Doing the math: what the FEDs 2% inflation goal and CPI fudging means for purchasing power

[swissaustrian]

I've had a long discussion with a Keynesian about the issue of money lately. He maintained that the 2% annual inflation goal of the FED (and many other central banks) would ensure "price stability". I told him that he doesn't understand simple math and that 2% annual inflation annihilated the savings function of money. So I went on to calculate a few examples for him. (I'll get into the phony statistical tricks behind CPI calculations later)

- Assuming the FED is successful in maintaining 2% annual inflation for 10 years ("over the medium term" as central bankers say"), it doesn't mean we have 20% inflation in 10 years, it means 21.9% (1.02^10 = 1.02*1.02*1.02... and so on) . Over twenty years we already get 48.6% (not 40%), over thirty 81.1% (not 60%). This means that our glorious money loses 4/5 of it's purchasing power every generation. If the FED just got the inflation targeting wrong by 0.1% over the same timeframes we'd get 23.1% (10y) / 51.5% (20y) / 86.5% (30y). As you can see, even very small changes make a significant difference.

- That brings the CPI into the game. It's basicly an open secret that the CPI is beeing massaged. First of all, it is against the fundamental principle of statistics to change the composition and calculation of an index basicly every year. That destroys any comparative value of annual data. Second of all, setting an index back to 100 every few years is just as deceptive as 2% inflation in the first year is less then 2% in the tenth year (see above). We all know the reasons why governments are doing this: economic indicators like GDP look better and CPI linked goverment payouts (like SS) don't have to be increased as much. Additionally, cold progression on income taxes doesn't look as cruel. Now let's assume that John Williams' (shadowstats) calculation of the CPI is more accurate than the official one.
For simplicity purposes, let's assume that real annual inflation was 5% instead of 2%. According to Mr Williams it was actually even higher than 5%:



Comparison 2% vs 5% over 10/20/30 years:
10y: 21.9% vs 62.9%
20y: 48.6% vs 265.3%
30y: 81.1% vs 432.2%

Q.E.D.

[ababba]

I've had a long discussion with a Keynesian about the issue of money lately. He maintained that the 2% annual inflation goal of the FED (and many other central banks) would ensure "price stability". I told him that he doesn't understand simple math and that 2% annual inflation annihilated the savings function of money. So I went on to calculate a few examples for him. (I'll get into the phony statistical tricks behind CPI calculations later)

- Assuming the FED is successful in maintaining 2% annual inflation for 10 years ("over the medium term" as central bankers say"), it doesn't mean we have 20% inflation in 10 years, it means 21.9% (1.02^10 = 1.02*1.02*1.02... and so on) . Over twenty years we already get 48.6% (not 40%), over thirty 81.1% (not 60%). This means that our glorious money loses 4/5 of it's purchasing power every generation. If the FED just got the inflation targeting wrong by 0.1% over the same timeframes we'd get 23.1% (10y) / 51.5% (20y) / 86.5% (30y). As you can see, even very small changes make a significant difference.

- That brings the CPI into the game. It's basicly an open secret that the CPI is beeing massaged. First of all, it is against the fundamental principle of statistics to change the composition and calculation of an index basicly every year. That destroys any comparative value of annual data. Second of all, setting an index back to 100 every few years is just as deceptive as 2% inflation in the first year is less then 2% in the tenth year (see above). We all know the reasons why governments are doing this: economic indicators like GDP look better and CPI linked goverment payouts (like SS) don't have to be increased as much. Additionally, cold progression on income taxes doesn't look as cruel. Now let's assume that John Williams' (shadowstats) calculation of the CPI is more accurate than the official one.
For simplicity purposes, let's assume that real annual inflation was 5% instead of 2%. According to Mr Williams it was actually even higher than 5%:



Comparison 2% vs 5% over 10/20/30 years:
10y: 21.9% vs 62.9%
20y: 48.6% vs 265.3%
30y: 81.1% vs 432.2%

Q.E.D.

I have an income of 10 dollars in year one. I buy five apples and five oranges in year 1, each of which cost one dollar. In year 2, the price of apples increases to 2 dollars and I decide to buy 10 oranges with my 10 dollars. What is the rate of decrease in my standard of living? Shadowstats says its a 50% inflation rate but that is mind blowing idiocy. Not so Q.E.D. after all.

If the cost of a computer in 10 years goes from 1000 to 1500, but the quality of the computer doubles or triples, then there very well may be deflation in the cost of computers, while shadowstats would claim major inflation. Not so Q.E.D. again.

And of course, surprise surprise, new goods get introduced. Good luck using the same basket from 1950 to measure the cost of living in 2012. People purchase dramatically different baskets of goods in the two years. You have to change the basket over time. Not so Q.E.D. again.

And wait, oh shoot, holding money itself is stupid because you can hold bonds, which, in the long run, outpace the rate of inflation and deliver a real return. Not so Q.E.D. one more time. You might want to think harder about this one.

[Steven Douglas]

And wait, oh shoot, holding money itself is stupid because you can hold bonds, which, in the long run, outpace the rate of inflation and deliver a real return.

Yep, as long there remains any CONfidence in public debt and promise of a greater returns of Fed's dollars promised by issuers, the bond market is As Good As Gold, right? Which makes bonds a Forever Sure Thing, of course, because, well, perish the thought that the bond market, let alone the currency it promises (the "real" return), could ever collapse. Otherwise, we might want to think harder about this one.

