Are Central Banks driving the World Economy into recession?

Food and energy are taken out of "core" inflation numbers due to their volatility. While their effects are still counted in the Consumer Price Index (CPI), their effects are ignored in the "core" CPI.

The logic is (so I'm told) that since food and energy prices can be very erratic in the short term, academics don't like their calculations to be muddied by the volatility. Their thinking is the same as yours - eventually the effects of higher energy prices will work themselves into the economy. I agree, that part is definitely true. But the picture isn't whole yet.

In the past, energy prices have notoriously spiked and then simmered back down to more managable levels in a short period of time. The same with food. Most likely, it is a good thing that the Fed and policy-makers are not taking into account all of the short-term fluctuations in energy prices. This would turn the world's largest central bank into an energy speculator to some degree. Energy is volatile after all.

My point is, I simply don't agree with the Fed's policy that energy and food need to be excluded completely from the inflation numbers. Perhaps there is a way to account for some of their short-term effects beyond the eventual diffusion through the economy and have that factored in to monetary policy decisions. It seems like the old "separate but equal" laws. What can happen is that as enery prices rise quickly, prices for final goods don't always respond as quickly. Over time this takes place, but even trucking businesses cannot possibly raise prices as fast as energy fluctuates. It would be madness. Profits are squeezed out first, then prices rise. Why? Competitors are always reluctant to raise prices against other firms. And firms colluding with one another to raise prices in response to energy price spikes would land them in front of the Justine Department for anti-trust infringement. People would call their congressmen with two words to say, "Price gouging!"

It just doesn't make sense that the two pieces of the CPI that could cripple my living standards faster than anything short of a layoff are ignored because they're supposedly too much for the smartest people in the free financial world to handle. I don't have the perfect solution, but the dual system of measuring consumer prices is a joke to me.

You can view a list of the current components of CPI here:
http://www.bls.gov/news.release/cpi.toc.htm

Take a look, tell me what would cause a bigger financial burdern for you: a 30% rise in the cost of clothing, or a 30% rise in the price of a barrel of oil (approx $100/barrel). Why is apparel kept as a "core" number? Or entertainment for that matter?

This is just my opinion, and like I said before I haven't got the solution - but I sure feel as if I have identified a problem heh! Comments and questions always welcome

I think we should start a new kind of eBay for wife and kid selling.

How 'bout www.wife-for-cash.com ? Sure beats doing business with a third-world slave-trader behind the truck stop dumpster.

I swear there's a demand for this - divorce rates are over 50% in some demographics. Instead of endless years of child support and alimony you could make a few bucks and get rid of a few headaches at the same time.

I love market-based solutions!

Our Subprime Fed

By GERALD P. O'DRISCOLL, JR.
August 10, 2007; Page A11

In recent years, monetary policy has created an expectation that the Federal Reserve will bail out investors when asset bubbles deflate. The recent crisis in the subprime mortgage market is at least partly the outcome of this new approach to monetary policy. That crisis has already had widespread ramifications for homeowners and investors.
http://online.wsj.com/public/resourc...0809172000.gif In February 2007, the popular press discovered subprime mortgage loans when two major originators of such loans, HSBC Holdings PLC and New Century Financial, disclosed increased loan loss provisions. HSBC is a globally diversified financial company. While it was a large lender in the market, the aggregate amount of its subprime loans was not a significant portion of its total portfolio.

New Century Financial fared much less well because of the concentration of its lending in this risky category. Its stock price collapsed after problems surfaced on Feb. 8, 2007 and the company eventually declared bankruptcy.
Other lenders in the subprime market experienced difficulties. Fears of a housing collapse and even an economic recession grew as investors gauged the size and extent of the problem in the mortgage market.

