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Source link: http://archive.mises.org/5452/alan-reynolds-defense-of-the-fed/

Alan Reynolds’ Defense of the Fed

August 10, 2006 by

Cato Institute senior fellow, Alan Reynolds, who writes pretty good columns on non-monetary issues but who writes terrible columns on monetary issues unfortunately chose to write about monetary issues today, attacking those who “second-guess” the Fed.

In a rather typical fashion for his monetary columns, he goes out of his way to mislead people when he tries to refute those who point out that even so-called core inflation (Setting aside for the moment the issue of the relevance of that concept, not to mention the issue of the justifiability from a libertarian perspective of central banking and inflation-targeting in the first place) have accelerated :“The Fed’s critics make it sound as though the past three months have revealed an enormous spike in “core” inflation (excluding direct energy expenses and, unimportantly, food). On Aug. 2, a Wall Street Journal report said, “The price index for personal consumption expenditures excluding food and energy (PCE) … rose 2.4 percent in June compared with a year earlier, matching the fastest annual rate since 1995.” Comparing the second quarter to the first, that same core PCE index was said to have increased “at a 2.9 percent annual rate, the fastest pace in more than a decade.”…

…In reality, the core PCE index rose at the same 0.2 percent pace in April, May and June, leaving only March “elevated” at 0.3 percent. Monthly increases also averaged 0.2 percent during the first quarter and during the last quarter of 2005.”

But as surely Reynolds must know, the numbers he mentions are rounded . The actual increase was 0.225% in April (from 111.264 to 111.514), 0.23% in March (from 111.514 to 111.571), 0.24% in June (from 111.771 to 112.038). That’s a 3 month increase of 0.7%, which means a annualized increase of 2.8%. Together with the 0.3% increase in March, this means a 4 month increase of 1%, or 3% at an annual rate.

This shows how Reynolds is flat out wrong when he claims that the reason for the acceleration in the 12 month increase is due to low increase 12 months earlier.

“The reason the year-to-year core PCE deflator appeared to increase from 2 percent to 2.4 percent over the past three months had nothing to do with faster inflation this year. It had to do with unusually slow inflation last summer — just 0.1 percent from June to August. That pulled the year-to-year figure down from 2.3 percent in November 2004 to as low as 2 percent for a while, and it made last summer a tough act to beat on any year-to-year comparison.”

Here clearly Reynolds try to make people believe the uptick in the 12 month increase was the fact that the increase in June-August 2005 was so low, but in fact only June have been phased out from the 12 month number.

He later mentions the acceleration of unit labor costs but dissmisses this as a factor. But it’s not just unit labor costs. For example, The Economist’s commodity price index, which Reynolds thought was interesting during a brief period when it had fallen have risen some 28.5% in the 12 months to August 1st, while the dollar have fallen (which will reduce the downward pressure on prices from foreign competition) during the same period. It is therefore a pretty sure bet that consumer price inflation will continue to accelerate in the near future.

{ 6 comments }

Roger M August 10, 2006 at 4:40 pm

Another good article from Stefan. Unfortunately, Reynolds isn’t the only writer who’s confused about the Fed.

BTW, Stefan, do you have any insight into why the Fed quit targeting money supply in the 1980′s?

Stefan Karlsson August 12, 2006 at 10:59 am

Roger, I haven’t studied the issue much, but from what I understand there were two main reasons for why the Fed stopped its money supply targeting. First, because they realized there is no mechanical links between money supply growth and consumer price inflation and secondly, because the economy was so weak at the time, the policy was deemed a failure (even though the economy was just about to recover).

Alan Reynolds August 18, 2006 at 2:19 pm

Sephen writes good columns on almost everything, but he missed my point on this one. My complaint was with expressing quarter-to-quarter changes at an annual rate and then comparing such a figure with a full year — 1995.

The annualized change in the core PCE deflator was 2% in the first quarter and 2.85% in the second. Which of those is the trend? We don’t know.

