There has been an on-going debate about inflation and whether policy makers should be focused on reducing it. The CPI increased to 3.8% y/y in August, further accelerating from 3.6% in July. These figures are above the Federal Reserve's comfort zone of 1% to 3%.
As defined by the BLS,
the CPI is "a measure of the average change over time in the prices
paid by urban consumers for a market basket of consumer goods and
services." First off, I have a couple broadly shared problems with using the CPI as the main measure of inflation. The first is that it only measures a relatively small fraction of the goods and services exchanged in the US, and thus may provide false reading on overall inflation. The second is that it does not account for changes in quality of products. For example, a t-shirt manufacturer could begin using less cotton in their shirts but continue to charge the same price. My final issue is the weighting of the basket of goods and services, which can provide skewed results should consumption patterns change.
However, the issue I see currently is that the CPI inflation measurements are more apt to provide misleading guidance, in my opinion.
Generally, inflation is the result of demand exceeding supply. Thus if inflation is too high, policy makers try to reduce demand through levers like raising interest rates. Alternatively, if deflation is a risk, policy makers attempt to increase demand by lowering interest rates.
The problem currently is that inflation is not a result of excess demand, in my view. Instead, I believe the root cause of the current inflation has been dramatic rises in costs due to higher commodity prices. These higher commodity prices are a result of, at least in part, by a weakening dollar associated with monetary easing. Companies have attempted to manage these costs through various tactics, including streamlining of operations, possibly reducing quality, and even layoffs. Eventually, however, they have been forced to pass along these costs to consumers, thus driving up CPI. These commodity cost increases have been an issue for companies for the past couple years.
Why is this important? Well, in short, the problem is not weak demand. The problem is much more structural and thus monetary policy is a dull tool against it. At its core, I believe the current economy is suffering from the mis-allocation of resources and excess supply. After decades of activist monetary policy that avoided more severe economic slowdowns, many less competitive companies have been able to survive due to lower interest rates. The lower rates both enabled consumers to service larger debt balances, artificially raising demand, and has enabled weaker companies to remain in business, artificially increasing supply.
I believe we are reaching a point where monetary policies can no longer prop up demand. This diminishing boost is due partly to historically low interest rates that offer less and less "fuel" as they decline, in my view. I also believe the distortion of the allocation of resources is the fundamental problem with which businesses are struggling. At the extreme, bubbles have formed and disappeared due in part to the distorting side effects of an activist monetary policy. The dot-com bubble, the housing bubble, and the recent rise in commodity prices are examples of these side effects, in my opinion. The rise in commodity prices appears to have actually hurt demand as prices have been increasing, thereby reducing consumption.
So where are we headed? The Fed appears intent on at least trying something, even if its chance of success are minimal. So we likely get another manipulation of the yield, distorting economic decisions. Deflation likely becomes more and more prevalent if the core reason of past CPI increases diminishes, which I believe has been commodity prices. Ultimately we avoid addressing the structural problems in the economy in the near-term, likely leading to slower growth in the future.
All these points imply long-term yields decline despite the recent CPI figures.
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