TICC

Tomorrow sees the release of US nonfarm payrolls, financial markets' monthly paean to the fetishization of statistical noise around a slow-moving signal.  Although Macro Man has not dug terribly deeply into this, on the surface there would appear to be some downside risk to the number, given the appalling weather that the country has "enjoyed" for the last six weeks.  Heck, even the diligent professionals of the Chicago construction industry have fallen behind in their renovation of Wrigley Field because of the weather.

Generally speaking, however, the labor market has improved so substantially that it would normally merit a tightening of policy.   Indeed, the degree of improvement is starkly illustrated by the scatter plot below, which shows unemployment and the corresponding Fed funds rate.  Other than the current ZIRP, the next-lowest level of Fed funds with unemployment at these levels was 0.8%, in the mid-1950's.

Of course central banks, particularly those with dual mandates, do not make policy for unemployment alone.  Inflation is obviously a clear determinant of Fed policy and preferences, especially given that it has remained persistently low in the aftermath of the crisis.  Now, Macro Man has opined on this topic on a number of occasions, but hopes readers will excuse him if he addresses it once again.

As you know, the Fed has chosen a reference target of 2% for the PCE price index, excluding food and energy, for inflation.  This is all well and good, except that the target looks unattainable- and not just because of the lingering impact of the crisis.   If we take a 5 year moving average of the core PCE deflator to smooth out noise, we should get a decent idea of what trend levels of inflation (as defined by the Fed) look like.  And what we find is that with the exception of mid-2008 to mid-2009 (oh, the irony!), the long-run average for the deflator has been well below 2% for nearly 20 years. 

(It is at his juncture that the uncharitable reader might choose to regard the Fed's long-term forecast for 2% inflation as the triumph of hope over expectation.)

Now, as your author observed a few months ago, a primary culprit for this shortfall in inflation has been the secular decline in the durable goods deflator.   Simply put, the price of manufactured durable goods started going down 20 years ago and has kept doing so, regardless of financial conditions, the economic cycle, sunspots, or any other variable that you might choose to measure.  For your convenience, the chart of the deflator index is reproduced below.

Unsurprisingly, Macro Man has not changed his view that there is nothing that the Federal Reserve (or any other central bank, really) can do to offset the secular decline in durable goods prices, nor should they try- the forces driving these declines are well beyond the sphere of monetary policy.  Attempting to do so, on the other hand, will impact the price of things that are responsive to central bank policy, such as many of the securities, futures, and exchange rates flickering on your screens.

Recently, it occurred to Macro Man that it might be interesting to craft an alternative measure of consumer inflation, something that Janet Yellen might think of as 'TICC' inflation, e.g. 'things I can control.'  Such a measure would not only strip out food and energy, the prices of which are driven by idiosyncratic factors that do not necessarily respond to monetary policy, but also of durable goods, which don't either.

To calculate this 'TICC' inflation measure, Macro Man calculated traditional core PCE inflation and that for durable goods.   Using the monthly weight of durable goods in total core PCE expenditures, he was then able to back out a figure for core PCE inflation, ex-durables.  Given that the weighting to durable goods in the overall basket is fairly modest  (12% currently, down from 15% a couple of decades ago, though these were nominal rather than real figures), the overall impact to the 'controllable' inflation measure is evolutionary, not revolutionary.  Nevertheless, the results are interesting, and set out below.

It is interesting to note that the average 'TICC' inflation rate since the announcement of QE2 has been 1.92%- more or less bang on the Fed's ostensible target, though the current rate is very slightly lower.  If you believe that the shape of the line matters more than the level, then you can still ascribe a level of deflationary concern to the Fed, insofar as both measures (core and TICC) are not hugely off of their post-crisis lows.

On the other hand, if you believe the level does matter, well then there is more breathing space for the Fed between the price of things that they can influence and deflation.   By the same token, this measure would have picked up that monetary conditions were too easy in the middle of the last decade in a way that core PCE did not.

Naturally, none of this is to suggest that the Fed will take this type of analysis into account.   One could argue, furthermore, that the fallout from the secular decline in durable goods prices (lower wages in the manufacturing and related sectors, for example) is something that the Fed should try to counteract with monetary policy, futile though it may be.

Nevertheless, as the debate about lift-off intensifies over the coming weeks and months, some observers will no doubt wring their hands about the low level of inflation and claim that the Fed couldn't possibly raise rates with core PCE so low, or the economy will tip into deflation.   Macro Man at least plans to keep tracking this TICC inflation so that he'll have an idea of how low it really is in things that the Fed can actually control.