David Stockman Is Not Particularly Amused With Your Inflation Targeting

By David Stockman as originally published on Contra Corner and reprinted here with permission

Now that the US economy has reached the #2 spot in the annals of business cycle expansions at 106 months of age, the Keynesian economists on Wall Street are starting to gum about the second decimal point in the monthly inflation print. As Deutsche Bank’s Torsten Slok, recently pontificated,

 “Since the financial crisis core PCE inflation has been below the Fed’s 2% target. As a result, the narrative in markets has been that ‘there is no inflation’ and ‘inflation is not a problem.’ But now core PCE inflation has reached 1.9 percent and in our view it will reach 2.3 percentby the end of this year. This will change the discussion in markets from inflation is too low to instead, inflation is too high and is the Fed doing enough to keep it from rising further?”

Really?

Is there one shred of evidence that the microscopic variance between 1.9%  and 2.3% inflation on the PCE deflator makes any difference to the performance and prosperity of the main street economy? Or that the Fed can fine tune the difference in any event?

No, there is not. The entire inflation-targeting narrative—both as to the low-flation and rising-inflation variants—-is a baseless institutional cover story for activist monetary central planning at the Fed and the resulting persistent and heavy-handed intrusion in financial asset markets.

It enables a moveable central bank kabuki dance for the ostensible purpose of keeping the inflationary temperatures neither too hot nor too cold, but just right.

Yes, they say that their Congressional “mandate” makes them do it, but puleeze!

This is what the operative amendment to the Federal Reserve Act adopted in the November 1977 actually says:

T h e (Fed) shall maintain long run
growth of the monetary and credit aggregates commensurate with
the economy’s long run potential to increase production, so as to pro-
mote effectively the goals of maximum employment, stable prices, and
moderate long-term interest rates……..

We’d call that some kind of paean to macroeconomic motherhood, which is so vague, rubbery and aspirational that it can be read to mean virtually anything. As to the inflation target, in fact, it could just as easily be 0.0% or 1.50% or 2.345%. Or it could be no number at all—as was actually the case under Fed procedures between 1978 and 2011.

As it happened, the 2.00% target adopted in 2012 is the handiwork of a couple of monetary wonkscranks named Ben Bernanke and Fred Mishkin. Their scriblings would have been little noted nor long remembered—save for the happenstance of their appointments to the monetary politburo by hack Republican politicians in the employ of George Dubya Bush.

Indeed, the fact that we are plagued with Bernanke’s inflation target is testimony itself to the larger point here: Namely, that the Federal Reserve statute is one of the most-opened enabling acts ever written.

It delegates to the Fed plenary power to directly dominate what is today a $100 trillion financial asset market in the US; and, indirectly, affords it suzerainty over multiples of that in the global financial system.

Accordingly, it is no exaggeration to say that the Fed is the equivalent of a monetary politburo, ruling all of economic life by the theories, dictates, canards and whims that happen to form the group think at any given time of its small circle of appointees and staff apparatchiks and the slightly larger posse of Wall Street and think tank economists who feed off its doings.

At the core of today’s group think, of course, is the discredited notion of the Phillips Curve trade-off between inflation and growth/employment; and the associated claim that the US economy has currently entered the zone of full employment and is operating near its maximum potential GDP.

It is held, therefore, that the Fed and Fed watchers alike need be vigilant for signs of “overheating” via measured inflation rates that are punching too far and too long above the magic 2.00%.

From that cautionary stance, in turn, flows an arcane and esoteric debate about how many decimal points above 2.00% are tolerable and for how long, and how preemptively and forcefully the FOMC needs to lean into the inflationary winds.

Here’s the thing, however. The entire debate consists of make-believe quasi-academic rubbish. The idea that inflationary decimal points make a difference and that the central bank is capable of managing a non-existent equation called the Phillips Curve is every bit as absurd as were the medieval debates about the number of angels that could sit on the head of a pin.

That is to say, owing to the modern history that has gone before, there is a global market for goods, services, capital and especially labor; and owing to the fecundity of the planet’s population in recent decades there is virtually an unlimited supply of potential labor—at least for the next several decades until the demographic curves begin their fatal plunges.

Likewise, owing to the misguided monetary fecundity of the Fed and its fellow-traveling central banks around the world, there now exists a like and similar floodtide of excess production capacity.

That is, because central bankers made capital too cheap through massive money printing and prolonged financial repression, the amount of installed mining, manufacturing, shipping, warehousing and distribution capacity in the global economy vastly outruns current profitable use.

The Red Ponzi, for example, now sports 1.2 billion tons of steel capacity but probably can’t use on a steady-state, flow-thru basis any more steel per capita than the US economy, which consumes about 650 pounds per year per person.

What we are referring to is the amount of annual production they will need for replacementpurposes (cars, refrigerators, rails, buildings etc.) when they get done building ghost cities, ghost plants, ghost bridges, ghost airports and ghost high-speed rail systems, whether the former are ever used or ever generate a payback or not.

