Just What Is Inflation? Is A Monster Just Around The Corner?

A casual reader/listener of many economics blogs, news stories, cable shows, and political speeches (in other words, the usual sources), would be forgiven for thinking that “inflation” is some awful comic-book super-villain that constantly threatens society.  It’s as if they think that any momentary lapse in vigilance that allows perhaps a declining unemployment rate will bring the villain back to life.  And worse, if we aren’t careful, they warn, the Inflation will morph dramatically into Hyperinflation, kind of like making the Incredible Hulk angry.  So even though the economy is struggling with millions of unemployed and underemployed people, we seem obsessed with the fight against Inflation.  Nevermind that inflation doesn’t harm us as much as unemployment, it’s what the powers-that-be fear now.  And recently as food prices rose during the winter and gas prices have recently risen back to the $4.00 per gallon range, we’re being told it’s coming!  Inflation.  Now before we hide the women, children and checkbook in fear, let’s stop and think about it.  Let’s start with Just what is inflation?

Inflation Is Not Just Price Increases

Many people assume that inflation is rising prices. It’s not. Rising prices are one of several signs that the economy might be experiencing inflation, but the fact that some prices go up is not inflation.  Inflation is a continuing, ongoing rise in all prices in the economy.  If you think of it this way, phrases that we read/hear like “food price inflation” or “gas price inflation” are just absurd, nonsense phrases that don’t mean anything.  It’s like saying “specific generality” or describing something as being “uniquely universal”.  If the price of only one group of specific commodities or goods are going up, then it’s not inflation. If the prices of all goods and commodities are going up, then it’s inflation.  So the fact that gas prices are going up or that food prices might have gone up means that buyers of those goods, which is most folks, are having to adjust their spending.  Those items are getting more expensive relative to other items.  In micro-economic terms, they are getting scarcer relative to the demand for them.  That’s an uncomfortable place to be if you need those products.  If you can’t cut back your consumption, if means you experience a real decline in your living standard. But it doesn’t mean the economy is experiencing inflation.  You cannot look at the price of one or two specific types of goods and conclude that inflation exists.  Period. You have to look at all prices across the economy. You have see that prices are rising for nearly everything that gets purchased.

This inflation-means-rising-prices-across-the-entire-economy aspect means we have to look at a very large number of goods prices, not just gas or food or gold.  But it also means more than goods prices going up.  All prices must be rising.  That means wages (price of labor), prices of financial assets, and prices of non-financial assets (things like real estate, collectibles, etc).  When we consider these other prices, we see that despite what we’re paying at the local Exxon station, inflation is conspicuously absent.  Wages are not increasing.  According to Data360, reporting government BLS data, the average hourly wage for good producing workers rose from $20.55 to $20.59 in first quarter 2011. That’s less than 0.2%.  On an annualized basis, it’s less than 0.8%.  No inflation in there.  Service-producing workers are worse off. The average wage is falling from $19.05 to $19.02.  Their wages actually declined!   Overall, no inflation in wages.

But what about non-financial asset prices?  Well the latest data on home prices also shows declining prices, not increases.  CalculatedRisk Blog reports on the March Case-Shiller house price index and reports a declines in recent months. No inflation in non-financial assets.

What about other goods, though? What about non-food, and non-gas price goods?  We can look at either the Consumer Price Index, the official government source, or we can look at MIT’s Billion Price Project index which tries to track a billion different prices and price changes in real-time.  It’s still a sub-set of “all goods”, but surely it’s a reasonable cross-section.  Paul Krugman reported on these indices on March 28, 2011 in his NYTimes blog.  This the graph he used:

Notice the scale.  Prices of a wide selection of goods are rising at a less than 1% rate.  That’s not really inflation folks. So despite the prices in the groceries (which may be easing in coming months – they’re driven by weather issues) and the price at the pump, inflation is not a problem.

But there’s another aspect to our definition of inflation that’s very important.  That’s the use of the word continuous or continuing rises in prices.  If prices go up once or go up for a couple months and then stop rising, it’s not really inflation.  Inflation is when all the price rises begin to feed off of each other.  Most goods go up in price, so workers demand and get a rise in wages.  The wages go up and firm owners want their profits to go up too, so they raise the goods prices, driving even more demands for wage increases.  A spiral develops.  It’s called a wage-price spiral.  Everybody begins to expect inflation, rising prices and wages and so they start basing plans on assumptions of future rising prices, further increasing their present demands.  That’s how inflation works.  That’s what happened in the U.S. and many developed countries in the period of the late 1960’s through the early 1980’s.  It is not happening now.

A major reason why it can’t happen now is that workers don’t have any bargaining power to make demands for wage increases.  Union membership is very, very low by historical standards.  When unemployment is at 9% and has been for nearly 3 years, there’s no bargaining power for workers.

Yes, we are experiencing higher gas prices today. Gas prices may well continue to rise for months yet.  We have also experienced some higher prices for food, although the future trend is not clear.  Yes, gas prices are a component of many other product prices since transportation is critical to any physical product.  But what we are not experiencing is inflation. We are experiencing, in econ-talk, rising relative prices for gas, oil, and food.  To the extent that these goods are essential and we must continue to buy the same quantities of them, it means something else must give. Our standard of living will decline. But it’s not inflation.  We could call it workers-get-screwed-againism, but it’s not inflation.

Why does it matter what we call it?  It matters because the usual sources want to call it inflation so they have a political cover to do things they otherwise couldn’t do.  They want to cut government budgets and spending.  Some of them (bankers and big investors) would actually benefit economically from mild deflation.  They can’t get a hearing that way, so they call it “inflation” and they raise up the threat of a monster.  But it’s only a comic-book fake monster. It’s not real. Not now.

