Two years
ago we
posted on the federal funds rate and demonstrated that the Federal Reserve has
been retaining an extremely simplistic approach when formulating its monetary
policy. Figure 1 depicts the cumulative values of effective rate, R, and the rate
of consumer price inflation, CPI, multiplied by 1.4. In the long run, these two
curves evolve along the same trend and intercept every fifteen to twenty years.
In December 2013, the cumulative R was approximately 20 points higher that the
cumulative 1.4CPI. With the currently low rate of inflation in consumer prices,
it will take another few years for the headline CPI to intercept the cumulative
R curve. This means that R will be very low in the years to come, likely
through 2020.

We presumed that the
main idea to keep R above the rate consumer price inflation is that a higher funds
rate should suppress price inflation due to the effect expensive money. On the
other hand, the FRB has likely to retain the interest rate at the long term
level of price inflation in order to create neutral conditions for money
supply. This would be a wise prerequisite for a central bank. Then why the FRB needs that factor of 1.4?
Actually it does not and the answer comes from the historical GDP data. The problem of the multiplier is in wrong
estimates of inflation since 1950. Essentially, the FRB, the BEA, and the BLS
all lie.

Figure 2 depicts the
evolution of real GDP per capita in the US since 1970. As we have already
mentioned in our posts, there are two trends in the historical GDP data –
before and after 1950. Before 1940, the (red) regression line with a slope of
~$61 per year in Figure 2 provides a good approximation of the actual curve.
After 1950, the actual curve evolves along a straight line with a slope of $387
per year, i.e. the slope rises by a factor of 6.34 after 1950. Real GDP is
defined as the ratio of nominal GDP and the GDP deflator. Both values are
measured and estimated (also using a subjective hedonic factor) by the BEA and
BLS. Therefore, the estimates of real GDP per capita heavily depend on the
definition of price inflation.

Let’s suppose that the
real GDP curve evolves along the old trend after 1940, as shown in Figure 2.
Then the level of real GDP per capita in 2008 would have been $10,774 instead
of $31,178 as estimated by. This means that the GDP deflator was underestimated
by a factor of 2.89 (=31178/10774). The
reported increase in the level of consumer prices since 1960 was of 7.27, i.e.
CPI(2008)/CPI(1960) =7.27. Then we
expect that the actual price increase (i.e. reported plus underestimated) would
have been 7.27+2.89=10.16, and the rate of CPI inflation was underestimated by
10.16/7.27=1.4 times.

This
is exactly the factor of the federal funds rate above the rate of price
inflation. Hence, the FRB retains the
interest rate at the level of actual inflation and thus does not influence inflation.
The BEA, BLS and FRB lie (intentionally or not) about the rate of inflation and
the growth in real GDP. The current level of GDP per capita in the US should be
around $11,000 not $31,000.

Figure 1. Cumulative
values of the monthly estimates of R and the CPI multiplied by a factor of 1.4.

Figure 2. Historical estimates of real
GDP per capita.

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