[ababba]

Yep, as long there remains any CONfidence in public debt and promise of a greater returns of Fed's dollars promised by issuers, the bond market is As Good As Gold, right? Which makes bonds a Forever Sure Thing, of course, because, well, perish the thought that the bond market, let alone the currency it promises (the "real" return), could ever collapse. Otherwise, we might want to think harder about this one.

Bonds, or TIPS or stock, or gold or silver or whatever the hell you believe you can hold that will maintain real purchasing power. Cash is stupid next to all of them.

The point is you shouldn't pick the thing least likely to maintain purchasing power as something to hold up as an example of what loses purchasing power.

Nice job dodging all of the other points though, congrats.

[Acala]

The point is you shouldn't pick the thing least likely to maintain purchasing power as something to hold up as an example of what loses purchasing power.

Lol. The op is about inflation and the CPI. By definition we are talking about the supply of, and exchange value of, dollars.

[ababba]

Lol. The op is about inflation and the CPI. By definition we are talking about the supply of, and exchange value of, dollars.

Well I could care less if the dollar maintained purchasing power if nobody holds a lot of dollars or everyone has access to a savings vehicle that has real returns in some way. Its completely irrelevant from a practical perspective. The purchasing power of the dollars is relevant if there are people that hold a substantial amount of assets in dollar bills they hide under a mattress. That's just not true. Most people don't hold mountains of cash. The few people that do are either outside of the United States or drug dealers and gamblers.

[seraphson]

Please correct me if I'm wrong but isn't constant 2% year over year inflation a compounding interest? Will you not inevitably hit the tipping point of a hockey stick formation which will then shortly (relatively speaking) lead to the demise of such a "one-way" system?

[Steven Douglas]

Bonds, or TIPS or stock, or gold or silver or whatever the hell you believe you can hold that will maintain real purchasing power. Cash is stupid next to all of them.

Yeah? So Google, Microsoft, Apple, et all are stupid for hoarding all that cash, keeping their cash balances flush like there was no tomorrow?



Your presumption revolves around maintaining "purchasing power", with a focus on status quo investment return values, ceteris paribus. Because of legal tender laws, cash (FRN's) is ultimately the only thing with any real purchasing power, regardless of its evaporating exchange value, because you have to actually liquidate whatever else you have (bonds, TIPS, stock, gold, silver, etc.,) to get some of those green stamps before you can efficiently make any actual purchases.

Nice job dodging all of the other points though, congrats.

I didn't dodge them, I just didn't take issue with them. Then. I saw your "What is the rate of decrease in my standard of living?", as if that was any kind of valid metric, and rolled my eyes and left it alone. Why can't anyone expect an INCREASE in their standard of living (as people once did?). In a growing economy, a sound currency will gain in value, with a resulting INCREASE--not decrease, not just maintenance--in the standard of living. But somehow a lack of a decrease in the rate of one's standard of living means (assuming we accepted that was even a fact for everyone) means that somehow everything's A-OK. It's not. People are getting ripped off by a monetary policy that actively and deliberately punishes and erodes the value of savings, as it invisibly siphons wealth from all currency holders (irrespective of QE), which deliberately prevents an INCREASE in standards of living that would otherwise have been in place for anyone who followed the now-artificially-defunct mantra of "Work hard and save your money".

[ababba]

I didn't dodge them, I just didn't take issue with them. Then. I saw your "What is the rate of decrease in my standard of living?", as if that was any kind of valid metric, and rolled my eyes and left it alone. Why can't anyone expect an INCREASE in their standard of living (as people once did?). In a growing economy, a sound currency will gain in value, with a resulting INCREASE--not decrease, not just maintenance--in the standard of living. But somehow a lack of a decrease in the rate of one's standard of living means (assuming we accepted that was even a fact for everyone) means that somehow everything's A-OK. It's not. People are getting ripped off by a monetary policy that actively and deliberately punishes and erodes the value of savings, as it invisibly siphons wealth from all currency holders (irrespective of QE), which deliberately prevents an INCREASE in standards of living that would otherwise have been in place for anyone who followed the now-artificially-defunct mantra of "Work hard and save your money".

This is a methodological point. Its about the science of measuring inflation. Your post is completely orthogonal to that.

Obviously the purchasing power of money can either decrease, increase or stay the same over time depending on a number of factors. My point that you were responding to is about the proper measurement of the purchasing power of money. I don't really care about the morality of the purchasing power of money.

Obviously the value of a dollar will eventually be worthless. I think its important to state both that this doesn't matter that much and that we should correctly measure the rate of decrease in its value and not just make up shit and repeat it over and over.

Companies hold cash partially because inflation is actually very close to zero right now and the cost isn't large. They won't hold the cash indefinitely, they are just waiting for good investment opportunities. In addition, cash probably doesn't even mean dollar bills, its most likely short term debt instruments that pay interest. In the investment community, a money market fund is often referred to as "cash", but it makes a huge difference for this conversation. They also probably didn't hold as much cash when inflation was in the double digits in the 70s.

[Steven Douglas]

Please correct me if I'm wrong but isn't constant 2% year over year inflation a compounding interest? Will you not inevitably hit the tipping point of a hockey stick formation which will then shortly (relatively speaking) lead to the demise of such a "one-way" system?

Absolutely, irrespective of any compounding function during any one time period. It is exponential because the percentage of increase from one time period to the next includes everything that was added in during the previous time periods. The moment anyone says "n% per-given-time-period", it is exponential by definition, with its own doubling rate and a corresponding "hockey stick" curve as a mathematical certainty, and a guaranteed "tipping point" (or decoupling point), as the finite physical realities eventually can no longer keep pace with an infinite expansion that is made possible only by (and within the vacuum of) mathematical constructs.

Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist. Kenneth E. Boulding