The Fed's definition of price stability is probably different than yours

REUTERS/Kevin LamarqueFederal Reserve Chair Janet YellenThe Federal Reserve Act, as mandated by Congress, established a dual mandate to guide the Federal Reserve (Fed) in setting monetary policy. Price stability, one of the mandates, benefits economic growth as it allows investors, corporations, and consumers the ability to better predict future prices and therefore allocate investments and spending in a more optimal manner.

To consider why price stability is beneficial, consider an oil producer deciding whether or not to invest in a new well. To simplify the analysis, assume the producer only needs to consider three variables to properly evaluate the project: (A) investment costs (fixed/variable), (B) a reliable estimation of the amount of oil, and (C) the future price of oil. The expected return equation dictates that profits must be greater than costs (B x C must be greater than A) to forecast a profit on the investment. The company has some control over investment costs and the surveying methods to determine the success of the well, but they have little if any control over the future price of oil. Therefore, the more stable and predictable the future price of oil, the more comfort the producer can have in making its decision about a new well.

As laid out in the above scenario, the Fed's price stability objective appears to be positive for the oil executives tasked to make the investment decision. At first glance who can argue that price stability is a bad thing? The problem though is not the objective itself, but how the Fed defines "price stability." Currently, the Fed believes that their objective to maintain "price stability" would be met if prices, as measured by the Core Personal Consumption Expenditures deflator (PCE- Fed's preferred inflation gauge), were to increase at a 2% rate per year.

Ask your spouse, family member or friend what price stability means and they will likely describe a relatively constant price for goods and services over time. Corporate executives and investors would likely answer similarly.

It is this juxtaposition between the Fed's definition of stability and the definition most people would use that is worth exploring. More specifically, how has the Fed sold us on the idea that inflation and stability are the same things? The example charts two series of annual rates of price change to help answer that question.

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Which is more stable, the blue or the green line? We venture to guess that you think the blue line is more stable.

The problem with that judgment is that it does not factor in price stability over any time horizon.

To maximize profits or quality of consumption, investors, corporations, and consumers are better served with predictability around what the effect of price changes will be over the long term. Given the long time frames associated with investments, capital expenditures and higher priced consumption, annual or even monthly variations in the rate of inflation hold little value. Longer term trends and the value of the dollar are what matter most.

The graph below, using the same data as the graph above, charts the purchasing power of a $100 over the 20 year period.

720Global

At a "stable" 2% rate of inflation (blue), the purchasing power of the dollar will be cut in half in 20 years. Said differently, the car you like priced at $35,000 today will cost $70,000 under a "stable price" regime in 20 years. Conversely, under the random scenario (green), with unpredictable year to year price changes, the purchasing power of the dollar remains largely intact for the entire period. We now ask again, which scenario is more stable? Which scenario would likely provide more value to our oil executives or anyone needing to know what a dollar can buy in the future?

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