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.
Time for some comedic relief. On my main site “One-Twenty Two” I posted my own satirical commentary on the recent announcement from Attorney General Eric Holder about the formation of the Oil and Gas Fraud Working Group. This taskforce is supposed to ensure prices properly reflect “real” supply and demand factors from the marketplace. In my post, I ponder what the story would look like if Holder decided to go after the Federal Reserve’s role in generating higher oil and gas prices (mainly through killing the U.S. dollar). Click here to read it.
What’s a debate about inflation without more price hikes from a steel company?
AK Steel (AKS) announced additional surcharges today based on “…reported prices for raw materials and energy used to manufacture the products.” This announcement is one more small reminder of how commodity price pressures begin pushing their way through the supply chain:
“AK Steel…has advised its customers that a $390 per ton surcharge will be added to invoices for electrical steel products shipped in May 2011.”
Disclosure: author owns shares in AKS
CNBC’s Lori Ann LaRocco interviewed Diane Swonk, Chief Economist at Mesirow Financial, about the status of the economy.
Swonk noted that most of her clients are worried about inflation. However, she sees inflation as a two-sided coin. On one side, inflation is squeezing producers, but companies that deal with consumers cannot pass on price increases:
“I remind [my clients] of how little pass through inflation that we have experienced in the last decade.
When I ask them how much they have passed along to consumers and you see a fairly substantial break. There are those who can pass along some of the increase in costs if their clients are other businesses. Those who deal with consumers can’t pass along the increases as easily or are paying the price in volume if they do.”
Swonk also notes that rising oil prices will be destructive for all economies. In particular, higher oil prices will further increase food prices and magnify the suffering of poorer nations, leading to yet more social unrest.
Great piece from Fidelity considering the implications of the inflationary boom that seems to be driving stocks skyward (“Is this bull unstoppable? The key is how—and when—the Fed exits its historic stimulus program.”)
I highly recommend reading the article as it contains excellent charts showing the relationships amongst monetary policy, earnings, stock prices, and commodity prices.
Here are some key quotes:
“I believe it is becoming increasingly clear that stocks are following the playbook of an inflationary boom. The Institute for Supply Management’s (ISM) January 2011 manufacturing survey is the highest in years, earnings are strong, and now money supply growth is picking up steam. Ultimately, I fear this inflationary boom scenario may be followed by an inflationary bust (or stagflation), but perhaps that day is farther away than I have been anticipating.”
“Food and energy prices have moved sharply higher in recent months and appear to be trending higher rather than mean-reverting. If this remains the case, I believe the Fed could misstep by focusing on core inflation rather than the perhaps more relevant headline inflation. After all, for most of the world, food and energy inflation are critical matters.”
“How long can this go on before the “rubber band snaps,” either by commodities plunging in a deflationary crash (like in 2008) or the Fed being forced (by the bond market) to tighten and thereby undermine the recovery? Or what if the Fed does nothing and the dollar falls further and sends inflationary expectations skyward?”
Southwestern Electric Power Co. has won regulatory approval for two rate hikes for its Arkansas customers. SWEPCO said Wednesday that a base rate increase in December will raise residential bills by 5 percent, or $3.84 for a customer using 1,000 kilowatt hours per month. A second increase will go into effect upon completion next summer of a 508-megawatt, natural gas-fueled power plant in Shreveport, La. To help pay for the $386 million plant, Arkansas customers will see an increase of 4 1/4 percent, or $3.17 a month for 1,000 kilowatt users. Combined, SWEPCO customers will pay 9.41 percent more for electricity, or $7.01 per month for 1,000 kilowatt users. That comes to $84 per year.
“…it intends to permanently shut down its Delaware City refinery due to financial losses caused by very poor economic conditions, significant capital spending requirements and high operating costs.”
The company tried to avoid this shutdown for a year:
“‘The decision to permanently close the Delaware City refinery was a very difficult one,’ said Valero Chairman and CEO Bill Klesse. ‘We have spent the last year diligently trying to avoid this situation, and I have worked closely with Gov. Markell in an effort to find a different outcome. Earlier this fall, we shut down the gasifier and coking operations in an attempt to improve reliability and financial performance, but the refinery’s profitability did not improve enough. Additionally, we have sought a buyer for the refinery, but feasible opportunities have not materialized. At this point, we have exhausted all viable options.'”
While this action may signal lower gasoline prices in the short-term, the long-term implications could be very inflationary. Capacity destruction in energy and commodities typically sets the stage for future inflation. It was just a few years ago when refiners struggled to keep up with the demand for gasoline and the angst then was that America had not built a new oil refinery since around 1976! As the population continues to grow, as more trucks and cars hit the road, and gasoline demand begins to surge again, gasoline prices may surprise significantly to the upside, at least in the Northeast.
With crude oil prices rapidly approaching $80 per barrel, expect gasoline prices at the pump to increase. In fact, it’s already happening in some locations:
- “Gas prices up 4 cents in Texas”
- “Gas prices on the rise again” (New Orleans)
- “A big bump in gas prices” (Omaha)
- “Area gas prices increase 15 cents” (Lansing, Mich.)
- “Gas prices show 1st rise in 8 weeks”
From the Colorado Springs Independent:
Colorado Springs Utilities’ decade-old coal-hauling contracts expire next year, so it’s time to make a new deal. And the negotiations, which began recently, are sure to bring higher costs, says Utilities energy supply general manager Drew Rankin.
That’s because East Coast utilities have elbowed their way in at the same mines Colorado Springs buys from: Powder River Basin in Wyoming and mines in northwestern Colorado. Eastern utilities want the coal because it has a lower sulfur content and burns cleaner. That’s crucial as the government looks to force power generators to cut carbon dioxide pollution and to add expensive emissions control equipment.
The city projects that rail charges will increase by about a third by 2012, from around $10 per ton in 2008 to an estimated $15 per ton, or $30 million annually. The price of coal itself will go up even more, doubling from 2008 to 2012 to roughly $27 per ton, or $54 million a year, city forecasts show. The increases definitely will impact rates, although it’s too soon to estimate how significantly.
Small wonder, then, that coal companies’ shares are soaring.
In related news, see “Goldman Raises Iron Ore, Coking Coal Price Forecasts.”