What is Inflation, Anyway?
Is it Consumer Prices? Or is it Assets?
By blackhedd Posted in Economy — Comments (28) / Email this page » / Leave a comment »
The Federal Reserve is front and center today, as it kicks off what has become a traditional late-summer shindig for central bankers, academic economists, and other assorted geeks in Jackson Hole this weekend.
And as luck would have it, one of the topics (probably chosen months ago) is housing. Inquiring minds want to know just what role a central bank should have in managing markets for housing. Especially since recent events have proved that disorders in housing markets are capable of erasing trillions of dollars in normally-uncorrelated markets.
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A lot of ink has been spilled here and elsewhere on what should the Federal government's role be in managing housing, a subject that is as near and dear to the hearts of as many voters as any other. I won't rehearse the arguments, but the question boils down to: should the government bail people out? No, they shouldn't.
As a semi-government entity, however, the Fed is in a somewhat different position. They have a statutory mandate to manage the banking system, and also to inflate "monetary aggregates" in a manner consistent with a steadily growing economy.
Now inflation is an extremely interesting subject. To start with, is it a good thing or a bad thing?
The Fed has traditionally been extremely vigilant on the matter of avoiding excessive inflation. Since inflation is basically what they do, everyone is constantly watching to make sure they don't overdo it.
Fed officials from Chairman Bernanke on down have consistently stated that their target for inflation is between 1 and 2 percent annual growth in consumer prices, net of food and energy.
But notice their unit of measure: consumer prices. Even when he was at Princeton, Bernanke believed as he does now that consumer prices are the key measure for inflation. (Greenspan was just as likely to get worked up about wage increases in excess of productivity gains, which is nearly the same thing.)
But there's another important measure of inflation: asset prices. That would be prices for certain industrial commodities, stocks, debt instruments, and... real estate.
During the period from 2004 to 2006, the Fed created an historically large amount of new money, and it seems fairly clear now that a lot of this found its way into asset prices, notably for residential and commercial real estate.
What it didn't do to any great degree is inflate consumer prices.
Did the Fed overdo it? They probably did.
There's an extremely important but little-discussed interaction between the overall state of an economy and its response to inflationary pressure. To state it overbroadly: when an economy is dynamic and growing, inflation tends to go right to consumer prices.
China is the case in point. Their current 12% or so of annual growth is about half inflation. And prices for staple grains and meat are exploding in China, threatening a considerable amount of social unrest. (And there is a lot of precedent for that in China. Food-price inflation was a huge problem in the spring and early summer of 1989, hint hint.)
By contrast, in mature economies (like ours and Japan's), inflation finds its way into assets. Japan can't inflate consumer prices no matter what they do, and they end up exporting all their money into carry trades around the world.
Europe at this point is somewhere in the middle. My sense is that they are now growing between two and three times as fast as the US in real (inflation-adjusted) terms. Tax reform is going to be very good indeed to old Europe.
So out in Jackson Hole, everyone is busy questioning whether the Federal Reserve did the right things during the fright month that was August 2007 (yes they did), and asking whether they should reduce interest rates in September (not necessarily).
And they'll also be asking whether the Fed, contrary to Chairman Bernanke's preference, should keep their eyes on asset prices as a key measure of inflation. They should.
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Oh, and people who invest in things, since our government doesn't index capital gains for inflation (or at least didn't ten years ago; this may have changed). Always struck me as one of the most inequitable features of our tax code: The government creates inflation, and then taxes you on your property's "gain."
In its most basic sense, inflation is the erosion of the value of money over time. But it all depends on what you choose to compare the current value to. If you look at USD versus computers, we are in a deflationary environment. However if you look at what most people spend 80-90% of their income (after tax of course) on, that would be food, housing and fuel. Now we have a differnent situation. Fuel has doubled in 3 years. Food is up 25-30% in 3 years, housing - well for the time being, it has doubled in 5 years. Wages? Up a few percent.
Depending on how you measure it, real consumer inflation has been running about 8-12% per year for quite some time.
http://www.shadowstats.com/cgi-bin/sgs/data
The Fed says 2%. I don't know about you, but the 10% number seems much closer to how my finances are at the end of the month.
The USG and the Fed prefer to adjust the method of measurement to ensure the CPI stays low for a myriad of *cough* debt service* reasons *cough* dollar support *cough* to keep it around 2% *COLA*. The our good friends the Kuwaitis figured that out and bailed on the USD. There will be more.
When people spend more of thier after tax dollars on basic necessities, it doesn't take long for much of our consumer driven economy to start grinding down. The Fed can claim 2% inflation all they want, but when I go to buy tires that last year were $80 each and now are $115, I'll put off buying that new 5% cheaper laptop or 10% cheaper plasma TV. Or saving for my kids college education.
