Saturday, June 30, 2007

The Folly of the Fed or: Why is the Fed so Hardcore?

Core inflation and other Fed idiosyncrasies
For an organisation blessed with as many economists of good repute, both on its policy-making committee, the FOMC, and on its staff, the Fed is remarkably obtuse when it comes to the role of core inflation in designing and publicly explaining its policies.

Core inflation is the inflation rate of a subset of the standard bundle of goods and services used to track the behaviour of the general price level. It excludes food and energy products (oil, gas, coal, power etc.). Headline inflation is the rate of inflation of the whole (supposedly representative) bundle of goods and services - core and non-core.

The Fed is confused and/or confusing about matters other than the role of core inflation in designing, implementing and explaining monetary policy. The Fed's effectiveness is hampered by at least two other flaws. The first is a design flaw not of the Fed's making. The Federal Reserve Act assigns the Fed three co-equal fundamental objectives: maximum employment, price stability and moderate long-term interest rates. Of this triple mandate for the Fed, the first objective is meaningless (maximum subject to what? whatever happened to full employment?), the second is sensible but only qualitative, and the third is weird. Fed officials, from the Chairman down, tend to ignore the third objective and speak of the dual mandate of the Fed rather than its triple mandate. When pressed, they mutter that moderate long-term interest rates (nominal/real?) really are not a macroeconomic monetary policy objective but refer to the financial stability role of the Fed. But that's not what the Federal Reserve Act says.

Of the three fundamental objectives, the only one to make economic sense, price stability, does not have a quantitative operational expression in the form of a price level target or an inflation target. Again the Fed cannot be blamed for this. Congress would not wear a numerical inflation target without a numerical (un)employment target.

The second pointless idiosyncrasy of the Fed is that
it pays more attention to a deflator-based index of consumer prices, the Personal Consumer Expenditure (PCE) deflator than the rest of the world’s central banks, who tend to focus on Consumer Price Indices (CPI). The PCE deflator is also unlikely to resonate well with the general public, who in all likelihood have never heard of it. The US Federal government's index-linked debt is linked to the CPI, not the PCE deflator.

It’s not clear that there is unanimity among the FOMC-12 (or even among just the 7 Board members) about whether the headline inflation measure they care about is the CPI or the PCE deflator. Greenspan was a PCE deflator man, but that was then. Bernanke has never expressed a strong preference for a deflator measure over a CPI measure. This matters, because a deflator measure of inflation (core or headline) is a Paasche or current-weighted price index while the CPI is a Laspeyre or base-weighted price index. Current-weighted price indices show lower inflation rates if there are any relative price changes than base-weighted price indices; historically, the PCE deflator rate of inflation has been about 0.5 percent per year below the corresponding CPI measure.

Uses and abuses of core inflation
It is essential to differentiate between what price index the Fed ‘cares about’ (if not ‘targets’) and whatever is the best predictor over the relevant policy horizon of the price index the Fed cares about. There is no doubt that the Fed cares about headline inflation and not about core inflation. It does not believe that Americans don’t eat, drink, drive, or use heating and air conditioning.

Even if we knew what the FOMC’s preferred headline inflation measure was (PCE deflator or CPI), the location of the comfort zone (the Fed’s Congress-proof euphemism for inflation target) is ambiguous. Bernanke in his pre-Chairman days appeared to have a PCE deflator comfort zone centered symmetrically around a 1.5 percent per year inflation rate. Mishkin appears to want to shift this up by about 0.5 percent. Given the historical difference between the CPI and PCE deflator rates of inflation, a PCE deflator comfort zone centered on 1.5 percent would correspond to a CPI comfort zone centered on 2.0 percent.

Two percent is also the Bank of England's inflation target, and 'below but close to two percent' is the medium-term inflation target of the ECB. The Bank of England's and ECB's CPIs are quite different from the US CPI
and it's likely that two percent inflation for a Eurozone-style CPI would mean a somewhat higher rate of inflation for a US-style CPI. Mishkin's apparent preference for the center of the comfort zone could therefore well be closer to the UK and Eurozone inflation targets than Bernanke's pre-Chairmanial comfort zone center. It is a strange spectacle, though, to watch the members of a monetary policy making committee argue in public about the numerical value of an inflation target that the institution they serve cannot admit to having.

