Is the Federal Reserve Board fighting the wrong war?
Since the financial crisis started in 2008, the Fed has engaged in a series of "Quantitative Easings" to ward off potential deflation. In its most recent iteration, the Fed will buy $70 billion of longer-term bonds per month. It has also committed to keeping the short-term Federal funds rate near zero percent indefinitely.
As measured by the Consumer Price Index, the Fed has succeeded. Over the past five years, CPI inflation has averaged exactly the 2 percent per year targeted by the Fed.
Is the Fed happy about this? It is not. Because inflation in 2013 will come in at about 1.6 percent, Quantitative Easing and interest rate suppression will continue until inflation expectations exceed 2.5 percent.
On one hand, the Fed's desire to pull the economy further away from deflation is understandable. Deflation, which occurs when prices are falling, is the hardest economic trap to escape.
Why? When prices deflate, consumers delay purchasing today what will be less expensive tomorrow. As consumers hold back, business activity and employment fall. Debt becomes harder to service as individual incomes and business profits decline.
The normal processes for stimulating the economy no longer work. It pays to hold cash even if interest rates are cut to zero. Tax cuts are more likely to go into savings than consumption.
The exact opposite occurs during periods of inflation. It is better to borrow and buy now before prices go up. Although inflation has its own adverse consequences in the long run, its initial phases can boost demand and increase employment. This is clearly what the Fed is hoping to do by getting the CPI above its target.
The problem is that real-world inflation may already be there.
Over the years, the methods for calculating the CPI have changed substantially. The largest component of the CPI -- housing expense -- was changed from the cost of houses to the cost of "owner's equivalent rent." This is currently understating the rate of inflation compared to past methodology.
The CPI is now subject to "hedonic" adjustment. Today's $25,000 car or $700 computer is better than yesterday's. In calculating the CPI, this counts as a price cut since the consumer is getting more for the same amount of money. From a "cost of living" perspective, yesterday's computer might theoretically cost $100 but nobody makes it so computer buyers shell out the same $700 as they did before.
The CPI also adjusts for "substitution." If the price of steak goes up, real world shoppers switch to chicken. This causes the CPI to put less steak and more chicken into the market basket making look as if prices have not gone as much as they have.
According to John Williams' Shadow Government Statistics, inflation is currently over 8 percent using the methodology in place before 1980 and over 4 percent using the methodology in place before 1990.
If true, the Fed's fear of deflation is overblown and its devotion to Quantitative Easing misplaced.
Jeffrey R. Scharf is chairman of Scharf Investments. Contact him at firstname.lastname@example.org.