The crisis was foreseen -- for more than a year before the bust, bankers, analysts, and even regulators knew they had a mess in the making. And once the mess became clear, it wasn't hard to see what was wrong. Lending practices in the subprime market were "shoddy and absurd," said John Makin of the American Enterprise Institute in March of this year. Lewis Ranieri, former chairman of Salomon Brothers, echoed those comments in this newspaper when he observed: "We're not really sure what the guy's income is and . . . we're not sure what the house is worth. So you can understand why some of us become a little nervous." Mr. Ranieri helped pioneer the bundling of mortgages into marketable securities ("securitization"), so he should know!

The collapse of the subprime mortgage market is the latest in a series of financial bubbles whose existence reflects, at least in part, moral hazard in financial markets. At one time, deposit insurance was a major culprit. For example, in an October 2002 speech to economists in New York, then Fed Governor Ben Bernanke described the savings and loans crisis of the 1980s as "a situation . . . in which institutions can directly or indirectly take speculative positions using funds protected by the deposit insurance safety net -- the classic 'heads I win, tails you lose' situation." After an intellectual and political battle of more than a decade, the deposit insurance loophole was sealed.

Today, monetary policy is fostering moral hazard. Monetary policy can generate moral hazard if it is conducted so as to bail investors out of risky and otherwise ill-advised financial commitments. If investors come to expect that the policy will persist, then they will deliberately take on additional risk without demanding commensurately higher returns. In effect, they will lend at the risk-free interest rate on risky projects, or at least at a lower rate than would otherwise be the case. Too much risky lending and investment will take place, and capital will be misallocated.

The new moral hazard in financial markets has its source in what can be best described as the Greenspan Doctrine. The doctrine was clearly enunciated by Alan Greenspan in his December 19, 2002 speech. Mr. Greenspan argued that asset bubbles cannot be detected and monetary policy ought not to in any case be used to offset them. The collapse of bubbles can be detected, however, and monetary policy ought to be used to offset the fallout.

Two months earlier, Mr. Bernanke endorsed the Greenspan Doctrine, arguing against the use of monetary policy to prevent asset bubbles: "First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them." Since Mr. Bernanke is now Fed chairman, it is reasonable for market participants to assume that the Greenspan Doctrine still governs current Fed policy.

The two men were surely asking and answering the wrong question. They were implicitly treating bubbles as solely the consequences of real shocks or disturbances. (An example of a real shock is a technological innovation leading to productivity gains and higher future expected profits in a sector.) They asked whether monetary policy should be used to offset the effects of real shocks, and concluded that it should not. The latter is the correct answer to the question they each posed.

A different question would be to ask whether monetary policy should be conducted so as to create or exacerbate asset bubbles. The answer to that question is surely "no." Consider Mr. Bernanke's apt characterization of moral hazard in the context of the deposit insurance crisis: "When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash."

He could have been talking about the subprime mortgage market. The Fed pre-announced that it will take no action against bubbles, but will act aggressively to offset the consequences of their collapse. In effect, the central bank is promising at least a partial bailout of bad investments. The logic of the old deposit insurance system is at work: Policymakers should protect investors against losses, no matter their folly. Or, in Mr. Greenspan's own words: Monetary policy should "mitigate the fallout [of an asset bubble] when it occurs and, hopefully, ease the transition to the next expansion."

In the present context, the "next expansion" could also be rendered as "the next asset bubble." If the Fed promises to "mitigate the fallout" from "irrational exuberance," then it is rational for investors to be exuberant. Investors may be at risk for some loss, as with a deductible on a conventional insurance policy, but losses are still being mitigated.

The Bernanke Fed has confused matters for investors by not yet cutting interest rates in the face of the recent crisis. There are two possible (not mutually exclusive) reasons for its not doing so. First, it may not view the current crisis as serious enough. Second, current price inflation is above its comfort zone, and the Fed may feel it has no room to maneuver. Time will only tell which is at work.

