What is inflation?

Inflation is generally a function of demand. Prices rise when supply is constrained. It can happen from both monetary and non-monetary factors.

  • One example of inflation is a rise in energy prices due to supply constraints of oil; it doesn’t matter if it is the result of a hurricane taking out every oil rig and refinery in the Gulf of Mexico or if the Arab states decide to cut production, the result is the same – higher prices if demand doesn’t come down to match or if more production isn’t brought online somewhere else.
  • Another example of inflation is price increases from supply constraints for food due to drought.
  • My last example of inflation is a monetary explanation where the Fed repeatedly expands the money supply faster than the demand for money is rising and there is no additional production capacity; there is more general demand than there is production capacity, resulting in a general rise in prices.

When inflation is a responsibility of the Federal Reserve

  • Inflation is a concern when it is of the monetary variety, a general rise in prices due to ongoing and repeated expansion of money beyond the demand for money.

When inflation is not the responsibility of the Federal Reserve

  • Inflation is not the responsibility of the Federal Reserve when there are issues such as a hurricane in the Gulf of Mexico affecting the supply of oil products or a severe drought that results in supply constraint of food. It is economically damaging when the Federal Reserve reacts to price increases resulting from supply constraints (such as it is doing now with a firm 2% target on top of general supply constraints from recession).

When we need to tolerate a higher rate of inflation and what it means

  • During a severe recession, supply capacity is temporarily reduced to match lower demand. As we start to recover and as people start getting back to work, general demand will increase on top of pared back supply. Prices will temporarily increase but it will be soaked up as capacity is brought back on line and we get back toward price competitive markets again.

What we should not do about inflation

  • We shouldn’t be so afraid of inflation it makes us crazy and we insist on non-recovery from a recession by capping price growth at the Federal Reserve leaving millions unemployed or under employed and unnecessarily damaging our financial markets. Price growth is a necessary side effect of recovery due to recovery of demand, but is only temporary.

We can’t get economic recovery without some temporarily higher inflation no matter what

  • We cannot recover without being willing to accept temporarily higher inflation because it is a side effect of recovery itself, with or without monetary stimulus.
  • It does not matter what we do on the supply side under the current monetary policy imposition of a 2% cap on core PCE because the cap results in a rearrangement of productivity from one area of the economy to another rather than an overall expansion of production capacity.
  •  We cannot centrally plan our way to recovery. It amazes me that most people who are terrified of inflation are more willing to try that route, forgoing income increases as more and more people enter social programs as a matter of survival. They also hate the ballooning, enormous cost of social programs. Would they rather allow mass starvation as a result of their preference to not recover economically?

My preference is to get people back to work so they can take care of themselves instead of being dependent on government because there are no jobs due to suffocation of demand with the 2% PCE target. The Fed needs to stop obsessing about inflation and allow recovery to take place. Even if it does not wish to employ monetary stimulus, it needs to back off of the explicit 2% PCE target and allow natural adjustment without further unnecessary market instability.

[Update 1/4/2014]

Flaws in basic assumptions – Inflation nutters and lack of context

Money is subject to the principle of supply and demand. To assume that QE, expanding the base, or “printing money” relative to money in existence will cause an issue with monetary inflation one must also assume that supply and demand for money is in a state of equilibrium when the base expansion occurs.

This can be explained by the identity MV=PY (Money * Velocity = Price level * Income/GDP)

If velocity is constant, an increase in M means an increase in the price level and income/GDP. But if velocity is not constant and is decreased, then the P and Y are also decreased if M remains constant; and an increase in M is required to maintain the price level and income/GDP.

But suppose there is a central bank that has an inflation target of 2% (P increases by 2% each year) and velocity decreases. According to the above identity, QE or other form of easing would be required in order to maintain even the status quo of P and Y. The inflation target would be undershot by likely a large degree if easing did not occur. Then, the price level (and expected future price level) would fall; and sticky wage theory predicts that when the price level falls, unemployment will become elevated.

This is a simplistic explanation, of course. But it is effective in explaining why those predicting runaway inflation and the crash of the dollar due to QE are wrong. They are wrong because velocity is not constant and has been decreasing by a large degree not only in the US, but globally.

[Update some time in 2012]

I don’t like to talk about “inflation” because it lumps various disparate causes of price increases into one term that has been used, abused, and stretched in all manners of ways that makes it more of a political buzz word than anything relating to reality. I do so here because it is what the debate has been framed with and I have been confronted with so many idiotic statements about inflation that I wanted to do my part in bringing some rationality to the debate.

In addition, I have my own suspicions that inflation fear has been generated from various groups including  the Federal Reserve that need a stirring of the political pot to cover up the intent behind certain policy actions for which I can find no other explanation than creating a central planning paradise – and it went very wrong. Folks like internet Austrians have been unwitting accomplices in the coverup – as the 2% PCE target with no make-ups for undershooting creates a similar environment to the gold peg, which is to say that stimulating one sector of the economy displaces activity in another or many others, instead of leaving them to free market forces. The IOR policy drained the shadow banking system of liquidity at the peak of the financial crisis – the place where regulatory actions were least impactful, seemingly when an approach creating an opposite effect would be called for, at least from a legal point of view. We have no free market investing dealers left, with the exception of select few on the Fed preferred lackey list. The Fed now controls everything and appears to be focused like a laser beam on housing, needing to displace other market investments to free up the resources to make what it wants happen. It’s the Bundesbank can of financial tyranny, the central bank overstepping its mandates in order to carry out supply side policy opened up by Ben Bernanke here in the US.

Everyone is so focused on and terrified of inflation, they barely notice that the Orwellian central planning nightmare has happened right under their noses.