I like to look at the updated Consumer Price Index (CPI) each month. I look at the CPI that is most often quoted by the Fed and financial media. I also like to look at the median CPI, which tends to be more stable.
The numbers in December show that consumer price inflation is continuing to tick upwards. The CPI was up by 0.3% from the previous month. Perhaps more importantly, the year-over-year CPI is now at 2.1%, which actually puts it slightly above the Fed’s 2% target.
The median CPI continues to be stable. The year-over-year median CPI ticked back up to 2.6%. It had been at 2.5% for the previous 3 months.
Since this is a libertarian blog, I have to give the usual disclaimer of why I am even looking at the CPI – a government statistic. While it is true that the government’s numbers on consumer prices do not reflect the true inflation, the CPI numbers are important nonetheless.
It is impossible to measure overall consumer prices anyway. It is impossible to account for all of the changes in quality, and it is impossible to know how much each consumer product is made up of each person’s expenditures. Even if you could get an accurate account, the numbers are going to be different for each individual and their family. Some families spend more on food, while others prefer to live in a bigger house. Other families may have to spend a higher percentage of income on medical expenses.
The CPI numbers are important though for two reasons. First, it is useful for telling us trends. Maybe the CPI numbers are understated, but they are telling us right now that price inflation is ticking upwards, at least according to the government’s own numbers.
Second, the CPI is important to look at because it is used by the Fed and the financial media. If the Fed is using the CPI numbers to base its decisions on monetary policy, then we must look at it too.
Right now, the CPI is telling us that consumer prices are slightly rising. It is not a lot. It is nothing close to the 1970s.
It is interesting though because the Fed has kept a tight monetary policy since it ended QE3 in October 2014 (over 2 years ago). But there are other factors that impact price inflation. These include productivity, the demand for money, and bank lending.
As I noted in a previous post, the excess reserves held by commercial banks have dropped significantly, even a little beyond the stated drop in the adjusted monetary base. If banks are lending more money, this is essentially the same as an increase in the money supply due to the process of fractional reserve lending.
Regardless of the various reasons for an uptick in consumer prices, it is important in how it may impact Fed policy. At this point, it seems it will make it more likely that the Fed will continue with its tight monetary policy, and that continued hikes in its target rate are more likely.
The Fed has been increasing (even if slowly) its target federal funds rate, which is the overnight borrowing rate for banks. The Fed has been increasing this rate by paying a higher interest rate on bank reserves. This is a continued subsidy (bailout?) for the banks.
So far, the Fed’s two rate hikes (December 2015 and December 2016) have not increased excess reserves. If anything, it has been the opposite. But if the Fed hikes its target rate enough times, it will have an impact. It will discourage banks from lending, as it is easier for them to earn a decent interest rate by parking their depositors’ money at the Fed. It is better to have a guaranteed rate with no risk of default.
It is possible we are in some kind of a mini-boom right now, as stock indexes continue to test new highs. But we shouldn’t expect this to last long. The Fed will have trouble keeping interest rates down if consumer price inflation continues to tick higher. The Fed will not be able to credibly threaten more monetary easing either.
Even though criticism of the Fed is running high (at least compared to the past where it received almost none), the Fed has still had something of a free lunch. It has been able to manipulate monetary policy with little fear of price inflation in the markets. The Fed was able to multiply the base money supply by almost five times from 2008 to 2014, yet there was little consumer price inflation to show for it.
Perhaps the easy days are over for the Fed. If consumer price inflation becomes any kind of significant factor, it is going to further limit the Fed’s ability to manipulate monetary policy, particularly on any future easing.
The worst-case scenario for the Fed would be a situation similar to the 1970s where there is increasing price inflation with recessionary conditions. It is still possible we could see that again, even if it takes a few years to play out.