Why doesn't the fed "do nothing?" Its quite obvious that Real Estate has been increasing at unsustainable levels for at least 5 years.
Whether you like it or not we need real estate prices to come down 20%.
Also, I did not see the fed get involved when the DOW(tm) hit 13,000 on the way up. I don't know stocks, but maybe that level is unsustainable as well.
Whether one agrees with it or not this "war" has been very expensive. That money did not come out of thin air (or did it).
I am especially suspicious of Mr. Bush. He would not have made an announcement like he did this morning prior to this summer. He has given up any pretense of being a conservative.
"I must complain the cards are ill shuffled 'til I have a good hand
Swift"
How does anyone currently HOLDING real estate 'need' prices to come down 20%? It sounds to me like your 'we' doesn't include anyone with a mortgage.
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the food and fuel is out of the Fed's control. Meanwhile, the inflation, by government reports, everything but food and fuel is under 2%. It's no surprise that there's a problem in going from very low Fed target rates of about 1%,circa 2001 up to 5.25% last year. As usual the interest rates, show their full affects a year later. The usual house ownership rates have gone from 60%-70% very recently, so this is a housing ownership and bad product, feeding the originator quick cash and the owners a home for a limited amount of time, correction.
Its disconcerting after yesterday to think that there is still a possibility that Bernanke still won't lower interest rates.
eeeggadds. Lowering rates would definitely help, keep the Democrats' crazy ideas on the sidelines and make Bush and company look like genius.
Yes, if we could get by without counting food in our budgets, we'd all be saving a lot more too. But that's a flagrantly bad way to measure. No, the Fed doesn't "control" food and energy. Nor do they control the prices of anything else. But the fact that some consumables are NOT rising in price has more to do with cheap imports than it does with a stable price level. Many economists have been talking about a sort of "stealth inflation" that we've been going through. If you look at costs of things like education or construction or dental care, those prices have been rising fast too. In fact, we can excuse away food, energy, housing, and services, and say that except for those few things prices aren't rising, but of course those "few things" account for approximately 80% of the average person's yearly budget. Thus, in real terms, we're experiencing real inflation.
And, lowering rates would be a disaster.
Those who cannot remember the past are condemned to repeat it. - George Santayana
...consumer-price measures that it tracks, is because those two categories exhibit sharp swings from month to month due to normal supply-demand pressures. The Fed is more interested in making sure it doesn't over-accelerate what it calls the "core rate of inflation," and they think a less-noisy proxy for the core rate is consumer-prices-ex-food-and-energy.
Yes, it's understood that food, energy, and other commodities tend to fluctuate, and that certainly explains why we might not want to use them to count. On the other hand, excluding them also has certain implications, which I think are being ignored here. My point was that we're missing some real issues under the surface if we focus only on the core numbers.
When we measure inflation for the purposes of managing our money supply we don't want to be influenced by short-term flucutations in supply caused by weather or politics.
Food and energy are volatile because of both.
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No, we don't want to see short-term fluctuations. On the other hand, if the only things we measure are the only things that are NOT going up consistently over time, then aren't we suffering from some measurement error of a different sort?
You can't just take core numbers and assume that measures everything. There are flaws in that system too.
say 6-month or 9-month - to damp out most of the volatility in food and enery prices and yet capture the underlying effect that these prices have on people's real cost of living?
I think that's a great strategy. Of course any measure will be imperfect at some point in history, so it's probably good to keep running averages at a few different time frames, but overall, I think that might be a good approach to take. Now, if you can find some way (this is a bit harder) to measure how this excess is running into housing or equities, we'll have the measurement problems licked. :)
The proximate cause of inflation is credit expansion. That is, when new money is created, new demand (which is a desire for goods combined with the ability to pay for them) is created. This drives prices higher.
There are two causes of credit expansion:
1) Fractional reserve banking, where bankers are permitted to fraudulently promise to pay depositors on demand, but actually lend out more money than they have, so they KNOW that they cannot meet their obligations if too many people require payment at the same time. This cause of credit expansion can be permitted by treating banking deposits as bailments, rather than as loans. Of course CD's or money markets would continue to exist, and pay interest, but without a promise of payment on demand.
2) Printing fiat money, which allows the Federal Reserve to create money out of thin air. This is worse than fractional reserve, because although a run on a bank destroys only the bank, and those foolish enough to try to bail out an insolvent bank, the monetary equivalent ... hyper-inflation ... destroys an entire economy. The solution to this cause of credit expansion is commodity based money, be it gold, silver, or something else. If more than one commodity is used, the government should not attempt to maintain a fixed relationship between them, as their prices will vary relative to each other based on the cost of production, and this is not controllable.
