The Everyday Economist

The conventional wisdom is that inflation always hits the poor the hardest. Writing over at VoxEU, Christian Broda of the University of Chicago disagrees and suggests that the larger inflation burden falls on the richest households:

Inflation differentials between the rich and poor dramatically change our view of the evolution of inequality in America. Inflation of the richest 10 percent of American households has been 6 percentage points higher than that of the poorest 10 percent over the period 1994 – 2005. This means that real inequality in America, if you measure it correctly, has been roughly unchanged. And the reason is just as dramatic as the result. Why has inflation for the poor been lower than that for the rich? In large part it is because of China and Wal-Mart!

Here is a non-gated link to his recent research paper on the topic.

Perhaps we should offer Ben Bernanke a do-over. On Wednesday the FOMC decided to hold interest rates steady despite the fact that global inflationary pressures are heating up. The statement released by the Fed hinted that they may raise rates in the future, but simultaneously talked of the weakening labor market and the perils of the credit markets. In doing so, the statement sent shivers down the spines of both those who are worried about inflation and those who are worried about rate hikes.

As an inflation hawk, I have been a bit careless with my recommendations to raise interest rates and I have not sufficiently answered those who are concerned with unemployment and the fragility of the economy. Thus, allow me to elaborate.

In a recent Bloomberg interview, Nobel laureate Ned Phelps wondered aloud whether or not the Fed understands anything about modern monetary policy. What Phelps was communicating is the fact that the Federal Reserve seems unable to distinguish between transitory changes in unemployment and those driven by structural changes in the economy. As Phelps rightly pointed out, the collapse of housing boom has created a restructuring within the economy. It is highly probable therefore that the natural rate of unemployment has risen. If so, any attempt by the Federal Reserve to combat rising unemployment with lower interest rates will prove to be futile. In light of such thinking, it is quite understandable that talk of rising unemployment in the FOMC statement was particularly troubling.

Worries about the credit markets are similarly overblown. So long as the Fed stands ready to serve as lender of last resort, a task they have admirably performed thus far, further crisis should remain averted even in the midst of higher interest rates.

Bernanke and the FOMC made a mistake by not raising interest rates on Wednesday (as indicated by the rising prices of gold, oil, and other commodities). The rise in unemployment is not temporary and therefore need not be of concern to the Fed. In the meantime, global inflation and inflationary expectations are on the rise. Let’s hope that the Fed doesn’t make the same mistake when August rolls around.

Those of us who have been hawkish on inflation have been lonely for several months now. However, recent data has suggested that the Federal Reserve may soon start raising rates again. Nevertheless, there are a group of individuals who believe that the inflation numbers are actually worse. Our friend Barry Ritholtz has been leading the charge claiming that BLS data is understating inflation and unemployment (some have referred to these claims as conspiracy theories). I think that Barry is correct to assert that inflation is worse than the numbers indicate, however, I do not think that the numbers are the problem.

The real problem is that our focus is always on the overall price level rather than relative prices. Commodity prices are on the rise, and will continue to be, so long as the world remains awash in liquidity and real interest rates remain low. The former stokes the demand fire and the latter provides a disincentive for discovery and investment. Looking at the overall price level, it seems as though inflation is quite modest all things considered (albeit above most economists comfort level). The reason that inflation seems so much worse than the numbers indicate is because the prices of things that most consumers consider necessities, like gasoline and food, are experiencing the most rapid increases. In an economy where homeowners were (are?) more leveraged than they have ever been, they are now seeing their wealth decline due to falling home prices while simultaneously experiencing an increase in the costs of food and gasoline.

The world has largely been awash in liquidity for the better part of this decade. Despite this increase in liquidity, price indices have largely been held down by the rapid productivity growth beginning at the end of the 1990s and continuing through the first half of this decade. These low levels of inflation, however, were providing incorrect signals to central banks and fears of deflation reinforced the easy money policies. The proverbial chickens, however, are now coming home to roost. Productivity has begun to slow and can no longer be counted on to hold down prices.

What can the Fed do?

The best solution that the Fed can provide is to begin raising the Federal funds rate. Aggressively raising rates should start to reign in liquidity and lower inflation expectations. Higher real interest rates should provide the incentive for an increase in oil production and reigning in liquidity should reduce demand thereby putting downward pressure on oil prices and likely other commodities as well. Critics may charge that the economy cannot cope with higher interest rates. However, so long as the Fed stands ready to act as lender of last resort (a role they have performed well thus far), the U.S. economy should be able to weather the storm.

There may not be an inflation conspiracy, but inflation is a much bigger problem than the numbers indicate. It is time for the Fed to reverse course and start raising interest rates.

It’s time for another edition of “Inflation? What Inflation?” Two stories from the WSJ today:

• U.K. Says Higher Rates Would Take Heavy Toll:
  

  New data showed the United Kingdom’s annual inflation rate jumped to 3.3% in May, and Bank of England Gov. Mervyn King set a two-year timeframe to nudge the rate to the central bank’s 2% target.