If expressing quarterly changes at annual rates made sense, then we could claim core inflation was 4% in the first quarter of 2000 and 1.5% in the fourth quarter. Yet neither figure was even close to the actual trend.

In a column that followed, “Inflation Exaggeration Part Two” (www.townhall.com) I explain the year-to-year confusion again, but using the CPI. For the summer months the year-to-year changes will appear to be growing larger even if they remain at 0.2%. By the fall the year-to-year change will slow, even if the monthly rate remains the same. It’s an illusion.

I’m no fan of central banking, which I have often described as the last refuge of central planning. I don’t like “core” inflation much either. For reasons explained in a different column, I’d prefer (for this purpose) watching some chain-weighted index of consumer prices that simply excludes energy alone (about 8% of the CPI). Unfortunately, neither BLS.gov or BEA.gov publishes such an index.

I just don’t like to see misleading statistics used to generate undue alarm.

I agree with the comment wondering why nobody is mentioning any money supply (or monetary base) figures, now that they’ve slowed way down. As my column notes, one Wall Streeter even manages to convert much slower growth of broad money into an omen of inflation (by calling it a rise in velocity).

Alan Reynolds August 24, 2006 at 9:57 am

In today’s Wall Street Journal, Art Laffer makes some of the same points I have been trying to make, though with differences. In particular, he puts considerable emphasis on the bond market’s vote of confidence in low inflation, on the distiction between relative prices of oil or gold and general loss of purchasing power, and on the slowdown in the Fed’s monetary base.

Apologies to Stefan for the previous typo on his name. I learned to type on a manual typewriter in the 1950s — on a computer I type faster than I can think.

Stefan Karlsson August 24, 2006 at 11:47 am

Alan-as I’ve stated repeatedly, I favor doing away with central banking. Short of that, I think the least distorting central bank policy would be to limit money supply or at least monetary base growth to gold standard growth rates-which is to say 1-2% (that number, as I wrote in my Greenspan article, is based on growth of global gold stock).

That is not based on a belief in some kind of mechanical link with a fixed time lag of x months between money growth and consumer price inflation (while a link does seem to exist in the long run, the short- to medium term link is very weak, indeed nearly non-existent), but because it would most closely resemble (central bank free) gold standard conditions and thus mean the least distortions.

The alternative view of some supply-siders that gold price targeting would most closely resemble gold standard conditions overlook that demand and therefore price for gold under the current conditions differ greatly from what it would have been had gold been used as money.

I’ve always preferred M3 as money supply measure, but since that have been “discontinued” in America, the closest available measures is M2 or MZM. And while both of these and the monetary base have indeed slowed from the heights of the Greenspan era, they are still running above the previously mentioned 1-2% range.

I am not in favor of targeting consumer price inflation whether including food and energy, excluding just energy or excluding both food and energy.

But if one are to have inflation targeting, then one should not apply it assymetrically (ignore it when it is above target, call attention to it when it is below target) or try to ignore the facts, which clearly show a strong upward trend of inflation, whether core or non-core.

While one can never be certain as to how inflation will develop in the future ( this is one of the reasons I don’t think inflation targeting makes sense), it seems more likely than not that the so-called core PCE deflator will be well above the Fed’s semi-official target of 2% for the coming year or so, as all of the leading indicators for inflation (except for one, inflationary expectations, but this will likely be overwhelmed by the others), such as commodity prices, unit labor cost and the dollar exchange rate point to higher inflation.

And the fact is that the core PCE deflator numbers
have been running high recently , with a monthly average of 0.25% (meaning an annualized increase of 3%) in March-June 2006, compared to the average 0.16% monthly increase (meaning an annualized increase of 2%) since 2000. While the drop in apparel prices indicated by the CPI report means that the July number will likely come in slightly lower than 0.25%, it seems more likely than not it will bounce back.

Nicolaas J Smith January 7, 2007 at 2:03 pm

Non-monetary inflation can be stopped.

