Only belatedly has it been realized that "Core" inflation is rotten. And I'd been saying this for quite a good deal of time by 2006. However Daniel Gross is late to the party here with this piece on mere core inflation.

The reason for this is the second point mentioned in Rotten to the Core Inflation, namely the asset inflation factor. Had the Fed, under Greenspan, acted correctly, or under early Bernanke, to cut off rising inflation, we would now be talking about how to get out of the recession. Instead, Greenspan and Bernanke both chose to be spear carriers for the right wing, believing that it would socially engineer the kind of society they preferred, and instead face us with a far worse problem. Namely the rip tide of meso-inflationary pressures.

The problem is that had we acted two years ago, both our asset inflation problem and our energy inflation problem were in sync. They were in sync because low interest rates were moving demand forward into an environment when innovation would not supply new products fast enough, so people bought bigger old products - SUVs and Houses - both of which used energy. The correct thing to have done at the time, had we had a Federal Reserve which did its job rather than acted as an unelected fourth branch of government with its own ideological agenda - would have been to

Raise Interest Rates

especially in light of the massive fiscal stimulus that Bush was applying. Greenspan's whinging about Bush's spending is hollow, he could have raised interest rates at any time to sterilize the excessive effects, but he wanted to create more people who owned houses and more people who were anti-tax and more people who were billionaires, and doing what he knew, as an economist and banker, to be right got in the way of his ideological mission to randroid America. So much for "honest conservative" - it is a contradiction in terms at this point, the libertarian right bent over and lubed up for the neo-conservative theocrats and militarists, and is now bitching that it hurts.

Had we included housing with energy inflation, inflation would have peaked for a month, October 2005, at over 10%.

However, we are now in a position where the two are not in sync. Housing is collapsing, and replacing the "rent of equivalent housing" with the government's own housing price number, we find that inflation is running at what seems to be a relatively tame 2%. However this is illusory, in that housing is going to accelerate, and there is going to be increasing discounting pressure on manufacturing as the economy continues to slow.

Right now the current position of the government is inflationary. This is to be expected, the groups that have systematic advantages like inflation, because they can translate systematic advantage into pricing power. And one man's inflation is another man's pricing power. However people with houses are no longer in the group with pricing power. According to DPT, they should, logically, be dropping out of the political coalition and are. Unfortunately for them, there is no coalition to join. They are all set to vote for Her Royal Clintoness, expecting that she will be good for them. But they are fools, idiots and consumerist ding bats, because she is all set to gut suburbia to keep exurbanite freep off her back. Suburbia is going to find that HRC is going to raise their taxes, raise their costs of health insurance, raise their costs of education, in order to fund a massive defense budget, because it will be so much easier for her to govern without all the military base bunnies calling for her impeachment because she is a running a lesbian hooker ring out of the Oval Office. The base bunnies will be hearing that and other variations on "life on planet wingnut" from Rush Limbaugh every day. Since suburbanites will vote for Hillary sight unseen, and the base bunnies won't, basic political triage says she taxes the surburbanites to bribe the base bunnies.

The falling prices of houses sets up a policy bind. That is, a macroëconomic case in one of the corners of the graph of solutions, where you are damned if you do, and damned if you don't. Energy inflation calls for, clearly, higher interest rates. A simple Taylor rule inflation number would have the Federal Reserve setting its overnight rate at 6.25%

As importantly, the hard numbers indicate that the Federal Reserve has been losing control of inflationary policy in general, that is the variation in CPI itself is rising, not just CPI. This increasing variation is an indicator of underlying mesoïnflation, not merely macroïnflation. The Federal Reserve has limited ability to control mesoïnflationary factors, though of course it can drop an anvil on fiscal authority that is not fighting mesoïnflationary factors by simply raising interest rates until it gets serious about underlying problems. This Greenspan and Bernanke have declined to do.

