A Message To The Fed: Take Your 2 Percent and Shove It

In which the entire economy is predicated on nonsense policy.

May 19, 2018

If you pay any attention to financial news—even just by listening to Kai Ryssdal perform vocal gymnastics on Marketplace once in a while—you might have picked up on the fact that the Federal Reserve has a 2% inflation target. If you've paid especially close attention, you might also know that this target is supposedly "symmetric," meaning that the target is really a range somewhere between, perhaps, 1.9% and 2.1%. Whether we slightly overshoot or undershoot, being within range on either side of the inflation target is good enough for the Powers That Be.

The fundamental problem is that like much of economics, the Fed's legal and economic policies, including its inflation target, are built on a foundation of bullshit. The Fed picked a round number that you won't find in any economics textbook, made it dogma, and then, it substantially changed the way it measured that number.

The press likes to talk about the inflation target and whether or not it has been met, but the financial media almost never questions where the 2% number came from in the first place. It's as though the number was handed down on a set of stone tablets from Mount Sinai. One quasi-exception is a 2015 piece in The Economist which purports to explain why the Fed chose an official target of 2% in January 2012. The only problem is that the article doesn't really answer the question, except to say higher is worse and lower is risky. But why not 1.5%? Or 3.5%? There's a notable dearth of mathematical support for this conveniently round number.

Something strange happened on our way to meeting the official inflation target. We're still "on our way" because on May 2, the Fed left the Federal Funds Rate (the formal name for the interbank lending rate that it sets) unchanged, stating only that the country had "moved close" to the 2% target. Yet from 2012 until today, housing prices, rents, and the stock market have skyrocketed to never-before-seen heights, which begs the question: if outrageously high prices don’t count for “inflation” what is going on?

The short answer is that basing economic policy on bullshit actually has consequences. The long answer is more complicated.

Legally, the Federal Reserve has a dual mandate: a legal requirement spelled out in 12 U.S.C. § 225a that it must help achieve two things for the U.S. economy. Those two things are price stability, which means low inflation, and high employment, or low unemployment. Arguably, the Fed has done a decent job at fulfilling the goals set by Congress for most of its existence, starting from its creation under the Federal Reserve Act in 1913.

By the time the Fed came into existence, the country was already in the midst of handling the aftermath of the Robber Barons who profited handsomely from the development of railroads. The Sherman Anti-Trust Act had already been introduced in 1890; Teddy Roosevelt earned his reputation as a trust-buster in the early 1900s. Managing income inequality therefore wasn't seen as the Fed's responsibility; the Fed had not yet arrived on the scene. There were other parts of government willing and able to tackle that particular problem. (For example, the FTC was formed in 1914.)

Today, as we sit in the middle of a second Gilded Age, these anachronistic circumstances matter. The first time inequality was a serious matter for the stability of the United States, the Fed didn't play a role in its creation. Today, the situation is far different: the Fed is front and center in every Wall Street investor's mind, and its highly controversial policies (such as bailing out AIG but letting Lehman Brothers and Bear Stearns go bankrupt) have shaped the economy ever since the 2008 financial crisis.

With interest rates at near zero for years, and then an extra bonus of Quantitative Easing, the stock market has behaved accordingly. For years, there was no news too bad to send the market to new heights. The European debt crisis involving Greece? Didn't matter. Russia invading Ukraine? Didn't matter. A womanizing, lying, untalented, ignorant Russian intelligence asset becoming President of the United States? Great news in the minds of investors. Record low unemployment numbers? Actually, that would be terrible news for the stock market, since it might mean that the Fed could finally make interest rates go up. Since 2009, the only thing that has mattered to the stock market has been the Fed. Consequently, homes anywhere in the Bay Area—where technology workers’ salaries are closely tied to technology stocks—and tiny condos in New York—where finance looms large—now cost millions upon millions of dollars.

