Re: (OPE-L) recent references on 'problem' of money commodity?

From: Rakesh Bhandari (bhandari@BERKELEY.EDU)
Date: Tue Nov 23 2004 - 01:36:24 EST

At 11:56 PM -0500 11/22/04, Allin Cottrell wrote:
>On Sun, 21 Nov 2004, Rakesh Bhandari wrote:
>>[W]hat determines the money put in circulation by the Fed or on
>>what basis does the Fed attempt to regulate the money in
>My take on the matter, as I have said, is that the Greenspan Fed is
>primarily concerned to stablize CPI inflation around a small
>positive rate, and to the extent they follow the prices of narrower
>baskets of commodities they are for the most part using these as
>putative advance indicators of general inflation/deflation.
>You, on the other hand, claim that the Fed is trying to stabilize
>the price of a small basket of commodities in which gold features
>Let's look at the data.

Yes indeed.
1. The data reveal that the Fed's rate hikes often cannot be
explained by an attempt to stabilize CPI inflation at a small
positive rate. In fact there are times that rates should have been
reduced rather than raised if Greenspan were really aiming at the
price level rising at a small positive rate.  Analysis of specific
rate hikes seems to invalidate that Greenspan is actually attempting
to stabilize CPI inflation around a small positive rate. I am also
not clear why Greenspan would find such an aggregate measure
meaningful or important; one could have limited CPI inflation with
extreme inflation or deflation for an important set of commodities.

2. Raising rates can in fact engender the very spike in CPI inflation
that retroactively justifies the hike. I don't remember how it works,
but James Galbraith quotes Randall Wray about this effect in his book
on unequal pay Greenspan's policy may at times ensure CPI inflation
at a small positive rate; that however is not its goal but the effect
of rate hikes imposed for other reasons, e.g. gold targeting.. You
also leave open the question of whether the CPI is manipulated to
show the trend that you see, thereby justifying Greenspan's
surreptious modified gold standard policy as successful in
stabilizing  CPI inflation around a small positive rate.

3. I doubt that Greenspan uses spot prices (rather than long term
contract prices) for oil and wheat in his index, but these seem to be
the prices that you used, no? In fact I don't know what is in his
index or how the commodities are weighed. So I don't see what you
have tested. There is of course both transcript evidence for gold
targeting (Wray's reading of the Fed transcripts for the 1994
interest rate hikes) and some econometric evidence (as for its
validity I am unfortunately unable to judge-- is also the point that Baker who would later have Greenspan
appointed did propose the use of a commodity index in which gold
would be first among equals. I can see how such a policy would be
forced on the US by its international creditors as the US went from
greatest creditor to greatest debtor country.

All this said, I am very grateful that you have attempted to test
ideas against the data that we have.

I am interested in any evidence that throws light on what the
determinants of policy making at Greenspan's Fed have been.

Would you recommend a single work on this topic?

Yours, Rakesh

>We can define a "control error", et, equal
>to the gap, each period, between the price of a chosen commodity
>basket and the target price, which could either be a constant or a
>smooth trend.  If there were just one commodity at issue the gap
>would be
>et = a0 + a1 * t - Pt
>where Pt is the price of the given commodity in period t.  If the
>price were controlled perfectly, et would = 0 in all periods.
>If there are three commodities -- you mentioned gold, oil and wheat
>-- the counterpart equation is
>et = a0 + a1 * t - (b1 * Pgt + b2 * Pot + b3 * Pwt)
>where Pgt is the price of gold in period t, Pot is the oil price and
>Pwt is the wheat price.  The b's are the weights on these
>commodities in the basket.
>We can obtain estimates of the variance of the control error, on the
>assumption that the average error is 0, by inverting these equations
>and applying least squares.  That is, one estimates
>1 = -(a1/a0) * t + (b1/a0) * Pgt + (b2/a0) * Pot
>     + (b3/a0) * Pwt + et/a0
>The dependent variable is just a constant.  We can't get estimates
>of all the parameters, but we can find their relative magnitudes and
>can compare the relative variance of the control error across
>baskets.  (Just to explore the math, note that if there were a
>linear combination of Pg, Po and Pw that was actually constant over
>time, or followed an exact trend, the above regression would produce
>a perfect fit; and in general it will "choose" basket weights so as
>to minimize the sum of squared control errors.)
>I did the econometrics using the price of gold on the London market,
>the price of Saudi light crude, and the price of hard red winter
>wheat, annual average data for the years 1988 (when Greenspan became
>Fed Chairman) to 2003.  I converted all variables to indices with a
>base of 100 in 1988, and made the dependent variable equal 100.
>(Besides the linear trend I included the square of time for good
>The estimated variance of the control error for this 3-commodity
>basket was 91.23 (that is, this was the residual variance from the
>regression indicated above).  I then repeated the exercise using the
>CPI-U as the basket (again, scaled to a base of 100 in 1988 and
>using 100 as the dependent variable).  The control error variance
>was 1.06, smaller by a factor of 86 or so. If you prefer to look at
>the sum of squared errors, the respective figures were 1003.5
>(3-commodity basket) and 13.8 (CPI).
>My conclusion is that there is no linear combination of the prices
>of gold, oil and wheat that has been *anything like* as stable
>around a trend as the CPI, over the last 16 years.  If it is the
>price of such a basket that Greenspan has been trying to stabilize,
>then he has failed abjectly.  On the other hand, if he has been
>trying to stabilize CPI inflation then he has done a pretty good

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