Why the FOMC’s new guidance weakens the Fed’s credibility

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Why Minneapolis Fed President Kocherlakota disagrees with the FOMC (Part 3 of 6)

(Continued from Part 2)

Kocherlakota’s dissent

The first reason Kocherlakota gave for his dissent to the policy statement relates to inflation. He pointed to the personal consumption expenditure (or PCE) inflation rate.

PCE inflation

The preferred measure of core inflation in the United States by the Federal Reserve is changes in the core PCE price index. The PCE inflation rate is a measure of price changes in consumer goods and services. Personal consumption expenditures consist of the actual and imputed expenditures of households—that is, expenditures pertaining to durables, non-durables, and services. This index is based on a dynamic consumption basket. Unlike the consumer price index (or CPI), which uses a fixed basket of goods with weightings that don’t change over time, the PCE uses a chain index, which takes into account consumers’ changing consumption patterns. The core PCE price index excludes the more volatile categories of food and energy prices.

The PCE food and energy component is composed of products like mineral waters, soft drinks, fuel oil, and gasoline. The Coca-Cola Company (KO), which is the world leader in carbonated soft drinks, and Exxon Mobil (XOM), a multinational oil and gas corporation, are examples of the companies whose products experience price volatility on account of several other factors besides inflation, so they’re excluded while calculating the core PCE.

Narayana Kocherlakota on PCE inflation rate

Kocherlakota points out that the PCE inflation rate has drifted downward over the past few years and is currently near 1%. The Federal Reserve’s target PCE inflation rate is 2% as per the statement of economic projections. The Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents are published right after the FOMC meeting, four times a year.

According to Kocherlakota, the new forward guidance set by the FOMC doesn’t mention any purposeful steps being taken to facilitate a more rapid increase of inflation back to the 2% target. The absence of this kind of communication weakens the credibility of the committee’s efforts to meet inflation targets. The guidance also seems to suggest that the persistently low inflation rate (below 2%) has become an acceptable outcome for the FOMC.

To negate the effect of inflation on their holdings, investors often invest in ETFs like the ProShares Investment Grade-Interest Rate Hedged ETF (IGHG), the Vanguard Short Term Corporate Debt ETF (VCSH), and the PowerShares Senior Loan Fund (BKLN), which are designed to protect investors against the interest rate risk caused by inflation.

To find out about why the Minneapolis Fed President thinks uncertainty about what would characterize maximum employment is a drag on economic activity, read on to the next part of this series.

Continue to Part 4

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