The economy of the U.S. of A. has struggled for the last ten
years. To say this, is probably the
greatest understatement uttered over the last five centuries or so.
It started with the real estate fiasco and the resulting financial
crisis and continued for another eight years due to inept and misdirected economic
The FED’s obsession with inflation fears has not been due to inflation
or any threat of inflation at least of the demand pull variety. To make things worse, the FED (Federal
Reserve System, our central bank), and especially its’ monetary policy making
body, the FOMC or Federal Open Market Committee, has lowered even further its
tolerance for inflation, moving its’ target downward to 2%.
“The Federal Open Market Committee (FOMC) judges that
inflation at the rate of 2 percent (as measured by the annual change in the
price index for personal consumption expenditures, or PCE) is most consistent
over the longer run with the Federal Reserve's mandate for price stability and
“The inflation rate over the longer run is primarily
determined by monetary policy, and hence the Committee has the ability to
specify a longer-run goal for inflation. The Committee judges that inflation at
the rate of 2 percent, as measured by the annual change in the price index for
personal consumption expenditures, is most consistent over the longer run with
the Federal Reserve's statutory mandate.”
Note: the “Committee” is in reference to the FOMC, or
Federal Open Market Committee.
Whatever happened to the FED’s concern for high
employment and a rise in medium incomes, as well as a brighter future for our
Dr. Yellen, ‘tear down this
wall’ of obsessive fear of inflation
In a previous and recent edition of this newsletter, we pointed out
that the decision to pay interest on legal reserve deposits of depository
institutions, whether required or in excess, has become, though in a limited
way, a new tool of monetary policy, that of changing interest rates on reserve
deposits has in a limited way enabled the FED to influence interest rates
without going into the open market. This
new policy tool, while having been debated since the FED’s inception, has
become an additional tool for influencing interest rates in the economy at
In a ‘normal’
environment, the FOMC would set a targeted Fed Funds Rate and the NY Fed would
take the necessary steps in the secondary US Treasury Securities markets to
drive the rate in the desired direction.
If the FOMC wanted to drive up the rate, the NY Fed would sell securities
(or simply buy fewer securities than would otherwise be the case), causing
interest rates to rise due to the increased availability of securities. Conversely, if the FOMC directed the NY Fed
to drive down the Fed Funds Rate, they would purchase securities from dealers
in the secondary markets.
In 2011, the FED
instituted a policy tool wherein they would pay interest on depository reserves
at the upper targeted Fed Funds Rate.
“The Federal Reserve Banks pay interest on required
reserve balances and on excess reserve balances.” “As indicated in the minutes of the March
2015 FOMC meeting, the Federal Reserve intends to set the IOER (interest rate
on excess reserves) rate equal to the top of the target range for the federal
Drilling down on Price Level
Changes: Demand Pull; Cost Push
What we will do in this newsletter is to delve into the two major
causes of price level change, demand pull and cost push. We will examine the likelihood of each type
of price level change occurring and the ability of the FED to cope with each
The FED’s recent actions in raising interest rates, the latest on June
15 of this year, seems to imply that a bout of fairly serious inflation is just
around the corner. A few FED officials
point to the labor market and argue that it is in good shape and further
increasing pressures on the labor market due to demand pull pressures from
household and business spending will result in an inflation rate beyond the now
acceptable rate of 2%.
In the previous issue of this newsletter, we have argued that this
optimistic view of the labor market is a misinterpretation of the current labor
market’s condition due to a large amount of discouraged workers in the younger
end of age distribution from 16 to 54 years of age and especially the group from
16-24, and that any improvement in the economy’s outlook would lead to a
significant growth in the labor force participation rate due to an encouraged
If a bout of demand pull inflation (or deflation) occurs when elements
of aggregate demand expands (or contracts) too rapidly causing the markets
involved to experience price increases (or decreases) in an attempt to affect
the growing (or shrinking) scarcity of the good or service in question, the FED
has shown over the years that is has ample tools to cope rather easily with the
February 12, 2013
…Aggregate Demand http://econnewsletter.com/163001.html
“The term, Aggregate Demand for our goods and services,
is the sum of the four, PCE (Personal Consumption Expenditures) plus GPDI
(Gross Private Domestic Investment), plus GCE&GI (Government Consumption
Expenditures and Gross Investment), plus NEGS (Net Exports of Goods and
If however, a bout of cost push inflation or deflation occurs, the FED,
as seen at various times from 1973 to 2001, would face a much tougher challenge
in reducing such inflationary pressures.
An example of this type of demand pull price level change occurred in
the post-WWII period, when price controls were finally eliminated and the
Korean War began. Several demand pull factors arose, such as pent-up consumer
demand due to years of wartime rationing and the stoppage of the production of
passenger cars for a few years during WWII all contributing to pushing prices
higher. Demand pull inflation occurs in
the product markets for goods and services and it is fairly easy for the FED to
control with its current arsenal of monetary policy tools.
