Beat the Fed
graphics.wsj.comThis "game" seems to allow me to modify the outcome of the Fed's policies, and not the inputs. Unless it's advocating price controls as a means to economic prosperity, I don't see the relevance.
Am I missing something here?
Perhaps I am economically naive, but why does there need to be any inflation? Why isn't 0 a target?
People with money just sitting on cash (instead of investing) is a nightmare scenario - it's the shape of global economic meltdown. Capitalism requires that people with capital invest it. In theory, capital gets something worth more than what they spent, a business is created, it pays employees who pay other businesses who pay employees, etc. and you get a self-sustaining cycle of prosperity. Everybody is better off than they were before.
Inflation encourages investment - you need to invest in securities with a rate of return at least as good as inflation in order to not lose money. Incentives are aligned to make you do the thing that keeps the cycle going.
Deflation encourages hoarding - you would do better to keep the money under your mattress and wait for prices to fall before circulating it. Incentives are aligned to make you do the thing that destroys the economy.
Inflation in principle isn't horrible, but inflating prices while wages stagnate leaves everyone objectively worse off than they were before. This is already happening to an extent and causes a baseline level of unhappiness; if it were to get out of control things would be very ugly.
The task of a central bank is to use some very broad levers (interest rates, creating currency, etc) to try to keep the rate of inflation low but positive.
If deflation encourages hoarding, why don't we see that in items that are well understood to be deflationary? An example is technology. Everyone knows that the value of their smartphone will decrease by ~25-50% a year, but we still purchase them.
Economists discount deflation as being dangerous with just one sentence (it encourages hoarding). Are there any examples of deflation actually being harmful in an economy? There are plenty of examples of inflation being dangerous [0]. Technology is an example where deflation does not encourage hoarding.
Money works differently from technology. You can trade old cash for an amount of new cash with the same face value whenever you want.
If I bought a computer for $600 in 1980, it's not going to be traded for $600 today. But if I got a $600 check in 1980, I could cash it today for $600. Inflation is what makes this a reasonable thing to do. If money deflated, I wouldn't cash my check, I'd want to hold it for as long as possible. Deflation basically means you collect interest on any cash you have.
Yes you may not cash it in today if it's going to be worth more tomorrow but you also wouldn't have the money to use for something else you value.
I don't see how that's different from choosing not to spend $600 for a computer today knowing that it'll be only cost $500 a year from now. You buy it today because it has a higher value to you now rather than a year from now (we still prefer things sooner as opposed to later, despite deflation). You would also may choose to cash in the $600 knowing well that it will be worth more if you wait because you want to spend it on something now.
Even with deflation, people would still spend money as we prefer to consume now rather than later. If cash had a positive return, I'd imagine riskier assets would have an even greater return so you wouldn't necessarily be all tied in cash. I know cash has a negative return (due to inflation) but I still hold it.
I wrote a longer reply, but the problem is you're looking at this from the side of consumers consuming things they want. I don't give a shit about the resale value of my Macbook Pro, and in 2015 if you're buying a new car you're well aware that you're throwing away the first third of its value in 5 years. Deflation is not a concern when we're talking about people buying things for the joy of owning them.
What we're talking about is investors buying things (like capital equipment) for the purpose of making money. But even for an individual - would you go $200k into debt for a house that's going to be worth $50k in 10 years? Of course not! A rational actor would even shy away from leases - you want to jump to something cheaper (or better for the same price) as frequently as possible, to minimize the amount of time that you're paying above market value for housing. Just like how you want to move between tech jobs relatively frequently to minimize the amount of time you're being paid below market value.
Well it's not just one sentence. One of the problems with deflation is debt payments. And the value of labor, assets and prices.
Lets say a store has $50,000 worth of inventory bought on revolving credit. In normal times, $50k worth of inventory might sell for $100k. The $50 worth of gross margin goes to pay, labor costs, rent, and the owners take. Lets say due to deflation that 50k is now only going to sell for $90k, the business is short $10k. What's the owner going to do?
Go out out business that's what.
So the problem with deflation is it tends to rape the books of perfectly well run businesses. And then you get cascading failure. The mill has a cash flow problem, goes bankrupt, and then half the business in town close.
A most subtle problem is a lot of businesses really run on credit backed by pledged collateral. The chain of collateral forms what called a credit chain. When you have deflation and a demand slump the assessed value of the collateral becomes suspect. Credit chains shorten and collapse. And businesses can't get liquidity. And then fail.
