Federal Reserve’s Economic Theories Obsolete In Today’s Economy

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In the global economy, how can inflation that is largely commodity driven overheat in the rest of the world while the Federal Reserve doesn’t see enough inflation in the U.S.?

Perhaps Ben Bernanke and his cohorts on the Federal Open Market Committee need to get their eyes examined.

The Fed Chairman takes pride in being a scholar of the Great Depression. Bernanke believes the reason why the Great Depression was so deep and went on for so long was because the Fed tightened monetary policy too soon. So Bernanke thinks the fastest way to steer the economy out of the Great Recession is to do the opposite by keeping monetary policy as accommodative as possible for as long as possible.

The Fed views inflation through the lens of the Great Depression which has created tunnel vision as it has obscured the central bank’s ability to see that intellectual property is the primary economic driver of the U.S. economy today.

During the Great Depression, a greater portion of the products consumed were variable cost as the intellectual property content was small. Today it’s the exact opposite. The traditional methodology used to calculate inflation doesn’t take into account that certain sectors of the economy such as electronics and technology are permanently deflationary and therefore should be excluded from inflation measurements.* Yet the Fed treats technological innovation as something to be concerned about even though this “deflation” is considered business as usual in Silicon Valley!

This is why inflation should be measured only in sectors where commodities and labor are the primary cost drivers. Any industry with a gross margin under 25% would be most susceptible to inflation vs. industries with gross margins exceeding this.

True deflation only exists if a product is selling for less than its variable cost. For example, before higher gas prices revived the market in small cars, automakers were selling these vehicles for less than it cost to produce them.

In most situations where fixed costs are high relative to variable costs, monetary policy will have little immediate effect on employment. Employment in these businesses will only change as plants open, expand, or close - events which do not occur smoothly or quickly based upon Federal Reserve policies. They occur in fits and starts with little sensitivity to monetary policies in the short term.

Given the fungibility of money, the Fed’s excess liquidity will be driven to asset inflation rather than increasing employment in industries with low variable costs.

Instead of wasting time deciding whether to formalize an inflation target (when the Fed has been pretty blatant that it’s “informal” target is between 1.5% and 2%), the Fed should thoroughly analyze which industries to target and how employment is driven by liquidity in order to prevent excess asset inflation.

The Fed can exclude food and energy costs from its economic models, but consumers and businesses cannot. Companies loved the Fed’s cheap money but now that many of them are having trouble fully passing through the higher commodity costs, that cheap money is not looking so cheap after all.

In this interconnected global economy of the 21st century, outsourcing asset inflation to emerging markets creates a boomerang effect as labor and material costs rise in these economies which ultimately increases the costs of these products in the U.S. Once again the Fed is asleep at the wheel back in the previous century.

I don’t assume for one moment that the Fed does not realize all the points I have brought forth. I believe the Fed is simply constructing its measurements to justify the policy it is pursuing.

*Healthcare and drugs should fit the deflationary electronics/tech model with its high intellectual property, but does not because it is a rigged market in three respects:

1. The consumer cannot directly choose which medical products and services to buy as the doctor enforces a structure that forces the consumer to purchase a group of services rather than individual services.

2. The majority of consumers participate in structured purchases through health insurance, leaving cash paying customers at a disadvantage. Cash paying customers face a “take it or leave it” environment as they have no leverage.

3. Consumers have no choice but to buy medical services, therefore they cannot protest the rules of the game.

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