There are many indices that measure inflation, and some of them are undoubtedly better than others. But I am not about to argue which index is better — or, as some conspiracy theorists have suggested all along, that all of them are rigged.
However, I would like to remind the numerous QE commentators that the Federal Reserve is quite a bit behind its inflation target compared with the progress made on unemployment.
In addition to the 6.5% unemployment target for quantitative easing, Federal Reserve governors have repeatedly mentioned an inflation target of 2%. When the QE tapering panic erupted on May 22, very few market participants cared to look up the personal consumption expenditures deflator ex-food and energy, which at the time stood at an all-time low of 1.1%.
The Federal Reserve likes to use the personal consumption expenditures deflator (PCED) ex-food and energy as its favorite measure of inflation. I know we all buy food and energy and that those items are more important to lower-income people because they comprise a higher percentage of their budgets, but the PCED including food and energy was just reported to stand at even lower than 1% in May. (At the time of the eruption of the QE tapering panic on May 22, this all-inclusive PCED measure was at 0.7%).
Other than a brief dip in negative territory for most inflation indices in early 2009, the U.S. has not experienced any persistent deflation similar to what Japan has experienced since 1995. I do believe the unprecedented and aggressive policies carried out by the Federal Reserve helped prevent the U.S. economy from slipping into a deflationary malaise. Had Chairman Bernanke not been as creative as he was, odds were (in my opinion) that we would be experiencing Japanese-style deflation at present due to the massive losses in the U.S. banking system brought on by the mortgage market collapse and weak aggregate demand.
Another factor that has helped prevent deflation brought on by a system-wide deleveraging process has been an unprecedented boost in government spending since 2009, aimed at filling the void in aggregate demand in the U.S. economy resulting from retrenching consumers and corporations. While the Federal Reserve has denied that the goal of QE is to fund the federal government, but rather help the overall economy via suppressing long-term interest rates, it has de facto done it — the government likely would not have been able to borrow as much at the higher interest rates that would have resulted without QE.
This structural change in aggregate demand is the trillion-dollar question and will be the true test of Bernanke’s monetarist theories if/when QE ends.
So why is inflation in the U.S. so low given how much money has been “printed” by the Federal Reserve? In my experience, it is not a well-understood fact that the “money” created by QE never really left the Federal Reserve Bank of New York and is still sitting there in the form of banking system excess reserves. Chairman Bernanke intentionally broke the banking system money multiplier and lowered monetary velocities, all in the name of lowering long-term interest rates while preventing the printed cash from circulating in the banking system in a destructive manner.
It is M3 growth that creates deflation or inflation in a fractional reserve banking system. So far, M3 has been remarkably well-contained, arguably through unorthodox monetarist means. (M3 money supply is no longer officially reported by the Fed since 2006. Still, it can be extrapolated using Flow of Funds data and has been reported by many outlets, some of them conspiratorial in nature.)
I know there is an issue of too much Treasury supply aiming to fill this deleveraging void in aggregate demand. It seems to me that QE was a maneuver to buy time so the economy could achieve its own escape velocity and the government could put its finances in order before the Federal Reserve ends QE.
I am not sure that either economic escape velocity or frugal governmental finances have been achieved, so I will be willing to err on the side of caution and think QE is likely to end later than the present market panic would suggest.
Ivan Martchev is a research consultant with institutional money manager Navellier and Associates. The opinions expressed are his own.