Inflation All Around Us, But Not A Drop To Drink
Chuck Ponzi October 2nd, 2007
If you do any amount of reading in financial publications or blogs lately, the word inflation has been thrown around quite a bit. However, few words seem so clear in economics yet are shrouded in half-truths. What is inflation? If you ask 10 different people, you’ll get 10 different answers. Even academics differ on what inflation is, even the definition of the word. While one might suppose it is monetary expansion, another only sees its effect on prices. Others argue it is the relative growth of the first in relation to the economy that drives the second. Still others argue that “it’s different this time” and the old rules don’t apply; in a way they are correct.
It is no secret that in the past few years, we have seen substantial monetary expansion. Such is not necessarily the case today. A fellow blogger, Mike Shedlock, notes that we are in a very slow monetary growth period compared to years past in his post: “Is the Fed Deflating?”
It is very easy to prove the statement “the Fed is not massively printing” but people believe what they want to believe. However, Fed policies have been such to enable super easy credit transactions to take place by holding interest rates too low too long. When interest rates are held too low, asset bubbles build and credit/debt transactions soar. So does the velocity of money. But the Fed ignores these bubble (in fact even embraces them) as long as consumer prices are held in check.
Mish hit upon some very important points:
1. Inflation is time-lagged.
2. Bubbles are not inflation.
3. People believe what they want to believe regardless of the facts.
Inflation is Time Lagged
Inflation has a place in any money. Yes, even vaunted and irreproachable monies like gold can and have experienced periods of strong inflation when the purchasing ability of gold declined significantly. One such gold inflation periods happened with the California Gold rush in 1849, and later after the discover of dissolving ore in potassium cyanide in 1887.
Indeed, money produces nothing, it is merely a confidence play, though some have industrial uses (gold as an electrical conductor, or paper money as a combustible material to name a couple). Money is a confidence game… nothing more, nothing less. Only barter economies approach removing the “confidence” value. These tend to be terribly inefficient, and are not likely to return, regardless of what happens to our monetary supply. In fact, in today’s global liquid markets, many other assets have taken the place of money as a hedge to traditional fiat currency systems systematic devaluation.
Monetary inflation is valuable to prevent price deflation. In fast-growing economies, where gross domestic output is increasing as well as a growing population, if money were to become scarce, prices would need to drop to reflect that scarcity. To the counterpoint, monetary deflation is also valuable to prevent price inflation. If money is plentiful, removing that money from the market keeps prices from spiraling higher and higher. These facts are accepted in economics textbooks covering basic supply and demand relative to the money supply, and is well understood in all economics circles. So, if the answer is so simple, why don’t we simply measure one and react with the other?
You shouldn’t be surprised that our Federal Reserve has tried just that.
Unfortunately, other factors keep popping up that throw the next administration for a loop.
First, it was productivity as a deflationary force.
Then, it was a credit orgy as an inflationary force.
Then, it was a “savings glut”, reserve currency, or some other reason as a deflationary force (stockpiling dollars, removing them from spending).
As you can see, managing supply and demand is not as simple when poor information is available about who is holding the currency, and what they intend to do with it. Especially since there is a time-lag.
Basically, introducing currency into a system does not provide an immediate change in prices. This works in excellent principle in economics textbooks in perfect countries with names like “utopiaville” and “Gilligan’s Island” where perfect information abounds and prices immediately reflect available money. In addition, money is instantly used on whatever provides the most utility.
Unfortuately, humans are irrational, greedy, and inefficient. Prices are sticky. Expectations vary wildly and change in an instant. In this environment, a steady, stable central bank that moves slowly and ignores short-term glances while focusing on the long-term is likely to be the most successful. There are no heroes in this arena. Middle of the road beaurocracts are the name of the game. However, when forced by the situation, herculean pushes against inflation and short-term fixes such as the time when Paul Volker crushed the inflation of the 1970’s in the US with double-digit Fed fund rates.
Unfortunately, this is not the 1970’s.
Bubbles are not Inflation
This is the era of financial bubbles. These are extremely irrational price moves of assets where fundamental values detach from the current values. Increasing investment and overdependence on a specific asset class produce outsized gains, and more pile on, creating a self-fulfilling prophecy of higher prices and greater inflation.
Then it happens.
The bubble pops. It becomes self evident that the prices moves were irrational, and it painfully returns to it’s longer-term trend. Bubbles are not price inflation, they are driven by inflation. The only way that bubbles can form is by a single enabling forces: monetary inflation. Instead of the money chasing a fixed set of goods and inflating their prices, humans instead choose to purchase assets. That’s not inflation. It may look like it, but it’s only temporary, not systemic.
Before you begin to think that I am a current FED apologist, consider what I believe to be the root of financial bubbles… monetary inflation. That is controlled by the Federal Reserve.