Cost push inflation occurs in the markets for productive resources
(labor, debt and equity capital, entrepreneurship, and land). It is a much more difficult type of inflation
for the FED to control than is the demand pull type of inflation.
A relatively recent example of this type of inflation was the period
from 1993 through 2000. In this case, it
was the productive resource land in the form of crude oil prices. The cartel, OPEC, doubled the existing price
from $15 per barrel to $30 per barrel.
This was nothing new; OPEC had initially quadrupled the per barrel price
from $3.50 to $14 in 1973, marking their assumption of pricing and production
decisions formerly relegated to the so called Seven Sisters, the major oil
companies comprising the relatively benign oil cartel prior to OPEC’s takeover
of pricing and production decisions.
The source of this oil shock can be laid on the doorsteps of the
Anti-Trust Division of the Justice Department and the Federal Trade
Commission. Their inaction allowed 12
large U.S. oil companies to become four, sealing the economies doom to these
record oil prices.
>>>>Notable US oil
mergers of the last ten years<<<<
Ashland Oil combines most assets with Marathon Oil
British Petroleum (BP) acquires Amoco
Pennzoil merges with Quaker
Exxon and Mobil join to form
British Petroleum (BP) acquires
ARCO (Atlantic Richfield)
Chevron acquires Texaco to form
Conoco merges with Phillips
Royal Dutch Shell acquires
The FED: Efficacy
of Monetary Policy in addressing Inflationary Concerns from the Demand Side and
the Supply Side
The coping costs for the economy of the FED’s monetary policies in
controlling each type of price level change differs significantly. The FED’s monetary policy tools such as
discount rate changes and open market operations are geared to controlling
aggregate demand rather than aggregate supply.
The FED relies heavily upon the control of the growth rate of money,
credit and thus interest rates which are more effective in controlling the
behavior of the spenders such as households and business and much less
effective in controlling the behavior of the productive resources such as
labor, land, and entrepreneurship.
In this presentation, the aggregate supply relates to the
economy’s overall output of the productive resource mix (labor, capital,
entrepreneurship and land). This would
include output from foreign sources as well, i.e., imports.
Allowing the growth rate of real Gross Domestic Product to reach 3 or 4
percent and even 5 for a short while would enable a breakout of the economy
from the persistent slow growth rate we have witnessed since the financial
crisis peaking around 2008.
Unacceptably high price level increases of the demand pull type such as
a rapid expansion in the household and business sectors, could be slowed fairly
easily with existing tools of monetary policy if such a price level increase
was of the demand pull type as would most likely be the case.
We will now turn our attention to cost push price level changes. As mentioned earlier, these price level
changes emanate from the markets for productive resources such as labor and
land. Labor unions are cartels as is
OPEC. Labor and crude oil are productive resources. By controlling supply they can control price whether
you call it the labor compensation rate or the price of a barrel of crude
Speaking of Supply
Side: Let’s Talk Minimum Wage
The minimum wage is another example although it is put into place through
government legislation. If the cartel
price or legislatively determined minimum wage is below the true market price,
it is ineffective. If cartel price is
above the market price, it is effective and is maintained by control of supply by
either the cartel or government legislation. This leads to the significant
difference between the demand pull and cost push types of price level
To suppress cost push inflation with existing monetary policy tools,
aggregate demand must be depressed leading to an even greater fall in the equilibrium
quantity whether it is in the form of hours of labor or barrels of crude
This was not the case with demand pull inflation. This should wave a very large red flag to
those espousing more legislation to increasing the minimum wage. As the minimum wage on entry level jobs
rises, physical capital has replaced entry level labor jobs and these jobs
disappear as we are seeing at fast food stores.
These entry level jobs enabled young adults to learn the most basic
skills for being successfully employed and college bound younger adults to earn
incomes to help pay the rapidly rising cost of attending college whether it be
private or governmentally attached institutions of higher learning. This may be a major cause of the weak growth
in the number of those attending such institutions.
Another Supply Side Issue: Fracking
The end of fracking would have more widespread negative effects on the
economy. If fracking were ended, the
price of electricity which fell and continues to fall as fracking becomes more
widespread, would rise again. As is
currently the situation, the increased quantity supplied from fracking fields
such as Marcellus, have driven the price of electricity down and reduced carbon
emissions as this occurs.
The price for a KWH should continue to fall as stranded costs from the
conversion of coal and oil to natural gas are fully absorbed. This will cause an even further decline in
the price of electricity.
Ending fracking would reverse this process and result in a switch back
to using coal and oil. As this occurs,
the cost of generating electricity would rise, resulting in the rise in the
price of electricity. Accompanying this
rise in the price of electricity will be a rise in carbon emissions. In turn,
stranded costs due to the switch back from natural gas to coal and oil should
help cause a further rise in the price of electricity.
These are but two of the many possibilities highlighting the fallout
from the lack of thorough analysis leading to unintended consequences and the
like. As the old expression goes, “Talk
is cheap”, to which we add, the cost of bad policies can lead to enormous and
unnecessary burdens on society.