It goes on and on.
>items that are well understood to be deflationary
People buy smartphones because they want smartphones, not to make money on them. Rational capitalists, on the other hand, use their assets in a way that maximizes gain and minimizes risk.
In an inflationary economy, the best investments are profitable businesses, or derivatives/aggregates thereof. Your capital is put to use buying means of production that makes more money than it costs and employs people along the way. Every year, the prices of the products you sell rise higher, but you've already paid for the factory! And you're incentivized to fund that factory now, because factories are only going to get more expensive.
In a deflationary economy, cash is a low-risk/high-reward investment. Business, meanwhile, is hard - high-risk, aggregate low reward. Yes, consumers have more buying power, but production capacity is created and scaled by going into debt to buy capital equipment. In a deflationary economy, the real value of debt is increasing while prices are falling. So every day, the output of your assembly line is worth less, but what you owe on the line itself hasn't changed. You just have to hope that you can pay off the factory and make some profit faster than the price of the widget it makes approaches zero.
Why isn't this the case with technology? Because with technology, the rate of descent of the price people will pay for, say, smartphones still leaves room for a profit margin compared to the rate at which production is getting cheaper, and last year's high-end production lines are still useful for making what's now a third-world phone.
When you eventually get to a point of losing money on your factory, you lay off your employees, who now have less money to buy things from other factories, and if the economy gets on the wrong side of that snowball you're looking at hell. The more this happens, the more likely investors are to stop investing in businesses and park their wealth in cash. The same checking account balance will always be able to buy a bigger factory tomorrow. You effectively stop the pump of economic activity, causing recession.
In the crudest terms, the central bank printing currency like crazy can make sitting on cash an even worse option than investing in business again, so you opt for the latter.
tl;dr deflation makes it more rational to own money and less rational to own things that try to make money by employing people.
Good question.
I am not skilled in econ, but isn't this because the utility of new technology increases faster than inflation? In other words, utility(technology1, t1)/cost(technology1, t1) < utility(technology2, t2)/cost(technology2, t2).
Ignoring any affects of supply and demand,
If I buy a tractor 1.0 today for X dollars to produce Y units of utility (i.e. Y/X), but tomorrow tractor 2.0 costs 2X dollars (with inflation) to produce 4Y units of utility (i.e. 2Y/X), then my tractor 1.0 should be worth 1/2 dollars tomorrow (assuming that it still has Y units of utility). And, I may buy a tractor 2.0.
But, if on the next day, tractor 3.0 comes out and still has 4Y units of utility (technology stagnation) but costs X dollars (deflation occurs and production costs have gone down), then my tractor 2.0 should be worth 4X dollars. I'm not going to buy tractor 3.0.
> Are there any examples of deflation actually being harmful in an economy?
According to the Federal Reserve Bank of Minneapolis, no: https://www.minneapolisfed.org/publications/the-region/defla...
In fact, one of the theorists there suggested a rate of -3% (or 3% deflation) might be optimal.
A popular modern economic theory is that if prices rise slowly over time, people will tend to purchase today instead of saving money to purchase tomorrow, since they believe the price of what they want will be higher tomorrow. If prices drop slowly over time, people will tend to save as long as possible before purchasing, since they believe the price of what they want will be lower tomorrow. Since simple economic productivity is measured by summing the amount of dollars spent, the theory is that for these reasons low inflation leads to productivity.
All of which would be perfectly reasonable if humans were completely rational actors. But we all know we're not. We're semi-rational at best. Yes we try to maximize utility, but we're not Commander Data, calculating equations in our heads down the the 999999 points of precision, and coldly make decisions based on purely financial measures.
This is even more true for some things than others... few people are going to say "Hey, deflation is on, let me wait until next week to eat" when they're hungry today.
I'm not saying deflation is good or anything, but an awful lot of economic theory is rooted in some pretty shaky foundations.
