A danger of inflation: The misallocation of resources on the way to sustained price increases (an explanation of the mission of Inflation Watch)Posted: May 31, 2011
In January of this year, Professor Russ Roberts of George Mason University invited fellow economics professor Don Boudreaux to address “Monetary Misunderstandings” on the weekly podcast “EconTalk.” From the synopsis:
“Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts on some of the common misunderstandings people have about prices, money, inflation and deflation. They discuss what is harmful about inflation and deflation, the importance of expectations and the implications for interest rates and financial institutions.”
I was most interested in the discussion about the definition of inflation because I understand the importance of maintaining technical and economic clarity on this topic for “Inflation Watch.”
Boudreaux first deferred to Milton Friedman’s famous empirical proclamation “inflation is always and everywhere a monetary phenomenon” and lamented that the economics profession no longer defines inflation as an increase in the money supply. Now, inflation represents a sustained increase in the average price level in the economy. Inflation is not simply any increase in price; Boudreaux complained that this definition is a common misconception of non-economists. However, he acknowledged that he personally thinks inflation’s largest threat is the process by which price increases become sustained. This process features uneven injections of money into the economy, causing specific and identifiable distortions in the economy that lead to a misallocation of resources. (Roberts somewhat disagreed as he expressed much greater fear of hyperinflation).
Bill Fleckenstein first taught me this notion that increases in the money supply distort specific areas of the economy. Such distortions can morph into bubbles, inflation’s ultimate misallocation of resource (capital). Bubbles can occur without ever tipping the economy into an inflationary cycle via official government statistics. So, it is very easy, for example, for the Federal Reserve to do nothing about soaring prices in an important sector of the economy and instead simply plan for the ultimate clean-up of the bubble’s aftermath. In recent history, the disastrous wakes of bubbles have forced the Federal Reserve to resort to easy money policies that invariably help fuel the next bubble. (Fleckenstein famously reviews this process and a lot more in “Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve.”)
Through Inflation Watch, I identify news of price increases not because any one price hike defines inflation; as noted above, this approach is technically incorrect. Instead, these stories offer clues that potentially can uncover the misallocations of capital that flag inflationary forces may be developing. I am trying to piece together a mosaic of economic activity that may provide early indicators of inflation well ahead of the moment that government statistics show it or the moment the Federal Reserve officially announces an inflationary process is underway.
The general context is important. We are currently experiencing an extended period of easy money policies in most of the globe’s developed economies. Presumably, this money must go “somewhere” at some point in time. Financial markets are the perfect conduit for easy money; investors and speculators alike will flock to those parts of the economy that promise some protection against the devaluation of currency and/or profits from inflationary pressures. (Boudreax and Roberts never directly addressed the enabling influence of financial markets for transmitting inflationary pressures). I have argued in previous posts that the most favorable hosts for easy money are where demand is particularly robust and supply may be constrained or stressed. Today, commodities represent a perfect storm for global easy money policies. So, many of the recent stories in Inflation Watch have focused on commodities and industries dependent on consuming commodities.
The Federal Reserve’s current bias toward inflation shows because the Fed has demonstrated relatively quick action to thwart the perceived threat of deflation. The specter of the Great Depression always looms large. Recall that after the dot-com bubble burst, Greenspan cited the threat of deflation as a prime reason for aggressively loosening monetary policy. The crash of the housing bubble of course generated an even more aggressive policy of monetary easing given housing’s importance to the overall economy and consumer spending. The Federal Reserve’s recent success in averting deflation certainly adds confidence in applying easy money policies, much to the likely chagrin of devout deflationists. Meanwhile, the Federal Reserve has also made it clear that it will not act against inflation until price increases (or the expectation of price increases) reach sustained levels over time.
For example, last week, Bloomberg quoted Federal Reserve Bank of Chicago President Charles Evans in “Fed’s Evans Says ‘Slow Progress’ in Economy Justifies Maintaining Stimulus“:
“Inflation is a continuing increase in the price level over time: A one-off increase in the price level is not inflation…Price increases have to be sustained.”
I duly noted that at no time does someone from the Federal Reserve insist that deflation is a continuing decrease in the price level over time!
Evans goes on to express his comfort with the current levels of inflation by citing empirical research showing no correlation between higher oil prices and inflation. Even a casual examination of the current record of price increases demonstrates that oil’s price rise is just one small part of the general increase in prices percolating in the economy, especially where demand is strong and supply is compromised. Regardless, the conclusion of this research is intuitive given the numerous supply-related fluctuations in oil that have occurred with and without Fed monetary action. As we saw above, it is not likely that the increase in prices in any one part of the economy will produce the sustained increase in price levels required to signal inflation’s arrival. Without an increase in the money supply, increases in oil prices steal money from some other products in the consumer’s basket of goods. The net impact on official inflation statistics may be close to zero and “core” inflation, subtracting energy and food, could even decrease! But if increases in the money supply happen to coincide with a strengthening oil market, I contend we better look out.
