Ron Paul on Bernanke's Press Conference

CNBC interview with Congressman Ron Paul yesterday (April 28, 2011); click here.

The interviewer begins by quoting a statement Paul made after Bernanke's news conference:

Bernanke continues to ignore his culpability for the inflation all Americans suffer due to the Fed's relentless monetary expansion.

Let's take a look at U.S. inflation since 2008. Here it is.

The average annualized rate of inflation over this time period is a dizzying 1.6%. Note the significant deflation experienced during the economic crisis. Ah, good times. The rate of return on your money was really high back then! I can recall clearly how savers were rejoicing...praising the Fed for the deflation.

PCE inflation measures the nominal price of a basket of consumer goods. You know, the stuff people buy to maintain their material living standards. This price index was actually falling in 2010. For better or worse, the Fed interprets "price stability" as 2% inflation. This explains QE2.

PCE inflation has recently jumped up to near 5%. This jump is attributable primarily to food and energy prices. Despite what some people like to believe, the Fed does not control food and energy prices (at least, not separately from other prices). Most economists attribute these relative price changes to geopolitical events and other temporary global shocks affecting the world supply and demand for food and energy.

It seems that what Congressman Paul means by inflation (judging by this interview) is "commodity price inflation." I think he must have in mind the price of commodities like gold. Why is the price of gold rising? Because people are dumping the USD and flocking to a "currency" they can trust.

Well, alright. There is probably something to this notion of currency substitution. If the Fed grows the money supply, its value must fall. The price of gold must rise. In the interview above, the Congressman claims that even grade schoolers can understand this (suggesting that Bernanke cannot).

Recent money supply and gold price dynamics seem to support Congressman Paul's hypothesis, which he states as some sort of obvious universal truth. But if this is so, then what explains the following data?

The graph above plots the price of gold and the (base) money supply over the 20 year period September 1980 to March 2001. As you can see, the Fed created a lot of money "out of thin air" over this 20 year period. The base money supply increased by over 300%.

Imagine that you are 50 years old in September 1980. Imagine that a trusted friend of yours--oh, let's say your doctor--convinces you to put all your savings into gold. The reason he offers is that the Fed is pursuing a policy of "relentless money expansion." He warns you that the money supply is set to grow by 300% over the next 20 years. So you listen to him.

You buy gold at $673 per ounce. And then you wait. You wait until you turn 70. And then you go to withdraw your savings. You discover that the gold price in March 2001 is $263 per ounce. That's a whopping rate of return of...wait for it... -60% over 20 years. That's a minus sixty percent.

All you kids understand now? Viva la gold standard! Class dismissed.

Meet the FOMC

From CNBC News, a nice little snapshot of the people who currently make up the Federal Open Market Committee.

When people think of "the Fed," they might picture a monolithic building in Washington, D.C., or the serenely smiling, bearded face of its chairman, Ben Bernanke.

But the reality is, the group making decisions about raising or cutting rates or pumping money into the economy through so-called quantitative easing is made up of several highly educated, opinionated individuals with sometimes-conflicting ideologies, personalities and policy specialties.

Meet the Federal Open Market Committee.

Read more: Infighting at the Fed? 

Time to replace the Core Inflation measure?

As almost everyone knows, inflation appears to be ticking upward. PCE inflation has recently approached an annual rate of around 5%. However, core inflation--the inflation rate that strips out the food and energy components of the consumption basket--remains relatively subdued (almost 2%, though it too has been rising as of late).

The Fed is widely understood to have an implicit inflation target of 2%. And the Fed has been known in the past for preferring the core PCE inflation measure over actual (headline) inflation numbers. With food and energy prices rising rapidly as of late, the reference to core inflation makes the Fed look out of touch with the prices consumers actually pay for their daily basket (food and energy make up about 25% of the average consumption basket).

What, if anything, justifies looking at price indices that strip out components of the index? A cynical view is that the Fed may prefer core to headline because it evidently makes the Fed's performance look better (in terms of keeping inflation low). This cynical view conveniently ignores the fact that headline inflation is frequently below core.

If you want to educate yourself about the issues surrounding the use of core, I recommend that you read this piece by Jim Bullard: Headline vs. Core Inflation: A Look at Some Issues. He starts as follows...

Monetary policymakers are responsible for maintaining overall price stability, which is usually interpreted as low and stable inflation. In order to decide on appropriate policy actions given their objective, policymakers need to know the current rate of inflation and where it is headed. What makes for a reliable predictor of future inflation has been debated throughout the years and continues to be the subject of economic analyses today.  

and concludes with...

In the end, the policymakers' goal is to use the inflation measure that helps them achieve low and stable headline inflation in the long run. 

In short, the Fed is not wedded to any particular policy-relevant measure of inflation. Many different measures should likely be used as input into any policy decisions.

In terms of the use of core inflation, my own personal view leans toward dispensing with any inflation measure that strips out components of the consumption basket. If the main object of doing so is to get at some measure of "trend" inflation, then why not just compute a trend directly? For example, here is what one would get by using a simple exponential trend:

My crude measure of trend is not that much different from core. I doubt that there would have been any substantive difference in the way policy was actually conducted if reference had been made to this (or some other) measure of trend over the core measure. And an explicit reference to trend rather than core may have deflected the silly charge made by some that the Fed does not care about food and energy prices.