CPI: Deflation Watch

The September Consumer Price Index numbers are out. Inflation is really a sustained general increase in the level of all prices.  Since the price index itself can be rather noisy, varying a lot from month-to-month, many economists use some different techniques to smooth out the trend to see what the “sustained” action really is.  Three of the most popular ways of smoothing out the noise are called core CPI, median CPI, and trimmed-mean CPI.  In all three cases, the signals they are sending are not encouraging for recovery.  We are not yet into true deflation territory where prices are actually falling instead of increasing, but we are very, very close.  Both deflation and high inflation are undesirable.  But the risks are not symmetric.  Even very small amounts of deflation can be difficult to eliminate and can easily push an economy into a very prolonged period of stagnation or decline.  Inflation, on the other hand, can be more easily brought down if it gets too high.  Further, inflation at low levels, such as 2-4% isn’t very harmful at all.  In fact, a case can be made that 2-3% inflation is much more desirable than no inflation.

I like to think of managing inflation/deflation as driving down a desert road at the edge of cliff.  On the deflation side of the road is steep cliff with no guardrail.  On the inflation side of the road is a desert strewn with rocks.  Messing up and getting into inflation will get rocky and messy, but it’s manageable and survivable.  Erring on the side of deflation and things get real bad, real fast.   Best to leave a little margin of 2-3% inflation to make sure there’s no accidental plunge into real deflation.  For more than a year now, we’ve been playing daredevil with our economic futures by getting way too close to deflation.

Calculated Risk explains and offers one of their as-usual outstanding graphs:

…these three measures: core CPI, median CPI and trimmed-mean CPI, were all below 1% in September, and also under 1% for the last 12 months.

Inflation MeasuresClick on graph for larger image in new window.

This graph shows these three measure of inflation on a year-over-year basis.

They all show that inflation has been falling, and that measured inflation is up less than 1% year-over-year. Core CPI and median CPI were flat in September, and the 16% trimmed mean CPI was up 0.1%.

One last note about these numbers.  When The Fed increased it’s balance sheet dramatically two years ago to help bail out the banks and stabilize the financial system, the Austrians, Monetarists, gold bug types, and general austerians all complained that The Fed was leading us into a hyperinflation.  When the federal government budget blossomed into multi-trillion dollar deficit in early 2009, the same people warned us that it would lead to hyperinflation.  Now, 20-24 months later, we can conclude they were wrong. Their models are wrong and therefore the policy advice is wrong.  Deficits do not lead to hyperinflation when you have double-digit unemployment. Period.

Links on Modern Monetary Theory (MMT)

Hyperinflation is not just more inflation.  Additional conditions are needed to go from inflation to hyperinflation.  From New Deal 2.0′ s Rob Parenteau

The Hyperinflation Hyperventalists

<!– Friday, 03/19/2010 – 10:57 am by Rob Parenteau | 2 Comments –>Rob Parenteau explains why the the hyperinflationist deficit hawks need to take a deep breath.

After a two day blogging slugfest on fiscal deficits, I find that the question of hyperinflation now demands an answer.  And here it is: fiscal deficit spending may be a necessary condition of hyperinflation, but it is hardly a sufficient condition…..

Money is created by creating credit. Credit comes from nothing – banks make loans first. The loans create the deposits and reserves, not vice -versa.  From Washington’s blog and cross posted by Yves Smith at Naked Capitalism:

German Central Bank Admits that Credit is Created Out of Thin Air

Most people think that banks lend solely from their base of deposits. Some also know that with fractional reserve banking, they can loan out many times more than they actually have in reserves.

But very few people – with the exception of those in the banking industry and financial experts – know where credit really comes from.

Germany’s central bank – the Deutsche Bundesbank (German for German Federal Bank) – has admitted in writing that banks create credit out of thin air.

As the Bundesbank states in a publication entitled “Money and Monetary Policy” (pages 88-93; translation provided by Google translate, but German speaker and economic writer Festan von Geldern confirmed the basic translation):….

….more at:  http://www.bundesbank.de/download/bildung/geld_sec2/geld2_gesamt.pdf (in German)….

Do you get it now?

Private banks don’t make loans because they have extra deposits lying around. The process is the exact opposite:

(1) Each private bank “creates” loans out of thin air by entering into binding loan commitments with borrowers (of course, corresponding liabilities are created on their books at the same time. But see below); then

(2) If the bank doesn’t have the required level of reserves, it simply borrows them after the fact from the central bank (or from another bank);

(3) The central bank, in turn, creates the money which it lends to the private banks out of thin air.

It’s not just Bernanke … the central banks and their owners – the private commercial banks – have been running the printing presses for hundreds of years.

Of course, as I pointed out Tuesday, Bernanke is pushing to eliminate all reserve requirements in the U.S. If Bernanke has his way, American banks won’t even have to borrow from the Fed or other banks after the fact to have reserves. Instead, they can just enter into as many loans as they want and create endless money out of thin air (within Basel I and Basel II’s capital requirements – but since governments are backstopping their giant banks by overtly and covertly throwing bailout money, guarantees and various insider opportunities at them, capital requirements are somewhat meaningless).

The system is no longer based on assets (and remember that the giant banks have repeatedly become insolvent) It is based on creating new debts, and then backfilling from there.
It is – in fact – a monopoly system. Specifically, only private banks and their wholly-owned central banks can run printing presses. Governments and people do not have access to the printing presses (with some limited exceptions, like North Dakota), and thus have to pay the monopolists to run them (in the form of interest on the loans).

See this and this.

At the very least, the system must be changed so that it is not – by definition – perched atop a mountain of debt, and the monetary base must be maintained by an authority that is accountable to the people.