The bias of the Federal Reserve toward inflation is also rooted in the concept that “a little inflation” is good for the economy because it encourages spending. Specifically, inflation encourages consumers to buy today to avoid paying higher costs tomorrow. In a deflationary environment, consumers just wait and wait and wait. Boudreaux and Roberts sharply criticize this theory and cite examples demonstrating the fallacy of such thinking. For example, with even a little inflation, why don’t sellers just wait until tomorrow to sell since they can make higher profits? Why do consumers buy computers and many other electronic goods knowing full well that prices will be lower tomorrow (not to mention these goods will be of higher quality)? Why was America’s post-Civil War economy so strong for almost 30 years despite persistent deflation? Clearly, buyers and sellers are motivated not just by relative prices, but also the relative value (or utility) gained from consumption and/or alternative investments.
I have covered the core concepts reviewed by Boudreaux and Roberts related to the philosophy and approach of “Inflation Watch.” If you want more detail, I highly recommend listening to the podcast, reviewing the transcript, and/or perusing some of the references provided by EconTalk. Hopefully, you have also gained a better understanding of Inflation Watch’s mission: “Watching for inflation here, there and everywhere.”
It is pretty amazing that China has experienced rapid growth without rate hikes for electricity, but such has been the case for two years. The resulting power shortages are getting dire according to “China Raises Power Prices as Shortages Loom“:
“China’s electricity demand is running so far ahead of supply that it is expected to be short of 30-40 gigawatts of power capacity this summer, twice the deficit caused in Japan by the earthquake and tsunami on March 11.”
China is hiking rates by 3% for some users in an apparent effort to cool demand and/or encourage the production of more supply. It is feared that increases in supply will only further drive up the price of coal and offset any profits power companies would have otherwise earned.
In “Back in the green: CEO pay jumps 13 per cent“, Globe and Mail reports that CEOs at Canada’s top 100 public companies received average pay raises of 13% in 2010. This comes on the heels of dismal pay performance in 2009 and 2010 where pay was essentially flat. 2010’s pay hikes is similar to the double-digit pay gains Canada’s CEO typically experienced before the recession.
The article includes an interesting discussion of “performance share units” which calibrates performance-based pay to the company’s relative performance to its peers. This method prevents pay hikes from general market forces that the CEO does not control, like the rising price of oil.
Ford (F) raised its average car price for a third time this year. The latest increase is extremely small, just $124. For all of 2011, CNCB reports that Ford has increased prices a total of 1.3%, or $375.
Ford is clearly reluctant to hike prices and is choosing to dribble them in the hopes they go essentially unnoticed by the average consumer.
Ford cited higher commodity prices for this latest increase.
It had to happen eventually…Japan’s core CPI finally experienced some year-over-year lift. In “Japan Core CPI Rises First Time Since 2008“, Reuters reports:
“Japan’s core consumer prices rose in April from a year earlier for the first time in more than two years as the impact of school tuition fees faded and commodity costs crept up, but underlying prices remained weak as the March earthquake hurt consumption…
…A government policy to subsidize school tuition fees is no longer distorting annual changes in prices, as more than a year has passed since the policy was introduced. The move was estimated to have pushed down overall prices by about 0.5 percent.”
OK. So this lift is not likely to last given the special adjustment, but it is a nice break from the regular drone of deflationary news. As I have stated before, I tend not to pay much attention to official government statistics on inflation, but this headline alone made me pause. The rest of the article summarizes the prospects for Japan’s post-disaster recovery economy.
J.M. Smucker (SJM) announced today that “sustained increases in green coffee costs” have forced the company to hike prices on many of its coffee brands:
“The J. M. Smucker Company…announced today that it increased the list price for the majority of its coffee products sold in the United States, primarily consisting of items sold under the Folgers®, Dunkin’ Donuts®, Millstone®, and Folgers® Gourmet Selections® brand names. Prices will increase an average of 11 percent on impacted items.”
This price hike motivated AP to run a story summarizing the state of the coffee industry and market and the experiences with soaring costs – see “Coffee drinkers keep chugging, as prices rise“. AP notes that SJM has increased coffee prices four times in the past year. SJM’s stock performance suggests this pricing power has contributed to a strong bottom line.
The pricers at AK Steel (AKS) are at it again. This time, the company announced price hikes for carbon steel products:
“Base prices will increase by $50 per ton for hot rolled and cold rolled carbon steel products, and by $60 per ton for coated carbon steel products.”
AKS is facing higher input costs for making steel. More importantly, the company is experiencing stronger demand for its carbon steel products.
Disclosure: author owns shares in AKS