The Wall Street Journal’s recent piece, Fed May Have Acted on False Alarm [link - ($)] recounts how the Fed’s policy of ultra-low interest rates were sold to the public as the Fed’s efforts to avert a disastrous deflation (what’s so bad about deflation, anyway?). The deflation phobia was motivated by very low rates of measured inflation. But a low CPI may not be an indication of low inflation. For one thing, food and energy prices are exculded from the CPI computation. Central bank interest rates below the “natural rate” of interest will be inflationary because the Fed must support this rate by loaning any supply of new money into existence necessary to maintain this rate peg.
Journal reporter Greg Ip summarizes a study done by the Atlanta branch of the Fed showing something that Austrians have known for a long time - money is not neutral. Inflation changes relative prices within the economy as well as generally influencing the purchasing power of money. The Fed report shows how inflation changes spending patterns away from the prices that are measure in the CPI into other goods that are inflating faster:
two-thirds of that decline in the core inflation rate reflected slowing increases in rents and rapid declines in used-car prices. When the Fed slashed rates, auto makers introduced 0% financing. The move increased demand for new cars, but it hurt demand and increased the supply of used cars, driving down their price. Similarly, Fed policy drove mortgage rates down sharply and spurred many apartment renters to buy homes. Rising apartment vacancy rates restrained rent increases. That also indirectly held down the measured cost of owner-occupied housing, which is based on rents for similar housing units rather than house prices.
These developments “reflect not a fundamental weakening in housing and vehicle demand, but, instead, the dynamic effects of interest rates on consumer demand for substitutes,” according to Andrew Bauer and Nicholas Haltom, of the Atlanta Fed, and William Peterman, now at the Brattle Group, a consulting firm. If price trends for used cars, rent and housing had remained the same after November 2001, core inflation today would be 2.7%, instead of 1.6%. After accounting for the used-car prices and rents, “the recent downturn in the business cycle appears to have had little impact on the path of overall core inflation,” the authors write.
