In the Rush to Monetary Stimulus, Controlling Inflation Is Not Just a Sidebar

11/19/2012 by Alex Carrick

The U.S. all-items Consumer Price Index (CPI) in October was +2.2% versus the same month of the previous year, according to the Bureau of Labor Statistics.

That was a slight acceleration from the September figure of +2.0%. Most central banks, including the Fed, adopt +2.0% as the most desirable level for the inflation rate.  A little inflation helps grease the wheels of industry. For example, it makes it easier to pay back nominal loan amounts. Indebted workers can count on rising wages and indebted firms can raise the price for their goods or services.  

The “core” rate of inflation, which omits food and energy, was exactly on target in October at +2.0%. That was the same rate of increase for “core” inflation as in September.

Year-over-year food prices in October were +1.7%. Energy prices were up more, +4.0%, with gasoline rising even faster, +9.1%. 

It’s interesting to note that the sub-index price for “piped gas service” was -8.4%. For consumers, there are real benefits to the boom in energy development that is underway south of the border.

The Fed has a double mandate with respect to its monetary policy – to keep inflation under wraps and to promote jobs. These can lead in contradictory directions. For example, massive increases to the money supply for the sake of job stimulation may take away from controlling inflation longer-term. More on this in a moment.  

But first, let’s talk about goal-setting. There are some among the Board of Governors who think the Fed should take on additional targets at this time. One set of criteria that has been proposed is to bring the unemployment rate down under 7.0% while not letting the rate of price increase go above 3.0%.

Others among the Governors think this could lead to confusion. Breaching either of those figures might suggest an imminent increase in interest rates. 

This isn’t the message the Fed wants to convey. The Fed has said it will keep its key policy-setting interest rate, the federal funds rate, between 0.00% and 0.25% until mid-2015.

It doesn’t want to waver on this commitment. The purpose of setting out its low interest rate policy in the first place was to assure the business community that financing charges will stay low for the long-term. That’s the way to encourage positive investment decisions.

At the same time, the Fed is certainly pumping money into the system. More than $2 trillion has been added to the money supply through QE1 and QE2. Plus there is the latest program in which $40 billion of mortgage-backed securities are being purchased each month.

Traditional economic theory suggests that such large increases to the stock of money will eventually contribute to a run-up in prices.

There’s no escaping the fact. Over many years, the rate of inflation is the major determinant of interest rates. Therefore, higher inflation will eventually have an obvious impact on lenders and borrowers.

But there’s an aspect to higher inflation that can easily be overlooked. It plays havoc with the income – and by extension, the consumer spending – of seniors.

Japan has struggled for almost two decades with an alternating low inflation-deflation problem. The general public has been more accepting of this situation than one might expect for one major reason. The country has a very large body of seniors. The nation’s birth rate is low and, unlike the U.S. and Canada, immigration (i.e., of younger workers) is not encouraged.

Therefore the proportion of seniors is high and they often live on fixed incomes. They don’t want to see their everyday costs for food, housing and transportation rise.

A similar problem is imminent in North America. The front-end of the post World War II baby boom generation is moving into retirement age. In Canada, baby-boomers were born between 1946 and 1964.

For their living expenses, many of these people will depend on funds accumulated through “defined contribution” pension plans.

That’s as opposed to “defined benefit” plans, where the employer is responsible for fixed and usually more generous retirement pay-outs. Many of these were set up assuming rates of return that are unrealistic in these days of low interest rates. They are now pretty much confined to the public sector.

Some of the most prominent corporate failures have been among companies locked into “defined benefit” plans. The Big Three automakers have only become financially viable again because they’ve managed to offload their “defined benefit” pension obligations.

Under “defined contribution” pension plans, individuals must manage the total sums they have set aside to their own best advantage. Upon retirement, they and their financial advisers have to make certain assumptions about yield, duration and the subject of this article, inflation.

The inflation aspect works as follows. A registered income fund or RIF is like a backwards mortgage. Once assumptions are made about yield and duration, a calculation can be made to see what annual return will result in a zero balance (based on an initial total at the end of say 20 or 25 years.

The annual figure can be further refined to a monthly amount.  

But do you really want to receive the same dollar amount every month for the next two decades? The answer is no and the reason is inflation. A fixed sum of money now won’t have the same purchasing power in five, ten or fifteen years.

Therefore, the way most RIFs are set up is to have smaller payouts at the front end so that the monthly income will rise the further along the time line you have progressed.

The higher the assumed inflation rate, the lower the front-end income payout, greatly reducing the recipient’s ability to maintain a normal consumption pattern. Most financial planners are currently using an “assumed inflation rate” of +2.5% to +3.0% per year over the next couple of decades. If that figures goes up, it will have serious consequences for seniors’ investment earnings.

The reality isn’t quite as static as the above suggests. Since there’s more than one variable used in the payout calculation, the final result will be more dynamic. For example, if inflation rises, the yield will probably increase as well.

Nevertheless, for the good of society as a whole, there is a valid reason keeping inflation under control is the primary goal of most central banks.

U.S. inflation – all items (CPI-U) vs all items less food and energy
(not seasonally adjusted)
U.S.  inflation – all items (CPI-U) vs all items less food and energy
In the U.S., the change in the energy sub-component index was +4.0% year over year in October 2012. Gasoline was +9.1% year over year.

The U.S. figure (CPI-U) is the All Items Consumer Price Index for All Urban Consumers.
Data source: U.S. Bureau of Labor Statistics (Department of Labor).
Chart: Reed Construction Data - CanaData.