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Inflation as best I understand it
Here is today's edition of the inflation chart that I compile,
and sometimes share, every month. You can see that we have a sharply
rising inflation rate and a long-term average of about 4%,
which is higher than policymakers intend.
Cutting to the main point, the current inflation is caused mainly by the
petroleum shortage from the war in Iran, and also, I think, by a large amount
of deficit spending.
We're going to have a lot of public discussion of inflation, which many people
misunderstand. I want to summarize what I know about it, as best I understand it,
and invite correction from people who know more economics.
Causes
Inflation has to do with how the supply of money compares to the supply of goods
and services. There are five basic causes of inflation (not just one, regardless
of whose book you read):
Some historic examples of these are:
Item (3) needs some thought. Borrowing increases the money supply.
To take an imaginary example, suppose our government only ever issued $100 in currency,
and you got hold of it and deposited it in a bank.
The bank could then lend $50 of it to someone else.
Now there are 150 dollars, even though only 100 were issued, because your savings account balance is $100 but the
other fellow has $50 in his pocket.
Borrowing always works that way, and that's why interest rates, which encourage or
discourage lending, are the main thing the Federal Reserve can use to affect the money
supply and thus the inflation rate.
One huge borrower is of course the federal government, with its deficit, but
business and consumer borrowing has the same effect.
Note that this can't be described as "the government printing money." All government
spending is financed by revenue or borrowing. And borrowing would increase the
money supply even if we were on the gold standard.
Item (4) is one people don't think about, but I think demand for money
(unwillingness to spend what you have) is a factor in inflation.
The more people are in a hurry to spend, the more easily prices can go up.
Item (5) deserves a section to itself.
Expecting and even benefiting from inflation
We may be entering a long period with inflation high enough that you can't ignore it in
everyday life. That's what the 1960s and 1970s were like.
Everybody took it for granted that prices would go up, and also (this is important)
that wages would gradually go up too.
People felt that they were advancing in their jobs
when in fact they were just riding along with inflation. Even poor performers got pay raises,
just not quite enough to keep up with inflation; it was a backhanded and painless way to get a pay cut.
Some economists felt that this was good for the job market because everybody felt they were
making progress, and everybody expected their salary to be readjusted every year, creating
worthwhile adjustments.
The big way my parents' generation benefited from inflation was by buying a house with a fixed
monthly payment and "growing into" the payment as their salaries rose with inflation.
Inflation makes a fixed payment easier and easier as you pay it with, so to speak, smaller dollars.
The problem with inflationary expectations is that they make it harder to bring inflation down.
Once people expect it and make plans for it, inflation becomes really entrenched, and long-term
plans, such as house purchases, can go wrong if the inflation isn't there!
Greedy shopkeepers?
Some people talk as if inflation were caused by sellers raising prices, and if you could
just stop them from doing that, inflation would go away. That is generally not the case.
The price of any particular item usually goes up because of increased costs spread widely through
the economy. If you impose price controls, you can seldom accomplish anything besides
creating shortages.
In particular, retailers have to cover replacement cost. When the hardware store sells
you a wrench, they don't just have to make a profit on what they paid for it. They have to
make a profit on the one they are ordering to put on their shelf in place of it.
I'm told that a couple of major British academic publishers almost went out of business in
the early 1970s because they were selling, e.g. for £2.00, books that had cost £0.75 to print,
but printing the next batch of the same book was going to cost £3.00 per copy due to
sharp inflation, and they should be selling it for £8 or so. In essence, their wealth was
stolen by a warehouse full of books priced at yesterday's prices. But I got some Oxford
Classical Texts for only a couple of dollars each...
Some, but not all, sellers are greedy, and some do engage in market-testing.
Here's an example.
A Kit Kat candy bar that used to cost me $0.79 at Wal-Mart (before COVID) seems to have risen
permanently to about $1.50 at Kroger (it may have been a loss leader at Wal-Mart).
But the other day, in the Home Depot next door to Kroger, I saw the same candy bar for $3.48,
which strikes me as outlandish. Maybe they were looking for "bigger fools" who would pay that
price without thinking; maybe people who could charge it to their employer while they were picking
up building materials; and maybe people who, using credit and debit cards, were just not paying
attention to the amount of money going out.
That last point is important. Be aware of prices even when paying with plastic.
In our cashless society, some people are insufficiently aware (maybe all of us are less aware)
of the amounts we are spending. In effect, we exert too little demand for money; we aren't
stingy enough. About twenty years ago, Starbucks Coffee got nicknamed "fourbucks" because its
clientele, early adopters of cashless payment, didn't seem to know how much cheaper coffee
could be elsewhere.
Inflation and unemployment
Attempts to control inflation, especially by reducing the money supply, tend to raise unemployment.
The reason is, "easy money," which spurs inflation, also spurs business growth.
The Federal Reserve System treads a fine line while trying to control inflation without causing
mass unemployment.
One detail that many people miss is that unemployment seldom goes much below 4% regardless of how strong
the economy is; some people are voluntarily between jobs.
During very prosperous times it has often been over 5%.
Right now, despite weakness in the economy, it is low, about 4.3%.
On the other hand, the unemployment rate does not measure underemployment,
in which people are in less productive jobs than they could be,
nor does it count "discouraged workers" who are off the market but would enter it if their
opportunities were better.
When the cause of inflation isn't primarily the money supply — such as when it's a petroleum
shortage, or reduced production during COVID — then the only real cure is to remove, or get past,
the actual problem rather than manipulate something else to compensate for it.
Otherwise you're operating on the wrong part of the body, so to speak.
What should the inflation rate be?
You've probably heard that policymakers aim for an inflation rate of about 2% to 2.5%.
Why not zero?
Mainly because, if they aimed for 0%, a slight recession would put us into deflation
(negative inflation, falling prices and wages across-the-board), which could cause real hardship.
Deflation is hard on anyone in debt because existing debts have to be paid in scarcer dollars.
It is hard on retailers because the selling price of the merchandise on their shelves drops
below what they've already spent on it.
In short, we don't want deflation, and the only way to stay out of it is to tolerate a little inflation.
See Bernanke, Inflation Targeting.
Another argument is that our measure of inflation, the Consumer Price Index, probably reads high
because people adjust their lifestyle in response to price changes, so 2% CPI inflation may be very
close to zero inflation in real cost of living.
What's an ordinary American to do?
It's not within the ordinary American's power to reopen the Strait of Hormuz, but when we vote,
we do influence inflation.
A serious problem is that politicians don't understand their own proposals and policies;
constituents enthusiastically vote for things that can't work.
Another is that elected officials don't do what they said they'd do.
As voters, we need to understand that
economics is complicated, and policymakers need to be experts or get expert advice.
Wishes and promises don't necessarily make things happen.
I have another political concern right now:
Heavy-handed efforts to force a change in the economy almost always backfire.
When people become too frustrated (or unduly alarmed), they may demand bad policy
just because they don't understand how bad it is.
How do we live with inflation? Several ways:
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