So if the Fed does not care intrinsically about core inflation, it must care about it instrumentally, that is, as an indicator or predictor of future headline inflation in the medium term - the one to three year horizon over which monetary policy decisions today have their effect. It may well be that historically, that is, using data for the Greenspan-Bernanke period 1987-2007, core inflation has been a better predictor of headline inflation than headline inflation itself. So-called ‘Granger causality’ tests of incremental predictive content support the view that, using monthly data for the period 1987M01-2007M05, core inflation Granger-causes headline inflation, that is, it ‘helps predict’ future headline inflation (for both the CPI and the PCE deflator) even when the predictive content of past headline inflation for future headline inflation is allowed for. Conversely, headline inflation does not Granger-cause core inflation.

However, over a longer period (1957M02-2007M05), we find that headline inflation Granger-causes core inflation and that core inflation Granger-causes headline inflation; in fact, headline inflation Granger-causes core inflation at a higher level of statistical significance than core inflation Granger-causes headline inflation. Of course, even for the period 1987-2007, the fact that core inflation Granger-causes headline inflation does not mean that past headline inflation does not help predict future headline inflation. In fact, past headline inflation does help predict future headline inflation, but so does core inflation, even after allowing for the predictive content of past headline inflation.

Core goods and services tend to be subject to nominal price rigidities – they are Keynesian goods and services if you want. I'll call them sticky price goods. These prices often are governed by long-term contracts, that do not have inflation indexation clauses and other nominal contingencies built into them.

Non-core goods, like agricultural commodities, oil, natural gas, metals etc. tend to have their prices set almost continuously in markets that look and behave like auction markets. Let’s call them flex-price goods. Not surprisingly, for much of the 20th century, core inflation therefore has been both less volatile and more persistent than the inflation rate of non-core goods.

The application of statistical methods to data generated by economic processes is a most hazardous exercise when you don’t understand the economic, social, political and technological phenomena in question. Too many technically highly qualified statisticians and econometricians are babes in the woods when it comes to understanding the economic, social, political and technological fundamentals driving these processes. The ruling conviction at the Fed that even today, current core inflation is the best predictor of headline inflation in the medium term (say the next 1 to 3 years) that the Fed operationally cares about, is a leading example of bad and dangerous use of statistics – the statistical analogue of driving a car while looking only in the rear-view mirror.

I am happy to accept as a fact the historical empirical regularity that, for the period 1987- 2001, say, core inflation may have been a useful predictor of future medium-term headline inflation. Then the world changed: a rapidly growing fraction of 2.3 billion Chinese and Indian consumers and producers became fully engaged in the global economy. They entered as suppliers of core goods and services and as demanders of (non-core) commodities. The result has been a major, persistent and continuing increase in the relative price of non-core goods to core goods. That means a long-lasting excess of the inflation rate of non-core goods over the inflation rate of core goods. The evidence for this is in Charts 1 and 2 below, which show the behaviour since 1970 of the ratio of the headline price index to the core price index for both the CPI and the PCE deflator. Apart from the wild decade of the 1970s, with its two oil price shocks, the increase in the relative price of non-core goods to core goods since 1998/99 is unprecedented, as pointed out to me by John Makin of Caxton Associates.

Acting as a bad statistician who does not realise that the data generating process of the time series he relies on for his forecasts has been subject to a structural break, the Fed continues to treat core inflation as a good predictor of medium-term headline inflation. As a result, inflation got away from the Fed and the Fed did not even realise it.

The point has been made well by Charlie Bean, Chief Economist of the Bank of England and an internal member of its Monetary Policy Committee (see It has also been made repeatedly by Mervyn King, Governor of the Bank of England, and by Governing Council members and staff of the ECB. But the Fed keeps blundering on – a living example of the dangers of Groupthink and confirmation bias.

It is clear that the current phase of the globalization process, with Chindia entering the global markets massively as suppliers of core goods and as demanders of non-core goods, has by no means run its course. Hundreds of millions of rural labourers in both China and India will move in the years to come from the remnants of the old autarkic national economies into the globally integrated economy. This is therefore a time par excellence when looking out of the window and recognising or anticipating a structural break is especially important. Forecasters should predict a continuing, structural increase in the relative price of non-core goods to core goods, regardless of what the past time-series properties of core and headline inflation may have been. Of course, a cyclical downturn in the global economy would bring about a lower relative price of non-core goods, but that would not refute the reality of the underlying trend towards stronger commodity prices.