From the Fed's narrow, legalistic viewpoint, this kind of inequality is a huge success. People have jobs. It doesn't matter if physics PhDs have part-time jobs as dishwashers in diners and social workers are moonlighting as Uber drivers a few hours a week (when they're not driving for Lyft). Nor does it matter if a mother of five has to work three different jobs and rent out her spare room on Airbnb just to make ends meet. People are employed, and according to the law, that's all that matters. Furthermore, according to the Fed, prices have been extremely stable, with barely any inflation at all and barely any wage growth.

How is that possible when nearly half of American families cannot afford food or shelter, which are now priced well out of reach? On January 25, 2012, the Fed stopped using the United States Consumer Price Index (CPI) to measure inflation, and instead shifted to a different measure called Personal Consumption Expenditures (PCE). Since both measures are represented by three-letter acronyms, it might seem immaterial, but there's a huge difference between the two measures, and that difference is in terms of weight. While CPI measures housing expeses with a weight of about one-third (which is what families are supposed to spend on housing), PCE weights housing costs at less than half that: 13%-15% of total expenditures by some indications. Why? Good question. It makes no sense.

If your housing costs skyrocket from $2,000 a month to $3,500 per month, but the price of milk goes down and the $50 you spend on gas stays unchanged, is it really fair to say that you haven't experienced much inflation? Ever since it started using PCE, that's what the Fed thinks.

This has enormous practical indications. Say, for example, that the country entered a housing bubble sometime after January 25, 2012. While that bubble would be reflected by higher readings of CPI, it would be noticed far less with PCE. And that's exactly what has happened. CPI has been well above 2% for months, and in some places, above 3.5%. PCE has not. Furthermore, the Fed set out its 2% target in 2012, just as it was changing indicators, with little experience actually relying on PCE for policy-making.

Neither CPI nor PCE take stock prices into account, as they are focused on the kind of inflation that affects Americans as they go about their daily lives, buying groceries, gas, furniture, books, tickets, and all of the things we spend money on. In fact, the Fed is supposed to ignore what happens in the stock market when it comes to setting interest rates. Yet it is hard to deny that something has been happening to asset prices as a result of Fed policy: they've skyrocketed. Remember the dot-com bubble, when the NASDAQ went to 5,048.62 on March 27, 2000? Yeah. We're bouncing around 7,200 on the NASDAQ right now.

In other words, while the Fed has been searching in earnest for enough inflation to meet is magical target, it has also been studiously ignoring that enormous housing price inflation that has families living in trailers or on the street in the Bay Area, and asset price inflation that has CEOs rewarding themselves with huge amounts of executive compensation while average employees suffer with minimum wage. After all, wage fairness is not one of the Fed's goals. The last time a situation like this arose, the Fed didn't even exist. All we have to rely on are the gut instincts of a bunch of mostly-white, mostly-male veterans of some of the most elitist institutions in the country. And those instincts, along with their newfangled inflation indicator, are telling them that everything is fine.

If the Fed were doing its job properly, it would have gotten banks accustomed to interest rate normalization after the financial crisis years ago: by 2013 at the latest. Instead, the Board has kowtowed to Wall Street by giving it free money hand-over-fist, which it is only now dialing back. The Board's supposedly concerned members have used the risk of (what in most times would be considered perfectly acceptable but) slightly higher unemployment rates as a thinly veiled excuse for showering money on the rich, while doing almost nothing to crack down on lending abuses to the poor, where the Fed has oversight authority. Janet Yellen literally waited until her last day in office to do anything about Wells Fargo, which is hardly the only bank with problems in this country. (Disclosure: I am short BOFI.)

Now, other supposed economic geniuses are concerned. Larry Summers and plenty of others have pointed out that if there's another crisis, with rates still so low, there will be no room for the Fed to manuever. But that's not even the biggest problem. The biggest problem is that the Fed is so spineless when it comes to cracking down on Wall Street that the only way it knows how to resolve the economic catastrophe wrought by a bubble's collapse is to inflate yet another, bigger bubble. And with record levels of debt, that's exactly where we are now.