NO TAPER in September

Most of the speculation with regard to the timing of a possible Fed “tapering” has been centered around the improvement in incoming employment data. This may make sense given the severe problems in the labor market over the past several years. But while it can be debated whether or not an improvement in the unemployment rate really tells the whole story of the labor market (we believe it does not), the Fed is charged with a dual mandate. Not only must the central bank attempt to achieve maximum employment, but it must also do so within the context of price stability. Typically, investors assume that this second mandate means that the Fed must ensure that inflation does not get wildly out of control. Under normal economic conditions, this is indeed the major goal. The most notorious example of the Fed fighting runaway inflation is when Fed Chairman Paul Volcker “broke the back” of inflation (or more accurately “stagflation”) by taking the Fed Funds rate up to 20% in the early 1980’s. Higher interest rates cooled the economy (at significant cost in the near term), and price increases began to level off.

But there is another side to the coin. Not only must the Fed guard against runaway inflation, but it must also fight against deflation. Deflation can be just as devastating, if not more so, to an economy than inflation. We need only look at the experience of Japan over the past couple of decades to conclude that we don’t want to experience that same fate. The problem with deflation is that consumers and businesses delay spending and investment because they believe they can get a better deal at some point in the future. Therefore, deflation suppresses economic growth and the job creation that goes with it.

Below we show several metrics that the Fed uses to determine the level of inflation in the economy. Because food and energy price increases tend to be volatile (and often transient), the Fed prefers to look at these metrics on a “core” basis, which is to say that they exclude the volatile prices of food and energy. It should be obvious when looking at the chart that the growth in price levels has been declining since early 2012. Economists call this phenomenon “disinflation” because it represents a decrease in the rate of inflation. And while disinflation does not necessarily mean that deflation will follow, the data has caused enough concern at the Fed for many participants to adopt a more vigilant posture.


Source: Bloomberg

“PCE Core” is the Personal Consumption Expenditures deflator excluding the cost of food and energy. “CPI Ex Food & Energy” is the Consumer Price Index excluding food and energy. “ECI” is the Employment Cost Index. “PPI Ex Food & Energy” is the Producer Price Index excluding food and energy. This last index measures prices at the wholesale level.

Unfortunately, the inflation metrics in the chart may not be capturing the whole story. There are several price categories that these metrics ignore. First and most obviously are the prices of food and energy. While food and energy expenditures are a much smaller part of the US consumer’s budget when compared to other countries (most notable emerging economies), this does not mean that consumers are unaffected by dramatic swings in the prices of such items. Furthermore, food and energy expenditures make up a much larger percentage of the moderate-income consumer’s budget than that of the more well-to-do. One of the criticisms of Fed monetary policy is that most of the benefits have accrued to wealthier Americans while middle America continues to struggle. For our part, we agree that the economic recovery needs to be more broad-based across income and wealth levels. Incorporating the rising costs of food and energy may be a step in the right direction.

Secondly, these metrics do not include housing prices. Instead, the relevant metrics include “Owner’s Equivalent Rent”, which does not measure increases in the cost of buying a home. Had Fed Chairman Greenspan included the rapid spike in housing during his tenure he may not have drawn the conclusion that inflation was not a problem. The most recent reading of the S&P Case Shiller 20-City price index suggests that housing prices increased over 12% from May, 2012 to May, 2013. If these increases in housing prices were incorporated into the Fed’s measure of inflation, there might be more appreciation of the cost of living for the average American.

And finally, these metrics to not measure the level of other asset prices. Yes, you guessed it. We are talking primarily about stock prices. The S&P 500 is up 150% from the low of March 9, 2009. Not only is Bernanke unconcerned about this meteoric rise, but he has been openly targeting stock prices as a way to increase spending and investment. This attempt to manipulate stock prices is probably our single-biggest concern with regard to Fed policy. There is little doubt that the rise in stock prices has supported spending somewhat through a “wealth effect.” People fortunate enough to own large stock portfolios are the major beneficiaries. But there is significantly less evidence that the increase in stock prices has led to job creation and/or an improvement in the financial situation of Joe Sixpack. Again, we believe strongly that the economic recovery must become more broad-based before we can declare victory. Instead, Fed policy is leading to large increases in the wealth gap between the rich and poor, which creates longer term problems of its own.

There is no doubt that inflation is subdued in most sectors of the economy right now. The lack of inflation is largely the result of slack in the economy (high unemployment and low factor utilization) and tighter lending standards at the banks. But it is also true that the metrics used by the Fed to track inflation are flawed. In our view, the failure to incorporate the prices of food, energy, housing and other assets (stocks) is causing mistakes in monetary policy… again. Given the continued evidence of disinflation using the Fed’s preferred metrics, we believe the Fed will ultimately decide to delay the decision to taper. Stocks may continue to rise on the news, but the Fed will simply be digging itself into a bigger hole.