The argument so far, that an increase (decrease) in the relative price of non-core goods to core goods will raise (lower) headline inflation relative to core inflation would be true even if the change in the relative price of non-core to core goods did not have any effect, even temporary, on the rate of headline inflation.

owever, because core goods are sticky-price goods while non-core goods are flex-price goods, a change in the relative price of non-core to core goods will, cet. par., have an effect on the rate of headline inflation. The cet. that should be held par. for this statement to be correct, are current and future nominal policy interest rates. Specifically, the following proposition holds:

When core goods are subject to nominal price rigidities but non-core goods prices are flexible, a relative demand or supply shock that causes a permanent increase (decrease) in the relative price of non-core to core goods will, for a given path of nominal policy rates (short-term nominal interest rates), cause a temporary increase in the rate of headline inflation, as well as a temporary reduction in the rate of core inflation.

This pattern is clear from Charts 3, 4, 5 and 6, which plot the difference between the headline inflation rate and the core inflation rate on the horizontal axis against the rate of headline inflation. This is done, in Charts 3 and 4 for the CPI over, respectively, the 1957-2007 period and the 1987-2007 period. It is repeated in Charts 5 and 6 for the PCE deflator over, respectively, the 1959-2007 and the 1987-2007 periods.

Therefore, when there is a continuing upward movement in the relative price of non-core goods to core goods, core inflation will be poor predictor of future headline inflation for two reasons.

First, even if headline inflation were unchanged, core inflation would, for as long as the upward movement in the relative price of non-core goods continued, be systematically below both non-core inflation and headline inflation.

Second, for a given path of nominal interest rates, the increase in the relative price of non-core goods will temporarily raise headline inflation above the level it would have been if there had been no increase in the relative price of non-core goods to core goods. When the increase in the relative price of non-core goods comes to a halt, headline inflation will not decline below the level it would have been at without the increase in the relative price of non-core goods. It would take a reversal of the increase in the relative price of non-core goods for headline inflation to fall below the path it would have been on in the absence of the increase in the relative price of non-core goods.

The implication is that for many years now (starting around the turn of the century), the Fed has missed the ball completely on the implications of the global decline in the relative price of core goods for the usefulness of core goods as a predictor of future headline inflation. Medium-term inflationary pressures have been and continue to be higher than the Fed thinks they are. If the Fed ever recognises the truth, the Federal Funds rate will have to be higher than the Fed and the markets believe today.

Chart 1

Chart 2

Chart 3

Chart 4

Chart 5

Chart 6

All data (SA) are from the Bureau of Labour Statistics.

©Willem H. Buiter 2007

Our Right for the Government Not to Know.

The previous post made me ponder how the heavy hand of history has at times weighed down even on me. During the 2001 UK Census, I was moved to commit an act of micro civil disobedience by refusing to complete all of the Census questionnaire. It was prompted by my knowledge of how the high quality of the Dutch population records together with the slavish civil obedience by the vast majority of the Dutch population, facilitated the Nazi's extermination of 75% of the Jewish population of the Netherlands during World War II.

A copy of the letter I wrote to the Census District Manager follows.

Census District Manager 2485 16 June 2001
E1 1AA

Sir or Madam,

Enclosed with this letter is the Census 2001 form for my household. I would like to draw your attention to the fact that I respectfully decline to answer questions 7, 8, 10, 11 and 13 for myself and for my two minor children. I recognize that, while question 10 “What is your religion” is voluntary, questions7, 8, 11 and 13 are compulsory.

Question 7 (“What is your country of birth?”), Question 8 (“What is your ethnic group?”), Question 11 (“Over the last twelve months would you say your health has on the whole been:....”, and Question 13 (“Do you have any long-term illness, health problem or disability which limits your daily activities or the work you can do?”) represent an unacceptable invasion of my privacy. As the information is not provided anonymously (the name of each household member must be provided), any present or future government or any other party with access to these data will have at its disposal all the information required for the effective design and implementation of policies that discriminate on the basis of country of origin, ethnicity or health status and ability to work.

Obviously, such grim scenarios will not happen under the current government or any likely immediate successor. However, within living memory on the European continent, this kind of information would have been sought and exploited with alacrity by those seeking to exterminate the jews, the gypsies and the mentally infirm. The argument that ‘it couldn’t happen here’ fails to convince, even if the expulsion of the jews from England, in AD 1290, was quite a while ago. In the UK, the references to Britain as a “foreign land” during the run-up to the recent General Election should be sufficient to convince one not to take unnecessary risks by enhancing the visibility and vulnerability of the individual vis-à-vis to the State.