The consensus is that slight deflation is much more dangerous than slight inflation, so while zero would be ideal it's not worth the risk of deflation
While there is agreement that inflation is costly and should therefore be minimized, for a number of reasons policymakers nevertheless aim for an inflation rate above zero. First, available measures of inflation are imperfect and tend to overstate “true” inflation. Second, a little inflation may make it easier for firms to reduce real wages—without cutting nominal wages—when necessary to maintain employment in an economic downturn. Third, a negative inflation rate—deflation— could be even more costly than a similar rate of inflation, suggesting that a low rate of inflation might be desirable to insure against falling prices. Finally, at very low levels of inflation, nominal short-term interest rates may be very close to zero, limiting a central bank’s ability to ease policy in response to economic weakness. Because nominal rates cannot fall below zero, policymakers cannot cut short-term interest rates any further once they have lowered these rates to zero. - George Kahn, VP Federal Reserve Bank of Kansas
Basically, it's because people want to see their wages go up, and a central bank loses the power to set short term interest rates when inflation is 0%, as we've witnessed in the US over the past 6 years.
Banks are typically leveraged about 12 to 1 meaning that one dollar of the banks money is paired with 11 dollars of depositors money to fund a loan. Since the banks capital is scarce relative to depositors funds it is usually the limiting factor in how many loans can be made and the overall amount of money in the economy.
When banks make a bad loan and are forced to write of the loan each dollar of loss results in 11 less dollars of loans that can be made. When this happens to a lot of banks at the same time you get a general decrease in the money supply and general deflation (like the Great Depression).
A positive rate of inflation allows banks to resolve some bad loans simply by holding the loan until inflation increases the asset value above the loan amount rather than a write-off. Positive inflation, in other words, is a lubricant for the banking system to make it easier to resolve bad loans which makes issuing loans simpler.
With zero percent inflation banks would demand higher standards for underwriting such as stronger credit and larger down payments. that would generally mean loans would be directed mostly towards older, larger and more established industries and less to newer and smaller industries. Less loans for young people and more for older people.
As a side note what makes the Federal Reserve special is that it is allowed to make loans with infinite leverage on capital. That means instead of a 1 to 12 ration of a typical bank it could be 1 to 100 or 1 to 1000. To keep this special position any profits are foreited to the U.S. Government and implicitly any losses are also eaten by the U.S. Government as well. Which is why which assets the Feseral Reserve purchases is a sensitive topic.
Boost equity prices. Putting money in mattress gets -(inflation) return, so how about stocks?
Very theoretically it sets a "you must be this tall to play" floor on stock financed capital projects. So if inflation is 4% and you think new railroad locomotives will pay off at 5% average, then you do it, or if new locos only pay off at 3% then you don't because you'd get a sub-inflation rate of return on stocks or bonds.
Another argument is its essentially a long term debt jubilee, given the extremely optimistic assumption that wages rise with inflation (LOL, not so much since the 80s or so). So at both personal and corporate level, debts as a problem kind of go away with time. A decade of 70s style wage inflation would certainly help with the student loan crisis and the real estate price crisis.
Leave it to economists to claim a correlation, and simply forget to say that the best models (supported by lots of empirical evidence) predict it's a causation.
Inflation acts as a tax on dollar-denominated savings. A modest inflation rate encourages people to do something with their dollars other than put them under the mattress.
To encourage spending
Inflation of zero is just as good for encouraging spending as small positive inflation -- the rate you'll get by low-risk investing will always beat inflation by a bit.
But the moment inflation dips below zero it really starts discouraging spending.
So I suspect it's about having a margin for error. Target zero and it will spend a lot of time negative, target mildly positive and it will spend most of its time mildly positive.
>But the moment inflation dips below zero it really starts discouraging spending.
While this view is common, it is incorrect.
This is obviously evident when you consider the price of computers and other tech products over the decades.
Even in computers, you had the dilemma of "should I buy now, or wait a year and get the same thing for less money?" That was a standard question for many years.
Despite that, companies like Apple have hundreds of billions in revenues. Which is to say, the falling prices aren't a real problem. After all, the same person could say they could get the same thing for even cheaper in 2 years, 3 years, 5 years or 10 years.
True. And yet, it still means there is some pushing of demand into the future due to the deflating prices. Which means that your argument in the GGP post is false. The fact that, despite the pushing of some demand into the future, Apple makes tons of revenue does not change the fact that demand is still being pushed into the future. That is, your reply, while true, is irrelevant.
>True. And yet, it still means there is some pushing of demand into the future due to the deflating prices. Which means that your argument in the GGP post is false.