People Believe What They Want
Regardless of the facts. Much like the crush of public opinion when the housing bubble was in full-blown effect, there is now a crush of opinion beginning to build about systemic inflation. Indeed, there is a growing believe in the infallibility of precious metals as a store of wealth. This has all the seeds of a future bubble in precious metals. If asked where I believe the next bubble will be, I’d put my money on precious metals. (and have put some)
Getting back to inflation, however, inflation is much like anything in the financial world… it acts like virus, and once it has infected enough, it spreads on its own, creating a self-fulfilling expectation of increasing prices. Expectations (or confidence) is the name of the game.
Unfortunately, like a virus, the only way to kill it or severely wound it is to remove its source of food… money. If people expect things to cost more in the future, they will stockpile that thing now, increasing demand for it and consequently prices. It is possible that much of the inflation of the 1970’s was a reaction to many Americans stockpiling food, water, and other resources in the shadow of the cold war. The same way that people fearing being priced out forever, they purchase more than they need now in the chance that they might need it in the future. Many people bought houses much larger, and in much greater quantity than their needs or abilities dictated in an attempt to remove that fear of running out.
Summing it up
Are we experiencing inflation? It depends on what you consider to be inflation. Prices are rising of many consumer goods. Conversely, a massive bubble is violently deflating. People’s incomes are not growing as quick as prices.
However, I can be confident about making one prediction. If housing prices in bubble areas do not come down fast enough, wages will need to increase faster than they have been. And, the Fed will allow the first while fighting the latter. As they say… don’t fight the FED.
This is a very good explanation of how inflation and bubbbles work. You are right on the money..
Had to chuckle about “people believe what they want”…Of course they are greatly influenced by all the five second sound bytes that seem to pass for news.
You know I’ve really come to hate the uncertainty in the markets.
Fed games with the money supply make it almost impossible to identify value.
I think a lot of the Fed thinking is about velocity of money. There seems to be a lack of understanding about accelrating factors and system stability though.
The low reserves (savings) along with the goads to invest are huge. So more money is available as investment with high pressure to produce returns. Unfortunatly this causes a lot economic dislocations to us real people. Those time constants are hell out in real life.
Seems like those second order dif equasions could use a higher dampening factor (savings).
I have a bunch of coworkers that went all to cash a few months ago. The Fed decided to inflate so their losses are substantial. I “gambled” on a rate cut causing a bounce. Just as likely to be wrong the next time though.
What a mess of a situation.
Most sane people would define inflation as the rate at which the purchasing power of a currency deteriorates.
Whether or not it is a monetary phenomenon is debatable, but that said, when Bernake decided that forcing the banks to measure M3 was too “burdensome” and should be done away with, that should have been a red flag to any thinking person. I’ve read estimates that M3 has increased by up to 15% over the past year, while the nominal rate of real goods and services produced in America has increased by a small fraction of that.
Meanwhile, the cost of education, healthcare, oil, gold, virtually every currency, and concert tickets have all gone through the roof. Whatever anyone thinks the inflation rate is, it AIN’T 2.2% or whatever lie the government is telling us.
Just imagine if the government had to adjust their colas at 5%-6% a year. Imagine if the government had to pay 8% on all it’s newly issued debt and on the massive amounts of short term debt being refied constantly. Just imagine what would happen to the California economy if our bonds started reflecting the risk adjusted premium + 6% real inflation rate. We’d go under.
The government has absolutely no choice but to lie about the real rate of inflation because if they didn’t, we’d be bankrupt.
I’ll admit, to me, it is not debateable whether inflation is a monetary phenomenon, both by studying the writings of Friedman, and personal observations. We are experiencing lagged inflation from the 2001-2004 rate cuts. That was the point of my argument. It remains to be seen whether the fed as done too little, just right, or too much since then. And, inflation is just one measure, optimal employment is another important one… problem is that when you mash on the accelerator, you need to mash on the brakes, or you risk running into the wall or off the cliff. I think we mashed the accelerator in 2001, but have been goosing the brakes for the past 3 years hoping it’ll slow us down. We’re still not slowed down, and It’s hard to tell how much of a lag we’re seeing and whether Al & Ben have been able to take enough speed off by driving through the rear-view mirror.
We are experiencing inflation! It is as simple as that. Although you wrote this a while ago, the economy has gotten worse since then.
You asked “are we experiencing inflation?” then you say “Prices are rising of many consumer goods”. The second statement is the essential part of the definition of inflation.
As far as people believing what they want to believe regardless of the facts, I think that is a true but misused statement, especially when inflation has an actual definition.
If you asked ten people to tell what they think inflation means and you get different answers, that means they do not know. It does not mean it does not have a definition.