The Fed cut the Fed Funds rate sharply after the bursting of the stock market bubble in March 2000. In the eyes of many, the Fed cut rates too far and held them down too long, fueling not only a vigorous economic expansion but also the housing bubble. In his December 2002 speech, Mr. Greenspan was at pains to deflect any argument that the Fed was inflating a housing bubble. "To be sure," he acknowledged, mortgage debt was high relative to household income (remember the date) by historical norms. But "low interest rates" were keeping the servicing requirements of the mortgage debt manageable (emphasis added). "Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite very large debt-financed extractions."

How wrong the Fed chairman was! If Mr. Greenspan was not worried about interest rates resetting, however, why should mortgage bankers and homeowners worry? It would have been reasonable to read into the chairman's musings an implicit guarantee of continued low rates. A homeowner is certainly entitled to bet his home on the come if he wants.

Should the central bank encourage such behavior, however?
A monetary policy of substantial stimulus will have a number of real consequences, including asset bubbles. These asset bubbles have real costs and involve misallocations of capital. For example, by the peak of the tech and telecom boom in March 2000, too much capital had been invested in high-tech companies and too little in "old economy firms." Too much fiber-optic cable was laid and too few miles of railroad track were laid.

By 2002, worried about the possibility of price deflation, the Fed introduced a strong anti-deflationary bias. A tilt to stimulus was understandable at the time. A continued bias against deflation at any cost, however, will produce a continued bias upward in price inflation. With the bursting of each asset bubble and the fear of deflationary pressure, Fed policy must ease. The Greenspan Doctrine prescribes a stimulative overkill that begins the cycle anew. The Greenspan-era gains against inflation will then prove to be only temporary. His doctrine will be the death of his legacy, a legacy that already includes a housing bubble and its aftermath.

Mr. O'Driscoll, a former vice president with the Dallas Fed and a former director of policy analysis at Citigroup, is a senior fellow at the Cato Institute.

Well said... That's exactly why Bernanke is breaking away from the Greenspan model.

I believe the Fed is starting to put increasing weight on headline CPI instead of core CPI precisely because in recent times, food & energy have been showing a more steady up trend instead of the usual noisy peaks and troughs, so they are taking food & energy more seriously.

THE BIG BIG PICTURE
Every time you step back and look at "the big picture" you have to realize that there is an even bigger picture that you haven't yet looked at:

The world as a whole is experiencing huge growth in the demand for energy and other NON-RENEWABLE resources (no, wind mills will never replace fossil fuels). This is in part because of the rapid development of "developing" countries, as well as because of the rapid growth of the human population as a whole. These non-renewable resources are being depleted and although they are not in danger of disappearing any time soon, they ARE becoming more and more difficult (expensive) to extract. Growing demand coupled with shrinking supply means prices moving up geometrically (in other words, really fast).

The same thing is happening with food: demand is growing steadily because of the rapid increases in population and the increasingly sensitive palates of the developing world (i.e more tasty but inefficient meat, less grain) while supply is dwindling due to human development, desertification and other factors encroaching on arable land, as well as over-fishing, climate change (which affects all of the above) etc... So food prices are also growing very quickly.

How is this relevant to the discussion? This is why food and energy prices have recently entered a real up trend instead of fluttering around, and these 2 items therefore DO contribure to REAL inflation. Furthermore, these factors are not very well accounted for in classic free-market economic theory, which assumes that day-to-day supply varies but that resources are, at the end of the day, infinite (or at least replacable). As I mentioned earlier, Fed is paying increasing attention to the headline CPI number as opposed to CPI EX. Food & energy, but there isn't much that can be done about it. Economic growth very much depends on the use of these dwindling resources, but their use in the long run, contributes to inflation. So the snake begins to feast on its own tail.