...a Ron-Paulite, so you may not be interested in understanding how things work outside your own theoretical world.
But I need to clarify something regarding your first point, because it bears directly on why I wrote this post in the first place.
Increasing the money stock does not necessarily create demand. That is a very serious fallacy. Increasing the money stock enables both production and consumption to rise (which is healthy), only if there was underlying demand in the economy that was not being met.
Supply and demand balance each other at any particular price level, but changing the price level often changes the equilibrium point.
This matters for the US economy because potential demand in the economy may not be much higher than current levels of real demand. If that is true, then the inflation which the Fed creates on a near-daily basis will probably just inflate asset values- not a healthy outcome. I don't know how to answer this question, and I believe the answer is just as likely to be exactly the opposite.
He's not arguing the "Ron-Paulite" position, as you call it. He is arguing the Austrian Economics perspective, which Ron Paul also tends to follow. This is the tradition of Hayek (nobel prize winner) and Rothbard and Mises and many other great economists. Feel free to disagree, but at least recognize that you are arguing against a whole school of thought, not a single congressman and a few random followers.
When I observed that he was a Paulite, it was by way of saying that I have no interest in engaging the bulk of his remarks, just the ones in his first paragraph that I specifically responded to.
This is a thread about inflation as a feature of the current political economy of the United States: how it should be understood, and how it should be managed. It's not a place for irrelevant dogma about hyperinflation and fractional-reserve banking.
Pardon my ignorance, but in what galaxy do we get to talk about inflation and declare comments about hyper-inflation or different views of how inflation develops as irrelevant. That's the most outrageous framing of argument that I've ever heard.
I said that I'm not interested in having a debate about hyperinflation, fractional-reserve banking, or commodity money.
Quite apart from the desire to avoid a threadjack, here are my reasons:
Hyperinflation is not a necessary outcome of fiduciary money systems. Even though most sound-money advocates would admit that if you pressed them, it doesn't stop them from dragging in ridiculous comparisons to Weimar Germany or Zimbabwe every time the subject comes up.
Hyperinflation requires incompetence, corruption, malfeasance, or all three, on the part of monetary authorities. I've heard Paulites (and libertarians generally) argue that these bad things actually are necessary concomitants of political authority. If that's what you're saying (and I know this is a strong backstory in Austrian economics), then just say so.
Fractional-reserve banking is the system we have. We've had more or less of it at times in the past, and the presence of deposit insurance (which by the way was not an idea that originated in the New Deal) interacts strongly with the reserve ratios that the public chooses to accept at any given point in time. (And you don't have to remind me that reserve ratios are heavily manipulated by the government.)
However, fractional-reserve banking is a red-herring in the inflation discussion. You'd have the same concerns about inflation even if the entire economy were to go on a strict high-powered money basis.
Whenever I hear a commodity-money advocate, I invariably discover an underlying sense that money is what matters most in the economy. That isn't true. The production of goods and services, and continued high employment are what matter.
If your definition of a "threadjack" is someone disagreeing with your basic premise, then I guess that's what it is. I suppose you can ignore, and attempt to marginalize an entire school of thought on economic policy. I just wanted to point out that this is what you are doing. I don't necessarily agree with Austrians point-by-point either, but I have enough respect for their position on some issues that I'm willing to give a fair hearing to their points on other issues that I'm not yet convinced of.
Once again, you've made the point that MONEY is not what matters, and of course most of us who are monetarists, Austrians, or others of the old conservative coalition that led to the rise of Reagan DO believe that Money is what matters. Again, you lead me to believe you're somewhere closer to the Keynesian camp than you are to any of the old free-market economists. Is there a particular stream of economic thought that you follow? Because what you are arguing isn't really mainstream economics either, any more than the Austrian version is. Would you care to expound on which economists you like to read?
Let me remind you of what this discussion is about. (Since it's my thread, I have standing to do so.)
It's not about whether hyperinflation is a bad thing. No one would argue that.
It's also not about whether we currently run an inflationary monetary policy. We obviously do.
It's certainly not about whether we should run an inflationary monetary policy. If you really see a need for the one-millionth blog post on that subject, go ahead and write it.
The current discussion is about this: at this moment in time, does the inflation created by the Federal Reserve do what it's supposed to do, which is support increased economic activity, or does it simply increase prices without stimulating additional capital investment?
And if the latter is true, then to what extent are the effects showing up in asset values rather than consumer prices?
A more tendentious way to ask my question is: Is the Federal Reserve now targeting the wrong inflation measures?
