Inflationary Expectations

July 30, 2007 – I recently wrote an article published on Kitco.com that made reference to a July 10^th speech by Federal Reserve chairman Ben Bernanke. The full text of his speech can be read at this link: www.federalreserve.gov

My article was critical of Mr. Bernanke’s analysis as well as his conclusions. I wrote: “In recent years the Federal Reserve has made much of its contention that inflation is a result of inflationary expectations. It asserts that if people expect inflation, there will be inflation. This theory despicably deflects attention away from the true culprit because it is not the public that causes inflation, but the Federal Reserve itself.” My article is posted at this link: ‘Gold’s Infallable Indicator – Six Months Later’

There is much bad thinking in Mr. Bernanke’s speech, and my article does not sufficiently skewer his novel, boneheaded theory on the cause of inflation. So I thought it might be useful to give it more attention. I’ve decided to do this by taking selected quotes from Mr. Bernanke’s speech (which appear in italics below) and then follow with my comments.

“As you know, the control of inflation is central to good monetary policy. Price stability, which is one leg of the Federal Reserve’s dual mandate from the Congress, is a good thing in itself…In the long term, low inflation promotes growth, efficiency, and stability–which, all else being equal, support maximum sustainable employment, the other leg of the mandate given to the Federal Reserve by the Congress.”

Price stability is obviously important, but this objective is of course impossible. In the real world, nothing is stable. Price stability was not even possible under the gold standard, but this mechanism achieved a state much closer to price stability than fiat dollars ever have or ever will.

Nor can the Fed achieve maximum sustainable employment. So the “dual mandate” Mr. Bernanke refers to is a red herring.

What is the Fed’s purpose for being? It has only one – to make sure that there are always enough dollars created to fund the federal government’s budget deficits. That’s it. There is no other reason for its existence. The Fed is there to make sure that the politicians have all the money they want in order to satiate their spending aspirations. The Fed is not there to fight inflation. Just look at its miserable track record in trying to achieve “price stability”.

Of course the Fed will jawbone incessantly that fighting inflation is a high priority, but that is just empty rhetoric to keep people from abandoning the dollar and moving into other monies. To repeat this important point, the Fed’s sole purpose is to make sure the federal government deficits continue to get funded with newly created dollars.

“Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank’s ability to achieve price stability. But what do we mean, precisely, by “the state of inflation expectations”? How should we measure inflation expectations, and how should we use that information for forecasting and controlling inflation? I certainly do not have complete answers to those questions, but I believe that they are of great practical importance.”

Even though he doesn’t have the answers, it won’t stop him from using us as laboratory mice in his grand experiment to control inflationary expectations.

“But in fact…long-run inflation expectations do vary over time. That is, they are not perfectly anchored in real economies; moreover, the extent to which they are anchored can change, depending on economic developments and (most important) the current and past conduct of monetary policy. In this context, I use the term “anchored” to mean relatively insensitive to incoming data.“

In other words, the policy of the Federal Reserve is to fool people into thinking that inflation is contained. In this way the public is supposed to spend their debased dollars completely oblivious to their loss of purchasing power.

“…the concept of anchored expectations is easily formalized in a variety of ways; in general, if the public is modeled as being confident in its current estimate of the long-run inflation rate, so that new information has relatively little effect on that estimate, then the essential idea of well-anchored expectations has been captured.”

Here he reveals his plan to herd people as if they were sheep to make them think inflation is not a problem. Governments and their advocates ignore people’s free will – their ability to change their mind or to pursue a course of action the government doesn’t want them to pursue. So when the government cannot achieve its desired result, it inevitably leads to governments imposing ever increasing controls. When Bernanke realizes that he cannot control inflationary expectations in an environment in which the Federal Reserve is allowing too much new money to be created, he will also turn to capital controls or other government imposed restrictions to make his ‘theory’ work.

“Allowing for learning has important implications for how we think about the economy and policy. For example, some work has shown that the process of learning can affect the dynamics and even the potential stability of the economy. Considerations of how the public learns about the economy affect the form of optimal monetary policy.”

This statement is complete nonsense, and ignores the true cause of inflation. If the Federal Reserve creates too much money, prices will rise. It’s that simple. Again, Bernanke is trying to deflect the blame for inflation from the one and only culprit, the Federal Reserve itself.

“Notably, in a world with rational expectations and in which private agents are assumed already to understand all aspects of the economic environment, talking about the effects of central bank communication would not be sensible…“

Yes, instead we are expected to leave everything to the central banking ‘priesthood’ and allow them to continue operating behind closed doors like some mad monks. We are supposed to place blind faith in these unelected central bankers who control our monetary destiny and like Bernanke, have never run a company or needed to meet a payroll.

“…if the central bank and the public learn from experience that high inflation imposes greater costs and fewer benefits than previously thought, then the equilibrium will adjust toward one with lower inflation and lower inflation expectations.”

This statement is novel. He is saying in effect that because we all know that inflation is bad, there won’t be any inflation because we don’t want it to happen. That proposition is laughable and makes me wonder whether Bernanke really believes this stuff. If he does, he is the perfect patsy to be Federal Reserve chairman. He will have no qualms about delivering exactly what the politicians want – more newly created dollars for them to spend.

“Notably, the sharp increases in energy prices over the past few years have not led either to persistent inflation or to a recession, in contrast (for example) to the U.S. experience of the 1970s.”

Not yet anyway, when inflation is measured by government statistics, which considerably understate the true rate of inflation. But give energy prices a little more time to have an effect.

