Preparations are being made at the Federal Reserve to set the third boat, QE 3, into sail should the economy sink as economic woes rise. The Fed is seeking solace in its preferred inflation measure of core consumer price index, CPI-U of the Bureau of Labor Statistics (BLS), energy and food prices excluded, of 1.5 per cent increase, year-on-year, to justify leaving on the monetary fire hoses longer, for the deluge has not yet soaked up the ground on the main streets of USA.
The non-preferred measure of inflation, as much as the central bank likes to look at all measures before the Federal Open Market Committee (FOMC) make any decisions before or during meetings, is inflation as used by the United States Department of the Treasury without excluding energy and food prices for the purpose of Treasury Inflation Protected Securities (TIPS). It is currently being recorded at 3.6 per cent increase, year-on-year, CPI-U (BLS). The divergence between the two is more than double.
The argument the Fed had used in the past, on a routine basis, is to stick to its preferred measure and wait for the higher headline inflation (preferred by the Bank of England and the European Central Bank because of their purely inflation targeting mandates) to transmit into core inflation before it preemptively began tightening money supply to stabilize inflation around 2-3.5 per cent core, balancing it with unemployment and long-term interest rates. This approach had worked well during the Great Moderation: inflation was low, unemployment was low and long-term interest rates were low.
Today, unemployment is high, the growth rate the economy can tolerate before inflation ticks up is low, and long term rates are low but their prognosis, given the level of national debt, is not good.
Phillips Curve, the short run trade-off between inflation and unemployment, can, to some degree, explain what is going on with the economy: preference for low core inflation from the investor perspective is ticking up unemployment. From a consumer perspective, the higher headline inflation explains the higher unemployment: consumers are spending less on other purchases, because they cannot spend less on gas and food. The two, put together, provide a synthesized explanation: lower consumption feeds back into lower real investment. The fear of higher energy prices due to asymmetric growth rates in the global economy (which in turn cascade into higher food prices) reduce investment, putting upward pressure on unemployment.
The employment cost index (ECI) is also inching higher because of sticky wages: workers do not want to sacrifice wages anymore than they have to, widening the gap between higher income , higher skilled workers and the rest, also putting upward pressure on inflation.
The higher CPI and ECI unambiguously imply the onset of a stagflationary economic situation.
Expansionary monetary policy entails freezing the government budget constraint to induce structural change and government reform at the same time.
QE 3 can work, in lieu of raising the debt ceiling (in contrast, both Geithner and Bernanke support raising the debt ceiling down the slippery slope of Japan’s liquidity trap), if the debt ceiling is not raised and the Federal Reserve expands money supply financing the nation’s budget deficits over the next decade, conditioned on structural change as I have argued for the past several years.
Inflation is a non-issue. Employment is.