“People today use the term `inflation’ to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise.” Ludwig von Mises – “Inflation: An Unworkable Fiscal Policy”.

All prices do not rise. Only the prices of variable real value non-monetary items while many constant real value non-monetary items are not fully updated and many are not updated at all.

The second inevitable consequence of inflation is the tendency of many constant real value non-monetary items NOT to rise at all – during the Historical Cost era while some constant real value non-monetary items are not fully updated.

Inflation today has and always had a second consequence during the 700 year old Historical Cost era.

Inflation has a monetary consequence, called cash inflation refered to above by Ludwig von Mises and defined as the economic process that results in the destruction of real economic value in depreciating money and depreciating monetary values over time as indicated by the change in the Consumer Price Index.

Inflation´s second consequence is a non-monetary consequence defined as Historical Cost Accounting inflation which is always and everywhere the destruction of real economic value in constant real value non-monetary items not fully or never updated (increased) over time due to the use of the Historical Cost Accounting model or any other accounting model which does not allow the continuous updating (increasing) in constant real value non-monetary items in an economy subject to cash inflation.

Inflation´s second consequence is solely caused by the global stable measuring unit assumption.

The stable measuring unit assumption means that we regard the annual destruction of a portion of the real value of our monetary unit by cash inflation in low inflation economies as of not sufficient importance to update the real values of constant real value non-monetary items in our financial statements.

This results in the destruction of at least $31bn in the real value of Dow companies´ Retained Income balances each and every year. Globally this value probably reaches in excess of $200bn per annum for the real value thus destroyed in all companies´ Retained Income balances.

The International Accounting Standards Board recognizes two economic items:

1) Monetary items: money held and “items to be received or paid in money” – in terms of the IASB definition.

2) Non-monetary items: All items that are not monetary items.

Non-monetary items include variable real value non-monetary items valued, for example, at fair value, market value, present value, net realizable value or recoverable value.

Historical Cost items valued at cost in terms of the stable measuring unit assumption are also included in non-monetary items. This makes these HC items, unfortunately, equal to monetary items in the case of companies´ Retained Income balances and the issued share capital values of companies without well located and well maintained land and/or buildings or without other variable real value non-monetary items able to be revalued at least equal to the original real value of each contribution of issued share capital.

The stable measuring unit assumption thus allows the IASB and the Financial Accounting Standards Board to conveniently side-step the split between variable and constant real value non-monetary items. This is a very costly mistake in low cash inflation economies – or 99.9% of the world economy.

Retained Income is a constant real value non-monetary item, but, it has been in the past and is, for now, valued at Historical Cost which makes it, very logically, subject to the destruction of its real value by cash inflation in low inflation economies – just like in cash.

It is an undeniable fact that the functional currency’s internal real value is constantly being destroyed by cash inflation in the case of low inflation economies, but this is considered as of not sufficient importance to adjust the real values of constant real value non-monetary items in the financial statements – the universal stable measuring unit assumption which is the cornerstone of the Historical Cost Accounting model.

The combination of the implementation of the stable measuring unit assumption and low inflation is thus indirectly responsible for the destruction of the real value of Retained Income equal to the annual average value of Retained Income times the average annual rate of inflation. This value is easy to calculate in the case of each and very company in the world with Retained Income for any given period.

Everybody agrees that the destruction of the internal real value of the monetary unit of account is a very important matter and that cash inflation thus destroys the real value of all variable real value non-monetary items when they are not valued at fair value, market value, present value, net realizable value or recoverable value.

But, everybody suddenly agrees, in the same breath, that for the purpose of valuing Retained Income – a constant real value non-monetary item – the change in the real value of money is regarded as of not sufficient importance to update the real value of Retained Income in the financial statements. Everybody suddenly then agrees to destroy hundreds of billions of Dollars in real value in all companies´ Retained Income balances all around the world.

Yes, inflation is very important! All central banks and thousands of economists and commentators spend huge amounts of time on the matter. Thousands of books are available on the matter. Financial newspapers and economics journals devote thousands of columns to the discussion of the fight against inflation.

