Email Exchange With The Cleveland Fed On Inflation Expectations

A couple weeks ago I received an email from the Cleveland Fed on A New Approach to Gauging Inflation Expectations.

People’s expectation of inflation enters into nearly every economic decision they make. It enters into large decisions: whether they can afford a mortgage payment on a new house, whether they strike for higher wages, how they invest their retirement funds. It also enters into the smaller decisions, that, in the aggregate, affect the entire economy: whether they wait for the milk to go on sale or buy it before the price goes up.

Real interest rates also play a key role in many economic decisions. When businesses invest—or don’t—in plants and equipment, when families buy—or don’t—a new car or dishwasher, they are making judgments about the real return on the object and the real cost of borrowing. As such, real interest rates can be an important guide to monetary policy. As Alan Greenspan once explained,1 keeping the real rate around its equilibrium level (which is determined by economic and financial conditions), has a “stabilizing effect on the economy” and it helps direct production “toward its long-term potential.”

I was told that I could set up an interview with Joseph Haubrich, vice president at the Federal Reserve Bank of Cleveland about his model. I tried to setup an interview but was directed to send my questions by email instead.

Here there are...

Inflation Expectation Questions For Joseph G. Haubrich

1. When was the last time you bought a computer? Did you expect prices to drop? Did you buy a computer anyway?

2. When was the last time you bought a flat panel monitor or TV? Did you expect prices to drop? Did you buy them anyway?

3. If you expected the price of steaks to keep rising, would you buy a years’ worth? Six months worth? Do you even have a freezer?

4. If you expected the price of milk to keep rising, how much supply would you keep?

5. Do you have a storage tank for gasoline when you expect gas prices to keep rising?

6. If your refrigerator was in good shape would you buy another one if you thought they were going up in price.

7. If your refrigerator, microwave, TV, or even car went out, would you buy them or wait if you thought prices would drop?

8. I keep hearing how inflation expectations will cause people to buy consumer items, or deflation concerns cause people to not buy consumer items, but in light of the above practical test questions doesn’t that seem to be a potty notion?

9. What about asset prices? Would people buy stocks if they thought they were going up? Houses? This one I will answer for you (you bet).

10. Does the Fed factor in asset prices into its inflation expectations? If so how? Did not the Fed completely ignore a housing bubble? In fact, isn’t it true the Fed could not see a housing bubble that 100 housing blogs could see?

11. Given that the Fed ignores asset bubbles, commodity speculation, etc (the only areas in which people actually do things simply because they expect prices to rise or fall) while focusing on consumer price expectations that have no bearing on what people do, doesn’t the Fed have its inflation policy ass backwards?

12. Isn’t it silly to actually think inflation expectations 30 years out matter one iota?

13. Given that the Fed has blown bubble after bubble of increasing amplitude, ignoring the problems until they blew up in the Fed’s face, with Bernanke denying there was a housing bubble, then denying there would be a recession, then coming up with preposterous unemployment expectations, pray tell exactly why should anyone believe the Fed can model inflation expectations or even inflation as it is actually happening?

14. If the Fed thinks that market expectations are important, why not simply let the market set interest rates?

15. How could letting the market set rates possibly be any worse than the repetitive bubbles the Fed blew under Greenspan and Bernanke?

16. Pray tell of what use is the Fed other than to bail out banks when they get in trouble? And of what use is that to anyone but the banks?

17. I would appreciate your comments on The Fed Uncertainty Principle, written Thursday, April 03, 2008, before the massive bailouts occurred.

The Observer Affects The Observed

The Fed, in conjunction with all the players watching the Fed, distorts the economic picture. I liken this to Heisenberg's Uncertainty Principle where observation of a subatomic particle changes the ability to measure it accurately.

To measure the position and velocity of any particle, you would first shine a light on it, then detect the reflection. On a macroscopic scale, the effect of photons on an object is insignificant. Unfortunately, on subatomic scales, the photons that hit the subatomic particle will cause it to move significantly, so although the position has been measured accurately, the velocity of the particle will have been altered. By learning the position, you have rendered any information you previously had on the velocity useless. In other words, the observer affects the observed.

Fed Uncertainty Principle: The fed, by its very existence, has completely distorted the market via self reinforcing observer/participant feedback loops. Thus, it is fatally flawed logic to suggest the Fed is simply following the market, therefore the market is to blame for the Fed's actions. There would not be a Fed in a free market, and by implication there would not be observer/participant feedback loops either.

Corollary Number One: The Fed has no idea where interest rates should be. Only a free market does. The Fed will be disingenuous about what it knows (nothing of use) and doesn't know (much more than it wants to admit), particularly in times of economic stress.

Corollary Number Two: The government/quasi-government body most responsible for creating this mess (the Fed), will attempt a big power grab, purportedly to fix whatever problems it creates. The bigger the mess it creates, the more power it will attempt to grab. Over time this leads to dangerously concentrated power into the hands of those who have already proven they do not know what they are doing.

Corollary Number Three: Don't expect the Fed to learn from past mistakes. Instead, expect the Fed to repeat them with bigger and bigger doses of exactly what created the initial problem.

Corollary Number Four: The Fed simply does not care whether its actions are illegal or not. The Fed is operating under the principle that it's easier to get forgiveness than permission. And forgiveness is just another means to the desired power grab it is seeking.

Those were my 17 questions for Joseph Haubrich and the Cleveland Fed. I sent them about a week ago. If I get a reply I will post it. However, I am not holding my breath.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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