At US per capita levels, steady-state flow-thru requirements would amount to only 450 million tons for China—assuming it can triple its per capita income before the entire house of cards collapses. And it also means that China has upwards of 700 million tons of excess capacity—or more than the steel industries of Japan, South Korea, the EU and North America combined.

In short, the supply side of the global economy is at high tide, meaning that a sustained inflationary breakout in the price of commodities and goods is simply not in the cards. To the contrary, the massive overhang of labor and productive capacity functions as a deflationary anchor, and will continue to do so for some time to come.

During the last decade, for example, the price of durable goods has fallen by 15%. And after the 2008 blow-off top in oil, so much energy production capacity has been brought on line–most notably the US shale patch—-that the global energy price index has continued to fall on a trend basis, notwithstanding short-run cycles in above ground inventory.

Nor is the predominance of the China Price in the global economy for goods the extent of it. Owing to today’s global information networks and technology, more and more services are being off-shored and traded as well.

That amounts to the India Price, where equipment investments have been fueled by cheap and abundant global capital and where labor is endlessly supplied from India’s huge reservoir of educated but under-employed workers.

Since 1993, for example, IBM’s employment in India has soared from zero to more than 130,000.

So on a global basis, the very idea of a rigid Phillips Curve trade-off is nuts because supply is highly elastic and opened-ended in both the goods and services economy.

Moreover, unless the Donald is successful in building super high trade walls around the US economy and imposing a degree of autarchy befitting his 17th century mercantilist view of the world—which we do not think will remotely happen—the idea of a Phillips Curve in One Country (i.e. the US) is no less nonsensical.

After all, US goods and services turnover with the rest of the world currently amounts to just under $6 trillion per annum. That’s a huge amount of leakage, and means that the implicit bathtub economics of Fed policy and the notion of a Phillips Curve in one country is just plain nonsense.

Surely, the reported shortage of certain categories of labor, such as truck drivers, proves nothing about a Phillips Curve, notwithstanding all the Keynesian gumming on the matter recently.

To the contrary, too few truck drivers at a moment in time is simply a matter of relative labor pricing. Employers will pay more to recruit, hire, train and pay truck drivers and at length the purported shortage will disappear; it’s a matter for the free market, not the monetary politburo in the Eccles Building.

More importantly, in a welfare state democracy there is always a huge reservoir of available additional labor—at a price.

That is, students, foods stamp recipients, early retirees, disability malingerers, unpaid household labor and much more are available at a sufficient labor price. That’s especially so in a gig-oriented economy where jobs by the hour and by the project have become an established modus operandi; and where modern recruitment and placement technologies and vendors make it highly efficient.

As we have often noted there are approximately 210 million adult American under the age of 68 who are theoretically employable in the monetary economy. At a standard 2,000 hour work year that is 420 billion potential labor hours compared to only about 250 billion hours actually being utilized according to the BLS.

We won’t say the true unemployment rate is therefore 40%. But we do strongly insist that whether tens of billions of those 170 billion potential labor hours get utilized in the commercial economy or not has virtually nothing to do with the Fed and its silly games of three or four symbolic rate increases in any given year.

Instead, this is a job for welfare reform to reduce incentives for non-work, on the one hand; and market prices to make it worthwhile, on the other.

But the idea that the bathtub of GDP is close to being filled to the brim and is fixing to trigger a Phillips Curve based breakout of inflation is just an academic folly; it’s a mere fig leaf to the keep the FOMC busy and all-in down in the canyons of Wall Street.

The truth is that even apart from the Phillips Curve nonsense, there is no practical reason for manipulating interest rates and other financial asset prices. Over the long haul, inflation has been running at 2.0% anyway, and during its short-run intervals of hotter and colder there is scant relationship to the undulations of output growth in the domestic economy.

As shown below, since January 2000, the annualized rate of CPI increase has been 2.15% and the cumulative rate of gain for the Fed’s preferred PCE deflator has been 1.84%.

There you have it. So far this century, the former has run 15 basis point per annum too hot, and the latter 16 basis points too cold—even by the lights of our monetary central planners.

And all the while the green line for real final sales—which is a reasonable proxy for economic expansion—has undulated in its own channel, reflecting world trade and production cycles ands sub-cycles as much as anything else.

So we have a better idea for the Fed. Forget about counting the inflationary angels on the head of the modern day Phillips Curve pin.

The inflation problem in America today is not in the CPI or the PCE; it’s in the stock averages.

And what threatens main street prosperity is the massive, unstable and ultimately incendiary bubbles on Wall Street. Unfortunately, when they crash it triggers desperate attempts in the C-suites to appease the trading goods by throwing workers, assets and restructuring plans overboard.

Ironically, therefore, in the name of fine-tuning inflation around the Bernanke’s groundless 2.00% target and attempting to balance monetary angels on the head of a Phillips Curve pin, the Fed is generating massive financial asset inflation and the serial crises and recession which inexorably follow.