I never said deflation cannot defer people's demand. The comment I originally responded to indicated that a deflation rate of 1% would, in general, discourage spending. I would wager, that almost no one defer buying an iPhone if they knew for a fact that it would be 1% cheaper a year later. Just as I don't think that knowledge that the price would be 1% higher a year later would cause someone to buy an iPhone they were not already planning on buying.
What I'm getting at is falling prices, in and of themselves, are not a huge problem. If you want to say that a deflation rate of 20% would cause huge problems, ok, maybe that's true for some products. Conversely an inflation rate of 20% would cause huge problems in some realms. Inflation is not generally good and deflation generally bad--that is the myth I'm addressing.
1% deflation doesn't shift demand very much. OK, I'll buy that. (Pun not intended, but not avoided.)
Does the cumulative "push" of "demand" into the "future" not have the systemic effect that in the future, there will be "current" demand?
This is one thing I've never understood about this whole "inflation incentivizes people into spending now rather than later". If we're simply pushing the demand into the future, aren't there already people from the past whose "future time to spend" is the current moment?
<opinion type="rant"> From my perspective, all that I see inflation doing is artificially forcing people to put more money into the stock market and investing than they should be.
That is a good point that I didn't address. Deferring spending in perpetuity is worthless unless someone gains some personal satisfaction merely from saving.
The price of computers dropped because of returns to technology investment, not because of deflation.
Why the prices dropped is irrelevant. Clearly spending on tech products has not ceased.
It also allows wages and prices to fall when necessary, without making the raw numbers decrease, which people are usually reluctant to do.
To make people feel good. Inflation means raises (even if productivity hasn't changed) and higher prices (shop keepers always love when prices go up, manufacturers increase revenue, etc.). Deflation means pay cuts (even if you didn't do anything wrong) and lower prices (shop keepers freak out when they keep the prices the same ... but fewer people buy. same with manufacturers). Things just work much better with inflation, rather than deflation.
"Fed’s goal: get the U.S. inflation rate to 2%": This is partially true, since the Fed's goal is also to maximize employment[1]. So really, they should add employment rates in these different categories as well. Which makes the job even harder.
In fact, balancing the two was thought to be a very hard job in theory, almost impossible. And that's why the EU central bank mission _is_ to only stabilize inflation and let each country focus on employment. (it's less and less true because of pressure from EU countries such as France and Italy).
Interesting fact: adding the unemployment part of the dual mandate came after the recession of '73-'75 which saw unemployment hit 9%. Originally, the Fed's only mandate was to keep prices stable.
[1] https://www.chicagofed.org/publications/speeches/our-dual-ma...
They have clearly adopted other goals as well, apparently popping bubbles or some such, otherwise with 10 year TIPS << 2% there would be no reason to raise rates.
At first glance, had no idea what I was supposed to do or how it worked. At second glance, it seems like you're just setting price inflation on a number of components, trying to get the weighted average to be 2%. Wildly overhyped "game"?
Yeah, I don't get it either. I dragged each control to the maximum one by one, until I got to 2%. Then I clicked the button and won, even though I hadn't touched half of the controls yet. I assume there's supposed to be some underlying lesson in it....
I'm guessing the 'lesson' from your iteration is that you increased prices most on a subset of goods- housing and utilities, health care, and financial services and insurance- while leaving the rest to track their industry.
The problem with that, and with health care especially, is that the 'native' price increase already far outstrips inflation. With that monetary policy, you've introduced an extra 5% tax on already quickly growing industry. So a family going through a health care crisis or crisis of changing insurance will be affected negatively, whereas a family only buying groceries and liquor will feel no undue changes.
So that's what I'm guessing the article is saying, where can/should/will the Fed attempt to affect American savings and purchases.
Of course, the Fed doesn't make that kind of targeting decisions because monetary policy -- the only lever the Fed has -- doesn't work that way. Targeted effects are the domain of fiscal policy (where government choose to tax and spend), not monetary policy, and are the domain of Congress, not the Federal Reserve.
This "game" is stupid because it doesn't do anything at all to show the trade offs.
As a gross generalization:
Higher Growth -> Higher Employment -> Higher Inflation
High Inflation -> Negative Income Growth (for those on low wages and fixed incomes) -> Risk of Recession and/or Social Disruption
Lower Growth -> High Unemployment -> Risk of Recession and/or Social Disruption
Put those parameters in and the "game" gets interesting. At the moment it's just pointless.
It's about time somebody did...