Simply based on the definition of an economic textbook and the third dictionary definition inflation is a rise in the overall price level (food, gas, etc.), which decreases the purchasing power of money.
Most things cost more than they did a year ago and the dollar is worth less, so by definition and not opinion we are experiencing inflation. Most years we experience inflation. There is nothing wrong with admitting that, that is why you can no longer buy a cheese burger for 25 cents. Inflation is apart of life. I think you are mixing “inflation” with “recession”.
Statically speaking 2008 has broken every monthly record for highest inflation increase since 2000. The month of June has had the highest inflation of all eight years at 5.02%, so I can not agree with you when you say “it depends”. Inflation is real and it is happening right now and is worse than our typical inflation increases. There may have been more broken records, but back to 2000 is the data I have available.
Sometimes people think and analyze too much. You are correct about many opinions being involved, but I think you fell into the trap as well.
I can see from the comments that others are cheering you along, but the answer is as simple as opening up a book. It is then when you can enter into a debate well knowledge on the foundation, even if you do not understand or know about the current media hype on the subject.
I do not follow others opinions, but the fact are printed in ink. If many economists or other people without economic knowledge agree, then some have made a lucky guess, but it does not mean they are wrong. People do not have to be scholars or gurus to be correct on their understanding of a situation.
Lastly, I would like to add that we are not only experiencing inflation, but close to a recession as well. I can respect someone disagreeing with me, because this is a hot topic, but again here is the definition:
An extended decline in general business activity, typically two consecutive quarters of falling real gross national product.
To my knowledge we have yet to actually have a decline for two consecutive quarters (I will check), but we are borderline. The stock market, homes and private businesses have been declining then rising just a little. Overall it is a decrease in business when compared to before this trend started happening.
I think we are in a worse situation than a recession because of the technicality of the meaning. People who are calling it a recession maybe wrong, but they are smarter for calling it that than to pretend nothing is wrong. It is possible to crash without ever having a textbook defined recession. (yes, even with insured banks)
All that would need to happen is a continuous deep drop and minor rise in economic business activity. That would keep us from labeling it a recession by definition, but in reality I think we need another word for what we are experiencing right now in the United States.
We are experiencing inflation! It is as simple as that. Although you wrote this a while ago, the economy has gotten worse since then.
You asked “are we experiencing inflation?” then you say “Prices are rising of many consumer goods”. The second statement is the essential part of the definition of inflation.
As far as people believing what they want to believe regardless of the facts, I think that is a true but misused statement, especially when inflation has an actual definition.
If you asked ten people to tell what they think inflation means and you get different answers, that means they do not know. It does not mean it does not have a definition.
Simply based on the definition of an economic textbook and the third dictionary definition inflation is a rise in the overall price level (food, gas, etc.), which decreases the purchasing power of money.
Most things cost more than they did a year ago and the dollar is worth less, so by definition and not opinion we are experiencing inflation. Most years we experience inflation. There is nothing wrong with admitting that, that is why you can no longer buy a cheese burger for 25 cents. Inflation is apart of life. I think you are mixing “inflation” with “recession”.
Statically speaking 2008 has broken every monthly record for highest inflation increase since 2000. The month of June has had the highest inflation of all eight years at 5.02%, so I can not agree with you when you say “it depends”. Inflation is real and it is happening right now and is worse than our typical inflation increases. There may have been more broken records, but back to 2000 is the data I have available.
Sometimes people think and analyze too much. You are correct about many opinions being involved, but I think you fell into the trap as well.
I can see from the comments that others are cheering you along, but the answer is as simple as opening up a book. It is then when you can enter into a debate well knowledge on the foundation, even if you do not understand or know about the current media hype on the subject.
I do not follow others opinions, but the fact are printed in ink. If many economists or other people without economic knowledge agree, then some have made a lucky guess, but it does not mean they are wrong. People do not have to be scholars or gurus to be correct on their understanding of a situation.
Lastly, I would like to add that we are not only experiencing inflation, but close to a recession as well. I can respect someone disagreeing with me, because this is a hot topic, but again here is the definition:
An extended decline in general business activity, typically two consecutive quarters of falling real gross national product.
To my knowledge we have yet to actually have a decline for two consecutive quarters (I will check), but we are borderline. The stock market, homes and private businesses have been declining then raising just a little. Overall it is a decrease in business when compared to before this trend started happening.
I think we are in a worse situation than a recession because of the technicality of the meaning. People who are calling it a recession maybe wrong, but they are smarter for calling it that than to pretend nothing is wrong. It is possible to crash without ever having a textbook defined recession. (yes, even with insured banks)
All that would need to happen is a continuous deep drop and minor rise in economic business activity. That would keep us from labeling it a recession by definition, but in reality I think we need another word for what we are experiencing right now in the United States.