the government - inflation will reduce the purchasing power of that money over the term of the loan (note the 16 oz. bottle of Coke example above).  Charging interest is how the lender protects herself against this loss.  If the rate on your credit card goes from 3% to 6% and you're carrying a couple hundred dollars balance, that might be an irritant - but you're probably losing about the same amount to the couch cushions each month.

But if you're $18.4 trillion in debt?

Even a single percentage point can be catastrophic.  And they saw it that way in 2007 at merely $5.4T!  No one refinances a debt at a higher rate, so as the rates go down and government debt comes due, at some point that debt cannot be rolled over.  If inflation is reported truthfully, that day will be upon us quite quickly.  So this is an effort game the numbers as long as possible.

So here is where we are: The 'data' has been gamed to say what the politicians want it to say.  The politicians are desperate to kick the can down the road so the fallout lands at someone else's door.  The Fed desperately wants to pretend not to know this.  But deep down inside, they know full well that the headline inflation rate is grossly under-reported.

To the retiree, this means retirement benefits do not keep up with the actual rise in the cost of living.  While the labor force participation rate has gone down across the board, it has gone up recently among the Baby Boomer generation as they discover that sub-one percent interest rates will not support them in retirement.

The rank and file in Organized Labor, whose contracts are tied to the CPI, lose to real inflation any gains they make for having paid their dues.  It is amazing to hear President Obama complain about the minimum wage with respect to rising food prices, and then listen as his administration under-reports inflation. Oh - wait - I forgot, they do not count the price of milk and eggs anymore in the CPI.

The problem is that if inflation is adjusted to actually reflect reality, interest rates simply have to follow or the whole idea of money and banking goes right out the window.  Or they will have to begin a new round of Quantitive Easing (QE), printing more money and pushing interest rates all the way down to zero or below - and, well, then the whole idea of money and banking goes right out the window.

Save for the possibility of monetizing oil and natural gas resources through a Natural Resources Royalties GSE which I pose here - on a ten-year pathway to a new gold standard - there is simply no way out.

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PS.  If you buy my books, either the one linked to above or this one - do not worry about a financial newsletter pitch; there is none.  I am not selling anything other than books at $0.99 a pop, so I seriously doubt I'll get rich off of all of this.  I am writing simply because I am your neighbor, and I think we stand a much better chance of fixing this mess together than if we rely on the 'experts'.  Only time will tell.

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