Friday, May 10, 2019

Financial Inflation?

Torsten Slok sends this lovely picture of the S&P500 and the price index for portfolio management and investment advice services. Torsten explains that "50% of the decline in core PCE inflation since the peak in July has been driven by financial services, and with the stock market rebounding, we should expect to see the financial services component move higher again."

What's going on? I think it's this: Most portfolio management payments are a percent of value -- you pay a fee, say 1%, of the total value of the portfolio. When the stock market goes down 10%, you pay 10% less in fees. Now, the BEA's job is to figure out, did you get 10% less quantity -- did you get 10% less "valuable advice" for that fee? You're not an idiot, so you're paying 1% off the top of your wealth annually, a third of Senator Warren's dreaded wealth tax, for something of value, the BEA figures. Or did the "price" of financial services go down 10%? Evidently, the BEA assumes the price, not the quantity changed, so the "price" of financial services tracks the stock market.

This is of course nonsense. On the other hand, I have no better idea how to separate 1% management fees into a "price" or a "quantity" (or, heaven forbid, a "quality improvement"). The number of people working to provide you financial advice didn't change 10%. Though, in the long run, it will if the market stays down. How should, or does, the PCE handle rents, or dividend payments? I don't know.

I went back to the documentation for how the PCE is constructed to try to understand these questions and see if my hunch is correct, but I failed to understand anything in there. (I got lost in the "commodity flow method," see p. 5-27.) I would value comments from people who understand this stuff.

Overall, I think the lesson is that our measures of inflation are pretty noisy. First we throw out food and energy. Now it looks to me that "core" should throw out management-fee based financial services, or at least assume that the price is fixed (1% sounds like a fixed price) rather than the quantity. Do real estate and other commissions do the same thing and the price index rises and falls with the price of housing? What's next?

(The point of throwing out food and fuel is not that they don't matter but a feeling that the core CPI today is a better guide of where the overall CPI will be in the future. A more thorough analysis of which components are better forecasters of overall CPI would be welcome.)

Maybe an inflation measure that is less comprehensive but better measured isn't such a terrible idea. Maybe the Fed worrying about 1.8% vs. 2% inflation is not such a good idea.


  1. I've asked this before. In a more robust competitive economy, no Fed, no tariffs and 15% flat tax, would MV=PY? I assume savings will supply capital and investors will demand capital with the equilibrium price equal to the market interest rate.

  2. I have never understood why fuel and food should be disregarded. They say they are volatile. I think that makes them better indicators of inflationary pressures than the less volatile prices.

  3. The Reserve Bank of Australia has an inflation band target of 2% to 3%. Other central banks have bands or in the case of the People's Bank of China "about 3%."

    Of course, some economists prefer a central bank targeting of nominal GDP.

    OT: Ray Dalio is positing that long-term Treasuries will eventually hit 0% and that monetary policy, even amplified by QE, will become ineffective.

  4. Just one more reason to ignore inflation and focus on the nominal aggregate that actually matters---NGDP. It's NGDP instability that leads to labor market instability and debt market instability. It's NGDP growth rates that best measure the "welfare cost of inflation", not inflation itself (which has never even been clearly defined by the profession.) The higher the NGDP growth rate, the higher the tax on capital. And since the optimal tax on capital is zero, that's basically your "welfare cost of inflation".

    Great post on the sociology of MMT, by the way.

  5. Your hunch is correct. The Handbook of Methods of the BEA on PCE indicates that prices for Portfolio management and Investment advice are taken from PPI indices. And, according to the BLS (, "management fee is most often based on a percentage of assets under management".

  6. This is a great example of why the market monetarists have it right. Inflation is not a useful measure to guide macro policy. It is income stability (NGDP), not price level stability, that matters. I can't pay my mortgage with a stable price level.

  7. You're right that any measure of inflation has conceptual problems. But don't you think it's important that policy makers do their best? Giving up on inflation measures would seem to be a worse option. The PCE (core inflation, as I understand the term?) is less noisy than "headline inflation" and therefore more useful?

    I wonder whether you think these links are accurate

  8. That CORE PCE moves in tandem with the S&P 500 because there is noise in portfolio management fees measurement is something really weird. Let us say there is a large deviation between valuation and price of financial assets and in bullish market those discepancies will be reinforced in inflation uptrend. Tracing parallel with housing sector, inflation measurements takes into account the benefits imputed to the hosing service, not the pricce, through Owner Equivalent Rents (OER). The same logic should apply to financial assets. This statistical measurement noise is worrisome because creates significant differences between CORE PCE, which includes portfolio management fees, and CPI which does not include it.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.