What do you think about those questions?
In a "property rights" kind of world, I suppose you have the right to ownership over your "thread", just as you have the right to ignore questions I ask which make you uncomfortable. Call it "baiting" if you will. I'm simply trying to get at the core of the disagreement, and you prefer to frame the argument as a surface thing. Whatever.
Certainly, if I try to answer your questions, you won't approve of my answers either, because they come from a contrasting school of economic thought, so this is probably a pointless exercise (unless someone else bothers to read this). But I'll give it a shot.
First, when you ask if the inflation created by the Fed does "what it's supposed to do" that implies that the Fed is supposed to stimulate the economy - a Keynesian mindset if I ever saw one, and a point I would argue. But even IF we did agree that this was a purpose of the Fed, I think we need to be more precise with the answer...not only IS it still stimulating, but is the value of the stimulation greater than the negative value of the externalities, if you will.
My best guess to this question (we can't do more than guess, can we?)is that we're reaching the "end of the rope" if we're not already there. It isn't that no "stimulation" is going on, but it is more an issue of the negative built-up effects of the externalities (inflation, etc.) overwhelming the short-term positive effects of the stimulation. I think you'll still see short-term stimulation from these measures now, but the negative effects, this time more a result of the real estate hangover, will overshadow the limited impact these efforts can have.
I don't really think this has to do with whether the Fed is targeting the wrong measures. But that's probably where our different views of the economy re-enter. You'd probably assume that, if they just were doing it right, that getting stable inflation is easy. Here, we firmly disagree. I would argue that it is the nature of this effort to stimulate the economy that leads to all these highs and lows, and that the only sensible position would be either a Misesian hard money standard or a Friedmanite fixed low inflation rate or some other mockup of one of these. Interestingly, there have long been rumors that Greenspan was so secretive because of his private preference toward using gold prices or similar commodity measures as his influence for measuring long-term inflation back in the 1990's. Of course we'll never know unless he writes a tell-all book before he leaves this earth. But it's an open secret that Greenspan got his start as a hard money Randian back in the day. Bernanke is cut from a different cloth, I'm afraid.
>>>but at least recognize that you are arguing against a whole school of thought, not a single congressman and a few random followers.<<<
then I'd agree with you. But when this stuff comes up on Redstate, you can be sure it's a Ronulan.
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It tends to follow that if only one candidate is talking about economics and he's advocating positions that fit your understanding of economics, then yes, we who study Hayek and Mises and Rothbard do tend to be Ron Paul supporters. But that doesn't make your characterizations accurate, any more than the ideas of Milton Friedman and Art Laffer were nothing more than Reaganomics.
I'm not sure what you mean when you say that increasing the money supply does not necessarily create demand.
Demand (which is short for effectual demand) is a combination of desire and means. The means may consist either of goods to trade, or of money to trade.
The science of economics is based on the idea that human desires are unbounded and insatiable.
Creating money is therefore guaranteed to create demand, since there always exists a desire that is not matched by means.
Note that when I say creating demand, I do not limit myself to demand for consumer goods. It may be demand for real estate that is stimulated, causing a real estate bubble. It may be the demand for investments that is stimulated, causing a stock market bubble. It may be the demand for consumer goods that is created, causing plain old inflation. All of these are a form of inflation.
I would argue that it is impossible to actually measure inflation, precisely because it is impossible to separate bubble growth in the stock market or the housing market from actual increases in value in those areas. I am quite sure that our current CPI measurement is not a full accounting of inflation.
the pre-existing demand. Now, if raising the money supply lowers the price of money, then that increases big D demand.
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What you're saying amounts simply to this: create more money, and it will go somewhere.
You don't limit yourself to consumer goods. Well, of course not. An increase in the stock of money can show up in all kinds of places. It can inflate consumer prices, wages, and asset values, it can decrease the velocity of money, it can find its way into productive investments, it can flow to high-yielding currencies in other countries, and it can do some some combination of all of the above.
So far, this is all obvious.
But the question that I'm really asking, is: what is the specific combination that's taking place now? Because the destinations are not equally desirable.
This is not anything you can predict with the "science of economics." And that's why Ben Bernanke is on such a hot seat.
Ronulans off the port bow, and they're uncloaking!
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are bankers. High inflation means you pay them back in dollars that are not worth as much as the dollars they lent you. They have a nice gig, paying you 3% return on a savings account while charging 7% (plus fees) for fixed rate mortgage - and you don't even get a free coffee maker or toaster oven any more.
They'll be plenty of 'contagion theory' talk out there in Jackson Hole regarding subprime, commercial, and other debt linkage. I don't expect any real words of wisdom though.
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