  [...]

  Data showed the annual rate of inflation rose to 3.3% in May — its highest level since 1992 — from 3% in April. Mr. King said the rate is expected to move above 4% in the second half of this year and remain “markedly above” the 2% target well into 2009.

  When the inflation rate is above 3%, the central bank governor is required to write a letter to the government explaining why prices are rising and what the bank intends to do about it.

• Fed Faces Dilemma as Costs Soar, Activity Slows:
  

  Data released by the Labor Department on Tuesday show companies are facing rising costs for an array of supplies, which may prompt them to increase prices on their products in the months ahead. The producer-price index rose 1.4% in May from the month before, partly reflecting a surge in crude-oil prices that pushed gasoline prices up 9.3%. Prices for other commodities also jumped.

  The index for core prices, which excludes energy and food, rose by a more muted 0.2% in May from the month before, but was up 3% from a year earlier, the biggest jump on a yearly basis since 1991.

It is time to restrain monetary growth on a global scale.

Paul Krugman writes:

But as I said, this time around there’s no wage-price spiral in sight.

The inflation hawks point out that consumers are, for the first time in decades, telling pollsters that they expect a sharp rise in prices over the next year. Fair enough.

But where are the unions demanding 11-percent-a-year wage increases? (Where are the unions, period?) Consumers are worried about inflation, but you have to search far and wide to find workers demanding compensation in the form of higher wages, let alone employers willing to accept those demands. In fact, wage growth actually seems to be slowing, thanks to the weakness of the job market.

And since there isn’t a wage-price spiral, we don’t need higher interest rates to get inflation under control. When the surge in commodity prices levels off — and it will; the laws of supply and demand haven’t been repealed — inflation will subside on its own.

Krugman is right in pointing out that wages are not beginning (or in the midst of) an inflationary spiral. Krugman seems to blame the invisible presence of the unions. Their invisibility could be due to their declining power and/or the fact that inflation today is quite different than the 1970s, but not for reasons that Krugman emphasizes. In my view, it is not the case that invisibility of the labor unions is the cause of a different kind of inflation, but rather that a different kind of inflation is causing the invisibility of the unions.

During the 1970s, the inflation rate was rising at a much higher rate than is currently the case. Energy prices were high, but there were also a great deal of other prices on the rise as well. As Krugman points out:

In May 1981, the United Mine Workers signed a contract with coal mine operators locking in wage increases averaging 11 percent a year over the next three years. The union demanded such a large pay hike because it expected the double-digit inflation of the late 1970s to continue; the mine owners thought they could afford to meet the union’s demands because they expected big future increases in coal prices, which had risen 40 percent over the previous three years.

Where the current situation is different is that the rise in the price level is less diversified. Food and energy prices are leading the charge, while technology and globalization are putting downward pressure on other prices. The result is that despite the fact that prices of consumer staples are rising, the overall inflation rate remains low by historical standards. This may also explain Krugman’s claim that, “it feels like a recession to most people” even if it technically isn’t. When the economy is slowing and the prices of consumer staples are rising, it forces some belt-tightening.

What to do about the current situation, however, is somewhat more difficult. Krugman believes that there is too much risk involved in raising rates and precipitating further crisis in the financial markets. However, one must also bear in mind that the low rate policies in the wake of September 11 and afterward largely set the stage for the current credit crisis. In my view, thanks in large part to financial market innovation, inflation targeting has proven to be quite inept. In addition, targeting a rate of inflation and simultaneously ignoring the forces of globalization and productivity growth leads to an environment of easy money. The economy is (and has been) moving ever toward completely inside money of the variety described by Wicksell, which makes monetary policy and especially inflation targeting more difficult to conduct.

In any event, I am convinced that the Fed Funds rate is below the natural rate and leaving it there for some time will only lead to further asset price bubbles. If there are underlying problems in the financial market, we cannot ignore them by keeping rates low and hoping that they will go away.

J.M. Keynes on inflation in The Economic Consequences of the Peace (p. 235-6):

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.”

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

HT: Robert Higgs

Recall from the equation of exchange that:

MV = PY

where M is money, V is velocity, P is the price level, and Y is real output. Therefore, when written as growth rates (assuming velocity is constant):

Inflation = Money (M2) growth - Real GDP growth

Inflation is thus graphed below:

The graph begs the question, “where are the inflation hawks?”

Inflation? What inflation?

Expectations are rising…

HT: Greg Mankiw

Andrew Samwick writes

Over the past few years, cheap credit and imprudent lending policies by some bad actors generated excessive consumption and investment in the real estate sector. This boosted economic activity beyond the level that would have prevailed with policies that we now wish, with hindsight, had been in place. That level of economic activity is the starting point for discussion of a recession, defined as two consecutive quarters of negative growth in real GDP. If we acknowledge that bad loans fueled the activity, why is it now a widely shared policy objective to maintain that level of activity?

Indeed.

HT: Larry White

Interesting thoughts on inflation from James Hamilton.