What’s more, the sharp increase in energy prices has already led to an increase in consumer debt, from home mortgages to credit cards as consumers have tried to maintain their standard of living by borrowing more money.

“If people set prices and wages with reference to the rate of inflation they expect in the long run and if inflation expectations respond less than previously to variations in economic activity, then inflation itself will become relatively more insensitive to the level of activity.”

It is too much newly created money that causes inflation. It is not caused by people expecting inflation.

“Certainly, increases in energy prices affect overall inflation in the short run because energy products such as gasoline are part of the consumer’s basket and because energy costs loom large in the production of some goods and services. However, a one-off change in energy prices can translate into persistent inflation only if it leads to higher expected inflation and a consequent “wage-price spiral.” With inflation expectations well anchored, a one-time increase in energy prices should not lead to a permanent increase in inflation but only to a change in relative prices.”

In other words, the dollar is debased as a result of higher energy prices. So it purchases less, meaning that people whose salary is dollar-denominated will become less wealthy. In effect, energy increasingly becomes a luxury good as it already is to the impoverished in much of the Third World.

“A related implication is that, if inflation expectations are well anchored, changes in energy (and food) prices should have relatively little influence on “core” inflation, that is, inflation excluding the prices of food and energy.”

This is a half- truth. Labor costs may not rise; as explained in my comment immediately above, people just become relatively poorer. But he is wrong about rising energy price. Companies will offset this cost with higher prices, rather than accept a reduction in profit margins to levels below those necessary to sustain their capital investment.

“Although inflation expectations seem much better anchored today than they were a few decades ago, they appear to remain imperfectly anchored.”

Thank goodness. It means that people are much smarter than the Federal Reserve believes them to be. They can’t be fooled by all the jawboning and spurious inflation measures reported by the government.

“The policy implications of the much-improved but still imperfect anchoring of inflation expectations are not at all straightforward.”

These are marching orders from Mr. Bernanke to his cohorts at the Fed. Says he — We have to fool the people even harder.

“First, how should the central bank best monitor the public’s inflation expectations?“

Simple. Watch their purchases of gold and silver.

“A fuller understanding of the public’s learning rules would improve the central bank’s capacity to assess its own credibility, to evaluate the implications of its policy decisions and communications strategy, and perhaps to forecast inflation.“

A central bank only needs to assess its credibility if it is not telling the truth. By implication, we can deduce that the Federal Reserve does not always speak the truth. Instead, it practices what is one of my favorite adages – namely, that central banks only tell you what they want you to hear.

“…the staff’s long-term track record in forecasting inflation is quite good by any reasonable benchmark.”

It should be. After all the Federal Reserve is at the center of the money debasement process that creates inflation, so it should obviously know how much it is inflating.

“…our ability to forecast inflation and predict how inflation will respond to policy actions depends very much on our capacity to measure and to understand what determines the public’s expectations of inflation.”

So here Mr. Bernanke is providing his justification for keeping the gold price suppressed – namely, because it will keep the public’s expectations for inflation suppressed. It is this point that I analyze in my Kitco article mentioned above.

“In short, for all the advances that have been made in modeling and statistical analysis, practical forecasting continues to involve art as well as science.”

It is interesting that Mr. Bernanke uses this terminology. The following statement by Antony Mueller wonderfully describes the true and essential nature of Mr. Bernanke’s so-called ‘art’: “Central bankers sometimes describe their activity as “more art than science,” which is implicit recognition of their ignorance. The “art of central banking” is the art of pretending to know what one does not know. Not only is it not a science; it is not even an art. At best it is alchemy; at worst it is a gigantic cheat.” (Ludwig von Mises Institute – ‘Nightmares of a Central Banker’)

“In making very near-term price forecasts, the staff also uses diverse information from a variety of sources, such as surveys of prices of gasoline and other important items, news reports about price-change announcements, and anecdotal information from our business contacts.”

I guess neither the Fed staffers nor any of their business contacts have bought a quart of milk recently. If they did, maybe they would stop saying that inflationary pressures are contained.

“For forecasting horizons beyond a quarter or two, detailed analyses of individual price components become less useful, and thus the staff’s emphasis shifts to inflation’s fundamental determinants.“

There is only one determinant – if the central bank creates too much money, inflation is the result. Inflation is money debasement, pure and simple. It is not about commodities, goods or services becoming dearer or any other factor.

“The two principal quarterly indicators of aggregate hourly compensation are the employment cost index (ECI) and nonfarm compensation per hour (CPH). Both are imperfect measures of the labor costs relevant to pricing decisions…Moreover, these two hourly compensation measures often give contradictory signals”[and]“…while inflation expectations doubtless are crucial determinants of observed inflation, measuring expectations and inferring just how they affect inflation are difficult tasks.”

These statements explain why command economies don’t work. Economy activity is too varied and complex for any person or group of persons to understand. Just look at what the Politburo did to the economy of the former Soviet Union. The Federal Reserve is doing the same thing to the US economy through policies that are destroying the dollar, though the Federal Reserve is operating at a slower speed than the Politburo did.

“Intuitively, if the Fed attempts to disinflate by raising the federal funds rate, the disinflationary effect will be felt not only through the usual output gap channel but also through a direct restraint on long-term inflation expectations.”

Of course. Former Federal Reserve chairman Paul Volcker proved precisely this point. Raise real interest rates high enough and you will – as the saying went back then – attract money from the moon.

“To be sure, this and similar analyses remain speculative. A good deal more must be done before such work proves a reliable basis for policy choices.”

In other words, the Fed doesn’t have a clue, but that won’t stop them from experimenting, using us as the guinea pigs.