I have read your Confidentiality statement “The information you provide is protected by law and treated in strict confidence. The information is only used for statistical purposes, and anyone using or disclosing Census information improperly will be liable to prosecution. Census forms will be held securely. Under the current terms of the Public Records Act 1958m the data will be treated as confidential for a period of 100 years.” I do not doubt the sincerity of this statement, but it is not convincing. As long as the information exists, it can be misused.

As a social scientist, former policy maker and present policy advisor and analyst, I am aware of the importance of good data for the effective design of policies and programmes that improve the quality of life. Fortunately, such useful information can be obtained without recourse to an intrusive Census. Scientifically designed sampling methods can be used to collect the information required for the design and implementation of effective social and economic policies without the threat to civil liberties and human rights inherent in the Census.

I regret having to engage in this small act of civil disobedience, but I cannot, in conscience, act any other way.

Yours sincerely,

Willem H. Buiter

I never received a reply to my letter from the Census District Manager or anyone else.

Shadows of the Holocaust in Hilversum

Mr. Ernst Bakker, the mayor of Hilversum, a small town in the Netherlands, is now a hero of mine. He has refused a request from the Dutch Ministry of Justice to provide the Ministry with information about illegal aliens who don’t qualify for a ‘pardon’. The information would be used to round up the illegal aliens who don’t have any prospect of legalising their residency status in order to expel them from the country.

The heavy hand of history hovers in the background of this story. During World War II, about 75% of the pre-war 140,000 Jewish community in the Netherlands was murdered by the Nazis. One of the reasons for this Nazi success was that the modal Dutch public servant continued to ‘do his job’ during the war. Local officials helped identify the Jews, the local police assisted in rounding them up, Dutch train drivers drove the trains that took them to the camps. Dutch mayors, as heads of local administrations and heads of police were heavily implicated in this widespread support by inertia - born out of cowardice - for the Holocaust.

The Mayor appears to be aware that he is speaking for the dead. When asked: “Should a mayor not just implement the law”, he answers (emphasis added): “I don’t obstruct the law. It says nowhere that I have to pass on these data. That’s not what mayors are for. Even in peacetime.”

In 1940-45 in the Netherlands it was the Jews that were reported, identified through yellow stars, rounded up, shipped out and exterminated. Ordinary citizens going about their daily tasks as usual, in the mayor’s office, in the population registry, in the police force, in the Dutch transit camps, were a major and essential part of the machinery of evil. What will be the next group to be reported, rounded up and shipped out to God knows where: Muslims, Communists, Libertarians, sufferers from Alzheimer’s, those with serious birth defects?

If there are enough men and women with the moral fibre of Mr Bakker, it need not happen again.

Friday, June 29, 2007

Another bomb scare in London

My first recollection of bombs going off in London goes back to the early/mid 1970s. After graduating from Cambridge in the spring of 1971, I often visited friends in the West End - Marylebone Mews, I believe. While staying there one day, I heard some loud bangs - sounds I now recognise as explosions. The IRA had detonated one of its explosive devices at the Selfridges Department store in nearby Oxford Street. In the years following, a performance I attended at Sadler's Wells Theatre was evacuated because of a bomb scare (false alarm), I had to leave a barber shop with half a hair cut, and people (including yours truly) got their knickers twisted in the Tube on a number of occasions because some nitwit had left a shopping bag behind. In 1997, I moved into the Canary Wharf area, first just to the north and later to the southern tip of the Isle of Dogs. Each working day, the Docklands Light Railway passed South Quay, where the IRA had set of a deadly explosion in 1996. Since then, of course, we have had the murderous post-9/11 attacks on London by Al-Quaeda-inspired British Muslim fanatics, the subsequent failed attacks on the underground system and today the two (so far) failed car bombs in the West End.

You don't get used to these outrages. With each attempt to terrorise us by maiming and killing the innocent, seemingly at random, I get more angry and determined not to let the bastards that want to destroy my city and my way of life and who endanger the life and well-being of my loved ones, have their way.

