The current market belief that inflation is rife comes during a time when very few in the markets can recall the oil price shocks of 1972 and 1978 nor the Volcker years of monetary targeting from 1979 to 1982. Indeed, the ‘inflation playbook’ that central bankers are gleefully dusting off (their relevancy now is greater than at any time during the last 4 decades) is 2 generations old and, quite possibly, predicated on unproven beliefs.
The current policy response to the perceived ‘inflation shock’ really needs some modern thinking. Let me reason…
Is there an inflation?
This question is fundamental to the policy response but no-one has proven that there is an inflation problem. Sure, the CPI is up 8.6% year-on-year in the US but this is not inflation per se. Energy and food prices have risen but other prices are stable. The wide variation in CPI components (energy is +106%, airfares +60% while doctors fees are +1.1%) points to a relative price effect that could easily be reversed (the Ukraine war finishes causing oil prices to fall and post-covid demand for travel wanes leading to airfare discounting). But, more importantly, this disparity does not fit the definition of an inflation – where all prices rise proportionally – that is an 8.6% across the board increase in prices. Further still, inflation is not just an increase in prices – it is an increase in the rate of change of prices. This means that energy prices dont just rise and stop. Inflation means that prices (all prices) rise and continue to rise through time with a propogation mechanism that allows it. The traditional mechanism has been money – where the money supply is allowed to grow at a rate that at least matches the rate of inflation over time so that the nominal price level does not feel short of fuel to continue the price increases. The jury is out on whether inflation is with us or the CPI rise just reflects a temporary increase in the price of a few key commodities and services.
Is inflation such a bad thing?
Despite 4 decades of stable prices, the inflation literature concluded that inflation is quite an efficient form of taxation. Seignorage is the decline in purchasing power suffered by holders of nominal assets such as fixed rate securities and (heaven knows who does this these days?) holders of currency. In the present case, holders of US dollar bonds and currency are paying the taxes. Whereas in the 1970’s the amount of currency in the average worker’s wallet was high, the current situation is much lower with most electronic forms of payment being linked to interest bearing deposits. As interest rates rise, the nominal tax on currency holdings is cushioned. The incidence of the taxation effect or seignorage is diminished on the average worker and increased on the holders of nominal assets (typically bonds). Nevertheless, the inflation tax can make the government’s real debt burden shrink quite quickly without political repercussions.
The 4 decade old playbook
The death of inflation in the 1980’s was somewhat surprising to economists who never really got around to understanding why inflation stopped let alone why it started in the first place. Hyper-inflations are clearly monetary in their cause and propogation but mild or moderate levels in the high single digits are curious. Without knowing the cause it seems silly to respond with a generic policy response like jacking up short term interest rates. This was Greenspan’s Fed reaction function and arguably kept short-term interest rates too high for too long at around 4%. It does seem we are heading back in this direction particularly when the President of the European Central Bank Christine Lagarde says things like “…we will do everything we can to keep inflation within our 2% target range.” No debate here about relative prices and inflation…
Some believe that sectoral shifts are confused with inflation where prices signal resource re-allocations (eg high oil prices stimulate switching to solar) and this gets reflected in the CPI. The correct policy response to this event is to facilitate the shift rather than stifle it. My head and heart are in this camp. That is, it remains to be seen whether the current CPI increase is inflation. If not, then the price mechanism needs to do its thing.
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