What's a Fed Chairman to do? Raising rates to fight inflation will kill economic growth. Lowering rates to stoke the economy will give inflation wings. These are problems that the WORLD economy is facing, and there is no realistic, socially responsible solution. The problems in the US are further exacerbated by the fact that a huge % of GDP is being spent on war, as well as other factors that I don't want to get into right now (but I will if there is interest), so we are seeing my scenario unfold vividly in the US right in front of our eyes, but rest assured the rest of the world will follow. It is no longer about "sustainable growth" because in reality, no amount of growth is sustainable indefinitely. It's more a question of who will be the last man (country?) standing in a world of too many people fighting over the same bowl. And so the snake continues to devour itself.

So... Central Banks are not trying to kill the consumer... They are simply trying to balance a system that naturally tends towards un-balance. In a matter of years, "stagflation" is going to be a household word from Brazil to Beijing, as it is an economists way of saying the world is exhausted and can't give much more. So the snake's spine is about to snap as its mouth closes in on its own head.

How so? Seems like Bernake is just fine with continuing the Greenspan model. He indicated that it would be a good idea for the Fed to intervene and help lessen the blow of bubble collapses - essentially validating the actions of Mr. Greenspan during the tech bubble blow-up.


About time!

You raise some very good issues. Allow me to explain how mainstream economists thing about "infinite" resources. You are on the right track in stating that the resouces become more and more expensive as total supply decreases. In effect, according to an economist, we won't ever "run out" of a scare resource like oil or natural gas. While there is a finite supply, the marginal cost of extracting the last remaining drops of oil/nat gas would be far too expensive to undertake for the value they would provide. Essentially, we won't get to the bottom of the well because it will cost too much to scoop out what's at the bottom.

While it may sound silly, I think I agree. Finite supply means never "running out" because the marginal cost to get a barrel of oil at a depth of 20,000 feet under the ocean may cost $500, while it may only be worth $200 on the open market (I am assuming that some day in the future we will have to drill to those depths to extract oil as conventional wells dry up). That oil will remain there for good - price would have to exceed $500/barrel for it to be worth extracting. Finite supply, but indefinite at the same time.

You ask the $1 trillion dollar question - what can the Fed do? Seems like a damned if you do, damned if you don't scenario. I would not want to be the one in charge right now.

I disagree with Bernanke not following the Greenspan route. They are on the same page without a doubt. The reason, and the only reason, that interest rates have not been lowered is the poor dollar, pure and simple.


FxJarhead you do my heart good, friend. Its the Fed that causes inflation, not combats it. More money printed, more inflation. Without gold backing the dollar as much can be printed as wanted. As a good author Murray Rothbard points out, the action is where the "new" money is before the inflation trickles through the economy. It just makes sense that whoever controls the printing presses controls inflation, not the other way around. And its just too tempting for politicians to want to get their hands on the new money to seal their power.

By the way, its called fractional banking when banks can lend more than they receive in deposits. And yes, its happening. The Fed was created for this very reason. If a bank gets in trouble it runs to the Fed before panic sets in and prints more money, which causes you guessed it: inflation.

If you want an education read the archives here: http://www.dailyreckoning.com/OLD_index.html

He may be saying so, but Fed hasn't dropped rates... Greenspan would have by now. In any case, I agree that he is certainly not turning Greenspan's model inside out, but I do feel that he is breaking away from it to some extent.

That's a bit of a moot point... The resource is FINITE and that's why matehmatically speaking, the price curve will "approach" infinity as supply "approaches" zero, with neither ever actually reaching those levels. But mathematics is only an approximation of reality and not reality itself... Hell will break lose long before the price of a barrel of oil reaches $infinity.00 as the world economy depends on affordable oil. That's exactly why I'm saying that classic theory doesn't account for it: IF it did, the world's economists wouldn't be striving for "sustainable" growth, because they would realize that it's an oxymoron. If you have growth, it automatically makes it UN-sustainable. A complete break from current economic theory needs to be implemented in order for the world to continue to thrive. Fat chance.

Although we may disagree on some of the finer points, it looks like we agree on what is relevant to the forex market.

FRACTIONAL BANKING......every trader that follows the Fed, in any form, should study all the above........You are Very correct!!!