President’s Corner – FOMC, Inflation, and the GDP

My younger nephews, ages 11 and 10, are prime consumers. It did not used to be that way. In the olden days of the late 1960s when I was that age, the actual consumer parents analyzed the cost of kids’ toys and clothes and purchased items based on that analysis, which consisted of driving to the mall or department store and comparing prices.

Today, the kids perform that analysis themselves with the click of a mouse. The main difference is that kids are completely price inelastic. That means that no matter how much the price of an item changes, kids will still want it; in economic terms, demand remains constant.

This sea change is important because of the challenges facing the Federal Open Market Committee (FOMC). This austere group is comprised of members of the Board of Governors of the Federal Reserve System and a rotating group of the eleven Reserve Bank presidents who serve one-year terms. The FOMC reviews economic and financial conditions, determines monetary policy, and assesses the risks of price stability and sustainable economic growth.

The FOMC is currently debating how fast to increase interest rates (In reality, the committee only determines the federal funds, or overnight rate, while the longer-term rates are determined by the marketplace.) The committee’s current stance is to increase the overnight rate when the inflation rate exceeds 2%. Through October, the average inflation rate this year checks in at 2.1%.

Sounds good, right? Here’s the dilemma. In the ten years following the Great Recession, the average inflation rate is 1.7%. During that same period, the Gross Domestic Product (GDP), which calculates our economy’s growth by measuring the value of all goods and services produced, only grew 1.4%. Typically, GDP grows at approximately 4% per year. Today’s ratios would be considered anemic by historical standards.

The media breaks up the various pieces of the economy into small discrete bites and ignores the relationship between inflation, GDP, the money supply, demand, production, and supply. One of the biggest political issues being debated in the blogosphere (that’s for people who spend their entire day on the Internet) is wage disparity. What is not discussed is the interrelationship between wages, GDP, and inflation. It has been proven over time that an increase in wages results in more consumer spending, which in turn increases production that increases inflation and hence interest rates. Tax policy, which is currently but which always seems to be a hot topic, may affect on whether employers will increase salaries but does not alter spending behavior at the individual taxpayer level.

This year marks the tenth anniversary of the passing of my beginning economics professor during my freshman year in college. He was an economist as well as the dean of the Graduate School of Education and was the founding president of an economic think tank. He was very influential in my thinking about the relationships between the many economic pieces. The professor also taught me a lesson on high finance for college students. In those days, students were able to sell their used books back to the student bookstore at the end of the term. Unfortunately, he elected not to teach the class again, and I was stuck with an expensive used Economics textbook. I do not recall Milton Friedman, John Maynard Keynes, or even Adam Smith addressing the economics of college textbook buybacks. Oh well, live and learn.

David M. Green
(925) 335-3802