Oh, Those Darn CPI Numbers !

Inquiring minds have been pondering Volcker's latest statements regarding stagflation, the Consumer Price Index (CPI), regulation of banks, and even the need for an administrator to watch over the Federal Reserve.

Let's see where Volcker is right and wrong, with his analysis of the current economic situation and what to do about it.

The U.S. economy is not now in the kind of stagflation crisis it had been in, in the late 1970s, former Federal Reserve Board Chairman Paul Volcker told Congress today, but it's not impossible.

"I think there is some resemblance now to inflation in the early 1970s,' he warned the Joint Economic Committee. The economy obviously does not have the full-blown, double-digit inflation crisis that finally appeared, but he said, 'there is an underlying tendency to inflation.'Volcker also told the committee that the Consumer Price Index may understate the actual rate of inflation. For example, during the real estate boom, the housing component of the CPI rose only slightly. And to consumers, 'when food and energy are running high, not for a couple of months and dropping, but running high for years, it doesn't sound quite right, it doesn't feel quite right."

As for not believing the CPI, I believe virtually no one does. Furthermore, as Volcker points out, housing was dramatically understated for years. Housing is overstated now. However, Volcker fails to go far enough with this line of thinking.

Other Problems Inherent With The CPI :-

The CPI cannot measure stock prices or prices falling because of rising productivity. Peak oil is a factor. So is worldwide demand. It's debatable that prices can even be accurately measured or that there is any such thing as a representative basket of goods and services to measure. Most importantly: the CPI is useless in measuring the magnitude of credit bubbles that manifest themselves in other ways besides prices. Finally, the CPI is a lagging indicator.

In my opinion, the final analysis shows that anyone who believes the CPI is (or is even supposed to be) a measure of inflation is making a huge mistake. The solution is to start with a sound definition of inflation and deflation: Inflation is a net increase in money supply and credit. Deflation is the opposite.

Volcker did not forecast a recession, rather he talked about a necessary rebalancing of an economy that depended too much on consumption financed with borrowing. 'Somehow that has to change,' he said. 'It's a kind of a rough ride but we have to have it happen to avoid more severe consequences.' And in fact, consumption is declining and exports rising, 'laying the basis for a sustained recovery.'

In my opinion, there is clearly a need for rebalancing. However, there is no basis whatsoever for believing a sustained recovery is possible any time soon. The recession is barely a few months old, and some do not even think it has started yet. More to the point: The jobs picture is miserable, banks are horrendously undercapitalized, and foreclosures are mounting. Banks failures are coming.

And, having necessitated Fed intervention to rescue the markets and economy as a result, the investment banks which used the financial innovations now need to face the same kind of regulation as commercial banks. 'I believe there is no escape from the conclusion that, faced with the kind of recurrent strains and pressures typical of free financial markets, the new system has failed the test of maintaining reasonable stability and fluidity,' Volcker said.

I feel the problem is not lack of regulation. The problem, I feel, is that the Fed itself is distorting the free market. Eliminate the Fed, eliminate fractional reserve lending, and eliminate borrowing money into existence and none of this would have happened, at least to any significant degree.