I don't care whether the perpetrators feel deeply aggrieved by what Bush/Blair/the US/the UK/the West/Christendom/the Crusaders and the Great or Little Satans may or may not have done to them and to the causes, beliefs and things they hold sacred. Sincerity and deeply held beliefs can explain actions, but do not justify them. No doubt Hitler was a sincere Nazi, Attila a sincere Hun and Idi Amin a sincere psychopath. Tout comprendre n'est past tout pardonner. There is no justification for the actions of these murderers and suicide cultists. The human excrement that perpetrate these crimes against God and humanity must be hunted down and locked up or killed. I admit that my occasional day dream, which involves tying the murderers/suicide cultists to their own explosive devices, and blowing them up one small piece at a time, is unworthy and does not express the teachings of the faith I would like to believe in. But I do not apologise for the righteous anger that prompts such musings, and I become even more determined that these emissaries of evil shall never prevail.

Thursday, June 28, 2007

Murdoch and the Wall Street Journal

Rupert Murdoch’s News Corp.’s bid for Down Jones & Co is bad news for all those who value independent news reporting and analysis and believe that information content and insight are not the same as entertainment value and celebrity. The jewel in the crown of Dow Jones & Co is the Wall Street Journal, one of only two English language newspapers with a global reach and a reputation for independent reporting and analysis. The other one is the Financial Times.

News and expert independent analysis have public goods features in a number of ways. First, like all information, it is costly to produce but can, with modern media technology, including the internet, be distributed/disseminated at effectively zero marginal cost. The fact that it is ex-post non-rival but costly to produce ex-ante means that profit-driven news and analysis provision will be sub-optimal.

Second, the free and independent provision of news and analysis is essential for the survival of a free society. Politicians, however committed to freedom of expression and enquiry and to openness, transparency and accountability while in opposition, invariably, once they form a government, uncover all kinds of self-serving reasons for interfering with these freedoms and for limiting access to information. Governments and their servants feed us a daily diet of spin, deception and outright lies, and try to erect barriers and obstacles to deflect and harass those who are searching for the truth. Private concentrations of power likewise are hostile to news and information that they cannot manage and control.

So independent news, commentary and analysis are public goods. How to ensure their survival, despite government hostility, the relentless pressures for quality debasement by the profit motive and the depredations of megalomaniac billionaires, is a serious challenge with no obvious answer. It must be clear, though, that for papers like the Wall Street Journal and the Financial Times, the shareholders are not the only stakeholders who should be heard when a change of ownership and control is in the works. The history of Murdoch’s ownership and control of media in Australia, the UK and the US makes it clear that there will be zero effective editorial independence for the Wall Street Journal should Down Jones & Co be purchased by News Corp.

Under Murdoch’s control both the London Times and the Sunday Times have become Red-Tops as regards content and quality. In the world of the media, Rupert Murdoch is the King Midas of the sewers – everything he touches turns to dreck.

RIP free and undistorted competition in the proposed Revision Treaty for the EU?

The Neanderthals have won. For the first time since the Treaty of Rome was signed in 1957, free and undistorted competition will no longer be among the guiding principles of the European Union.[1] This concession to the dark side was unnecessary and is unforgivable. If the EU is not about a single, free market with undistorted competition, then what is it about?

The proposed ‘Constitreaty’ represents a significant redistribution of voting power among Member States. There is also a material transfer of national sovereignty to Brussels involved in the following: granting the EU single legal personality; the creation of a full-time Council President; the creation of a single EU foreign minister – I believe the formal title is Lord High Executioner of the European Union for Foreign Affairs and Security Policy; the creation of a unified EU diplomatic service; and the extension of qualified majority voting in a large number of areas. There are further important constitutional changes such as the reduction in the number of Commissioners and the increased budgetary powers of the European Parliament.

Our leaders should not lie to us by insisting that this Treaty is just a minor tidying-up exercise. It is an amending Treaty only in the sense that death is an amendment to life. The British people must have the opportunity to vote in a referendum on this Constitution in Treaty’s clothing.

[1] From the Treaty of Rome (1957) to the Treaty of Nice (signed in 2001) the Treaties have contained, in the section on the Principles of the European Community, references to free movement of goods, persons, services and capital and undistorted competition. For instance the currently effective Consolidated Version of the Treaty Establishing the European Community, Part One –Principles, Article 3. 1 states: “For the purposes set out in Article 2, the activities of the Community shall include, as provided in this Treaty and in accordance with the timetable set out therein: (c) an internal market characterised by the abolition, as between Member States, of obstacles to the free movement of goods, persons, services and capital; (g):a system ensuring that competition in the internal market is not distorted; “.