Last updated: 17:04 / Thursday, 1 May 2014
Pioneer Investments

Fed’s Inflation Target Misguided? Good vs. Bad Disinflation

Fed’s Inflation Target Misguided? Good vs. Bad Disinflation

For more than a year the Federal Reserve Board has cited inflation below its targeted 2% level as one justification for maintaining its extraordinarily accommodative monetary stance. As of February, the core inflation rate was 1.1%, based on the Personal Consumption Expenditure (PCE)  inflation series, the Fed’s preferred measure of inflation. But there is good reason to question whether the 2% target justifies current policy.

What’s Driving Inflation Lower?

Today’s low inflation is taking place in an economic environment that is far different from the conditions that triggered falling prices during the Great Recession in 2007-2009. Those declines occurred as a result of severe debt contraction, a downward spiral in asset values across nearly the entire economy and a global banking crisis. The Fed’s actions to offset these damaging conditions were exceptionally timely and successful, and conditions are now the exact opposite. Values across a broad array of asset classes have seen significant appreciation, and many key economic sectors are exhibiting healthy competition and growth.

Good vs. Bad Disinflation

There is a difference between “good disinflation” and “bad disinflation.” Looking deeper at the inflation data over the past several years reveals that disinflation is the result of a variety of factors, including technological progress, new efficiencies in business models and strengthening competition. Let’s look at the commodity sector, one of the weakest areas within the inflation reports. Technology has had a tremendous impact on energy costs over the past few years. With horizontal drilling techniques and fracking, vast amounts of newly recovered U.S. oil and gas have been brought into production. We now produce so much oil & gas that we are considering changing laws so it can be exported once again. Energy CPI grew 0.4% year-over-year, and was an even lower -1.6% a year ago.

Time for the Fed to Correct Course

I don’t understand the Fed’s stance on these lower prices. Aren’t technological progress, new efficiencies in business models and processes drivers of economic progress? The truly worrisome deflation we should be concerned about is driven by asset price declines. When home values fell during the recent recession due to a confluence of unaffordable prices, poor underwriting, increased jobless rates and high leverage, they had a systematically disruptive impact on consumers, the financial system and the overall economy. When asset value and resulting debt value declines broadened beyond the residential housing market to most other sectors of the economy, the result was one of the worst recessions since the Great Depression.

We are clearly not in the debt contraction/asset price downward spiral that we faced during the recent recession. The reality is quite the opposite. I, for one, hope the Fed begins to distinguish the “good” disinflation from the “bad”, as I sense the markets have begun to enjoy the easy money party for a bit too long.

Analysis by Ken Taubes, director de Inversiones de Pioneer Investments, US.