Central Banks Would Do Better Forecasting the Weather

Last week America received some unexpected news. Inflation data was below expectation, and lower than the Fed’s target of 2%. While it isn’t catastrophic, it doesn’t help America’s monetary policy plans.

The Fed seems adamant that the US economy is growing sufficiently, at least. Hence raising interest rates by 25 points, the third hike in six months. But if inflation continues to fall, then the economy looks to be slowing faster than they had planned.

The situation has caused a stir of discussion. Inflation refuses to budge, yet the US gets closer to full employment. It’s a mystery that has economists puzzled and policy makers stabbing in the dark.

The science just doesn’t work if the numbers won’t obey. And so we’re left with people who have as much merit in directing a nation’s economy as they do forecasting the weather.

When the Fed voted to increase interest rates last Wednesday it would have been unanimous, except for one vote. Neel Kashkari, President of the Reserve Bank of Minneapolis, voted to keep rates on hold. Instead of praying that the economy continues to grow, he backed the data. Kashkari wanted evidence that inflation was going to rise in the future before committing to a rate rise.

At least the man had some conviction in the face of uncertainty. Economics is after all, not an exact science. The GFC may have been a decade ago, but it seems the rest of the Fed are still pushing an early 2000s doctrine.

So what, or who, is to blame for such low levels of inflation?

There are, of course, multiple theories. But today I want to give you my opinion. The opinion of a millennial.

For the few of you who are still reading at this point, let me state that this is an informed opinion.

In September 2008 Lehman Brothers went bankrupt, the stock market crashed…and I was about to finish year 11 of high school. The future didn’t exactly look bright.

Now I’m not suggesting older generations didn’t feel the effects of the GFC — far from it. I just want to point out that this was a defining moment for my generation. It set the tone for our view on economics.

Paired with the financial collapse was the advent of e-commerce. As millennials grew up, our consumer habits relied more on the internet. Now, I don’t need to explain the benefits that came about from our digital economy. But the internet has undoubtedly played a role in stifling inflation.

When looking at historical data you can clearly see how inflation rates have been smoothing in the long run. This isn’t only due to the internet, but it has played a large role, alongside other technological advances. We are more efficient at production, and we have more access to global markets than ever before. That perfect storm resulted in a price war, a sensational race to the bottom.

As an example, look at Amazon in the US. They account for half of every dollar spent online in America. How do they control such a huge market share? They’re cheap. Now that is simplifying it to a very basic understanding, but it doesn’t make it any less true.

At the moment, Amazon has its sights set on a new target, groceries. Analysts are expecting ‘a supermarket war of historic proportions’. That’s a war that Australia has played host to for a while now. Coles and Woolies have been squeezing every possible saving out of items in their aisles for a couple of years.

While the internet has led the way for cutting costs and lowering prices, competition is so fierce that traditional retailers have had to adapt or die. And it hasn’t even reached its full potential yet.

Disruption is so frequent that inflation doesn’t even have a chance to catch up. Well, for some goods and services at least.

You see, the fundamental problem is not that central bankers can’t stir inflation — they just can’t measure it properly.

Australia introduced the consumer price index (CPI) as a metric in 1960. It measures the average change in price for a fixed group of goods and services. Which is all fine and dandy when each good and service is generally localised in terms of production.

It’s why most central banks rely on the Phillips Curve.

If you’re unfamiliar with the Phillips curve, it’s an economic model that suggests that as employment levels rise, so will inflation. In brief, the reasoning is that with high employment rates, workers are in short supply. That means wages should rise as workers are in demand. Which now makes the cost of production higher, and results in inflation.

The problem is, not all our goods are made equal. I can’t imagine it was as easy to find an item with the words ‘made in China’ written on it in 1960 as it is in 2017.

When China can produce goods at a fraction of the cost and then trade it to us, inflation doesn’t have a fighting chance.

And what about non-tradeable goods and services? How have they been impacted?

Well, I’m fairly confident you’re just as displeased with the price trend on your power bill as I am with mine. In fact, electricity prices increased 114% in the past decade alone. Compare that to the CPI, which has only risen 28% in the same timeframe, and the argument surrounding inflation seems a tad moot.

As you can see, I’ve picked an extreme example to make my point. The CPI is after all a weighted average of 53,000 products. But how many of those do you think actually fall into the targeted 2–3% rise per year? From my cursory glance at the data, not many.

Maybe — gaspCentral Banks don’t even know what’s going on. It certainly feels like their dated metrics and models aren’t going to provide any answers.

When the Fed is placing its policies on faith, you should be concerned. When The RBA spruiks satisfactory inflation data while utilities are soaring and housing is outrageous, you should be truly alarmed.

As I said, I’m a millennial. My generation grew up with the internet and the sharing economy. Data is the foundation of our era.

Central bankers take note.

Regards,

Ryan Clarkson-Ledward,
Junior Analyst


Ryan Clarkson-Ledward is a junior analyst for Markets & Money. Ryan has degrees in both communication and international business. His priority is bringing you the latest price updates on stocks through ASX updates, as well as supporting Sam Volkering with background research. As part of the team at Markets & Money his aim is to provide unbiased and relevant news for readers. Ryan’s work with Sam is designed to provide research that complements Sam’s analysis for small-cap and technology stocks. Together, their objective is to break through all the jargon and give you the hard facts to inform your investment decision-making. Ryan writes for:


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