Consider this graph, which takes the CPI-W over 12 months and computes a simple statistical variance on it. There are more sophisticated tools for measuring variance, but for a crude picture this is sufficient to underline the essential point: inflation volatility, in itself, is an issue, because with inflation volatility comes the perception of upside inflation risk, and as Bernanke should know from his own economic work, it is the forward expectation of inflation which is as powerful a driver to inflationary activity in the present, as actors bet on inflation, and then dare the central bank to lower the boom and take the pain for disruption. Bernanke correctly predicted that he would be too much of a wimp to do it.

These then represent the new problems, core inflation being a way of stripping "volatility" out was always a lie, and it covered over the need to raise interest rates at a time when those chanting about core inflation were facing generationally low interest rates, a massively corrupt pool of pork from the war, and concessionary tax rates. Of course they would want to borrow money cheaply, make war profits, and then sock them away at low tax rates. D'oh.

The new problems are first, that inflationary volatility is on the rise, which is an indicator of disproportionate pricing power and speculation on commodities. D'oh, stocks are flat in currency adjusted terms, and have, largely, been since the relief rally after the ease of the Iraq invasion. The other new problem is that while there is still energy and commodity inflation, which is set to continue under massive fiscal and monetary stimulus and concessionary tax rates, housing is deflating. This is a larger problem than one might, at first think.

This is because the US regulates its own monetary supply by allowing banks to make loans based on the value of their mortgage portfolios. They now sell these portfolios to the quasi-government loan holders through intermediaries. In essence the government allows banks to print money to monetize assets, and then holds the loans on those assets. This is not necessarily bad - the people are on the hook for the money they print. Idiotic electorates will, sooner or later, pay for their idiocy. And we have been so very idiotic. In Greek id means "me" and an idios is someone who things of themselves first without thinking of the polis. To be idiotic is to be overcome by unenlightened self interest. Score another for Greeks not only having a word for it, but having a better word for it than we use today.

Allowing housing deflation is something that Ben won't do, because, again, his own academic work focuses on the perils of allowing a money supply contraction, which housing deflation would cause, in the face of economic contraction, which we are very clearly facing. He might make many mistakes, but he isn't going to make that one. The problem is that because he did not raise interest rates earlier, he is making the other mistake, also warned of in his own work, of allowing actors to bet that while the Fed does have a strategy to block inflationary activity, he won't use it. In otherwords, they know he has a "sucker preference" and be counted on to coöperate even though it is likely that he will be betrayed. Well, it isn't his money or neck on the line.

Thus the problem now isn't that core inflation is a scam for high inflation, it is that we have high inflation in goods, and deflation in the very commodity which our money supply rests upon. To reduce inflation would be to create dangerously deflationary pressures in the economy as whole.

This was predictable, because, well, I predicted it. Since 2002 it has been obvious that the long period of lower volatility brought on by the ending of the economic turmoil of the 1970's - the Age of Complacency was coming to an end. I noted at the time that there was an increasing variation in crude wholesale prices, which mean that inputs were becoming more volatile, and there was an increase, therefore, in systematic risk. Since the amount of money to contain risk is relatively constant, having to contain more commodities risk would mean less money to contain technological and financial risk, and therefore less money available for innovation, and therefore a period of slower technological advancement to market. This has come to pass, and can be seen in the rise in the VIX without corresponding real rise in the value of US equities.

With the end of both the "Great Commodities Depression" comes the ending, as Gross and others have finally noted, the big wins from globalizing the supply chain. We are, in fact, starting to pay the tax for allowing others to hold our instruments. One is at the pump, the costs of gasoline represent a tax that you pay to keep speculators afloat. Burma is another cost: the US isn't going to do anything about the crackdown, because Burma is now in the Chinese sphere of interest, and we don't have the economic or military freedom to do anything. We are busy trying to turn Iraq into George's Texas Annex with low low taxes and low low legal standards.

Our forward problem is then the volatility of inflation, and the increasing pricing power of non-US interests. Strangely, or not, this is the same combination that swept Reagan to power in 1980: America was bleeding money abroad, the purchasing power and savings of the middle class were being eaten by inflation, and the governing coalition had no ideas on how to deal with the problem.