But, when it comes to constant real value non-monetary items:

No sir, inflation is not important! We happily destroy hundreds of billions of Dollars in Retained Income real value year after year after year.

However, when you are operating in an economy with hyperinflation, then we all agree that, yes sir, you have to update everything in terms of International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies: Variable and constant real value non-monetary items.

But ONLY as long as your annual inflation rate has been 26% for three years in a row adding up to 100% – the rate required for the implementation of IAS 29. Once you are not in hyperinflation anymore (for example, Turkey from 2005 onwards), then, with an annual inflation rate anywhere from 2% to 20% for as many years as you want, you are prohibited from updating constant real value non-monetary items. Then you are forced by the FASB´s US GAAP and the IASB´s International Accounting Standards and International Financial Reporting Standards to destroy their value again – at 2% to 20% per annum – as applicable!

For example:

Shareholder value permanently destroyed by the implementation of the Historical Cost Accounting model in Exxon Mobil’s accounting of their Retained Income during 2005 exceeded $4.7bn for the first time. This compares to the $4.5bn shareholder real value permanently destroyed in 2004 in this manner. (Dec 2005 values).

The application by BP, the global energy and petrochemical company, of the stable measuring unit assumption in the accounting of their Retained Income resulted in the destruction of at least $1.3bn of shareholder value during 2005. (Dec 2005 values).

Royal Dutch Shell Plc, a global group of energy and petrochemical companies, permanently destroyed $2.974 billion of shareholder value during 2005 as a result of their implementation of the stable measuring unit assumption in the valuation of their Retained Income. (Dec 2005 values).

Revoking the stable measuring unit assumption is actually allowed this very moment by IAS 29 but ONLY for companies in hyperinflationary economies. At 26% per annum for three years in a row, yes! At any lower rate, no!

It is prohibited by US GAAP and IASB International Standards for companies that are operating in a low inflation economy.

That means the following at this very moment in time: Today all companies in, most probably, only Zimbabwe (1000% inflation) are allowed to update all their variable real value non-monetary items as well as all their constant real value non-monetary items.

But not the rest of the world.

The rest of the world is forced by current US GAAP and IASB International Standards to destroy their/our Retained Income balances each and every year at the rate of inflation because of the implementation of the stable measuring unit assumption whereby we are all forced to regard the change in the value of the unit of account – our low inflation currencies – as of not sufficient importance to update the real values of constant real value non-monetary items in our financial statements.

We are forced to destroy them year after year at the rate of inflation till they will reach zero real value as in the case of Retained Income and the issued share capital values of all companies with no well located and well maintained land and/or buildings at least equal to the original real value of each contribution of issued share capital.

The 30 Dow companies destroy at least $31bn annually in the real value of their Retained Income balances as a result of the implementation of the stable measuring unit assumption. Every single year.

Retained Income can be paid out to shareholders as dividens. Poor Dow company shareholders. They will never see that $31bn of dividens destroyed each and every year.

We have all been doing this for the last 700 years: from around the year 1300 when the double entry accounting model was perfected in Venice.

When we do this at the rate of 2% inflation (“price stability” as per the European Central Bank and as per Mr Trichet, the president of the ECB) we are forced to destroy 51% of the real value of the Retained Income balances in all companies operating in the European Monetary Union over the next 35 years – when that Retained Income remains in the companies for the 35 years – all else except cash inflation being equal.

Each and every one of those 35 years will be classified as a year of “price stability” by the ECB and Mr Trichet. Mr Trichet will not be the president of the ECB in 35 years time.

I think we will do ourselves a great favour by revoking the stable measuring unit assumption as soon as possible.

FREE DOWNLOAD : You can download the book “RealValueAccounting.Com – The next step in our fundamental model of accounting.” on the Social Science Research Network (SSRN) at http://ssrn.com/abstract=946775

——————–

Nicolaas J Smith
http://www.realvalueaccounting.com/

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