The Federal Reserve, as well as the European Central Bank (ECB) and other central banks, seems bent to be guided in its monetary policy by the consumer price index (CPI). In an August 24 Wall Street Journal op-ed, economist Arthur Laffer used information from the Treasury and TIPS (Treasury Inflation-Protected Security) markets that suggests the Fed has been controlling CPI properly, and thus deserves high marks for managing monetary policy. However, judging the Fed’s, or any central bank’s, performance based on the CPI and bond “spreads” is a mistake.

In the last decade, during the same years that the CPI hovered in the 2 to 3 percent range, the U.S. dollar was volatile relative to currencies of countries where measured CPI also varied within the same low ranges as in the United States. The measure of the U.S. real effective exchange rate relative to the seven major currencies varied between roughly 80 in 1995, to 120 in 2001, and back to 90 in 2005. The dollar was up in the same 30 percent range relative to commodity prices between 1997 and 2001. Then, between 2002 and the end of 2004, it went down by about the same percentage relative to gold and commodities (gold prices varying in the $300 to $700 range, after years of hovering around $400). Since the beginning of 2005, all “hard” currencies (except the Canadian and Australian dollar) are down by another 15 percent relative to gold, which is now in the $600 range.

The significant upward move in the U.S. dollar during the late 1990s ushered in havoc — not just financial, but political and social, too. This happened in countries that either pegged their currencies to the U.S. dollar or had “currency boards” (Argentina’s case being the most prominent). The more recent

downward move in the U.S. dollar has initiated its own brand of havoc — such as antagonism in trade relationships around the world and cries for protectionism.

High marks for the Fed? I don’t think so.

The U.S. — and the world — would be better off if the Federal Reserve decided to cease paying undue attention to the CPI and pursued instead some forward-looking preventive care. But to see this we have to get back to some long-forgotten basics.

The CPI roughly estimates the out-of-pocket costs of short-term living. It does not measure changes in prices of assets, and “shelter” — the biggest single component in the CPI — is mismeasured. The Bureau of Labor Statistics, in Chapter 17 of its “Handbook of Methods,” states that “Owners are out of scope for the CPI housing sample.” This means, whereas rents enter into calculations based on market prices, that the calculation of owner “rental equivalence” is left to the BLS methodology of choosing the houses, and from there deducing a hypothetical level of rent imputed on homeowners. Such a figure must carry with it a degree of error, the magnitude of which would be difficult to compute. Here is why.

When people expect housing prices to rise, there is downward pressure on rents. The expected capital gains lower the immediate cash returns that owners demand. Renters also have stronger incentives to buy homes of their own, which implies that they must be offered lower rents to remain renters.  During the high inflation 1970s, it was taken for granted that many would take a (tax deductible) cash loss on buying real estate and renting it out, expecting a tax-free capital gain down the line. Also, owners of rental units in general, instead of lowering rents, often offer better services, easier terms on security deposits, and so forth. How the BLS takes any of this into account — if at all — is unknown.

Let’s return to questions at hand: Did people over the last decade move into real estate and other currencies because of expectations of inflation and devaluation? Did the derivative markets — and the financial sector — expand, attracting top brains in mathematics because of the resulting volatility? Did political upheaval around the world have anything to do with the U.S. Federal Reserve’s mismanagement of the dollar? 

The volatile dollar and housing markets suggest that the answer to each question is “Yes.” The mismanaged dollar also has brought on a severe misallocation of resources both in the U.S. and abroad, the latter leading to unexpected political impacts on the United States.

Yet the CPI does not give the slightest indication that the U.S. dollar has been mismanaged.

Based on the CPI, one could indeed give good grades to the Fed. However, based on the dollar’s volatility, the expansion of the housing and derivative markets, and political upheaval abroad, one could form a different opinion. Such mismanagement does not show up in the CPI, nor does it appear in inflationary expectations derived from the Treasury and TIPS markets, since the difference in the returns between the two types of bonds only estimates, roughly, changes in measured short-term out-of-pocket expenses.

The housing component of the CPI can lead to grave mistakes in carrying out monetary policy. But so can other components of the CPI that a central bank, if it were simply to watch the CPI, would not figure in. Consider the following sequence of events: A government increases the sales tax; the “out-of-pocket” costs of many items increase; the measured CPI rises. So, should a central bank in this scenario pursue a restrictive monetary policy? No. And yet over the years many central governments around the world have done just that (Canada and New Zealand in the early 1990s, for example). The consequences were higher interest rates, increased short-term capital flows, and a rise in the local currency — leading the respective central banks to correct their mistakes after years of imposing significant damage.

Briefly, the U.S. Federal Reserve should manage monetary policy by first distinguishing between “things” (changes in global demand and the supply of a currency’s liquidity) and the “noises” (serious resource misallocation) these “things” are making. The CPI does not capture the latter at all. The only “thing” that is under the control of the Fed is the supply of liquidity.  When global demand for the dollar changes — be it because of geopolitical or domestic reasons — the Fed has to know what alarm signals to look at (gold and commodity prices among them), so as to prevent the emergence of long-lasting, harmful “noises.”

The Fed should manage the dollar, the world’s main reserve currency, sustaining it as a monetary standard, rather than reacting to and targeting mismeasured short-term domestic living costs.

– Reuven Brenner holds the Repap chair at Desautels’ Faculty of Management, and is partner in Match Strategic Partners. The above draws on his last book, Force of Finance

(2002).