On Inflation

You've seen the headlines. As the American economy reemerges from recession, politicos across the media are warning of dollar-printing madness, the ecstatic heights of naïve market optimism, and the looming debasement of the dollar. Some especially concerned pundits are calling this the beginning of the end for global dollar hegemony (something I've written about in a vastly different context).

Unfortunately, I can't tell you these fears are completely wrong. One vital flaw in the economics profession is it's knack for proliferating predictions which are retroactively parsed for accuracy, forcing those lacking clairvoyance to retreat to their respective theory-holes. What I can do, is demystify all this talk about inflation for you and maybe help you decide what you think about it. To the extent that economists' predictions only slightly beat statistical randomness, your prediction might seem prescient compared to Larry Summers' in a decade.

What People Say About Inflation

The story right now, as far as I can tell, is that Biden's agenda is causing too much money printing which is driving higher prices. That's pretty standard economic intuition. Most mainstream economists see inflation as a purely monetary phenomenon, meaning that money injection in excess of economic growth will increase the general price level. Sometimes called "Monetarism", this conception of the price level describes inflation (primarily) as a function of the money supply rather than of wages, input prices, or demand. 

I've described this equation before, but it is worth going over again. The commonly accepted relationship between money supply and prices (called the Fischer quantity theory of money) is as follows: 

M * V = P * T

Where M is the money supply, V is the velocity of money, P is the general price level, and T is the volume of transactions. All things being equal, when the left side of the equation goes up, the right side must go up to maintain the equivalence. Generally, money velocity and the volume of transactions are taken as constant. Hence, an increase of the money supply means an increase in the general price level.

The why of the equation is not immediately obvious without discussion. What this equation says, is that all dollars which exist (M) multiplied by the amount of times each dollar is used (V) must equal the total transactions in the economy (T) multiplied by the average price level (P). Or simply: the total money must equal the total goods and services. In the current case, many people are making the claim that there is too much money creation and that this money creation is going to cause runaway inflation.

What You Need to Know About Inflation

What is so often left out of the story of inflation, like other concepts from introductory economics, is nuance. Inflation is not one thing which mechanically functions upon one or two inputs. Inflation can be many things and can emerge from a multitude of underlying factors. Because it's complicated, there are a few notes I would like to make about inflation and why it might not be as drastic as you think.

It's Not as Bad as You Think

The first thing you need to know, is that inflation isn't always bad. In fact, inflation helps sustain economic growth. Over time, economies tend to become more productive as people invest savings into new technologies and capital goods. Higher productivity (generally) leads to lower prices as each good or service is produced for less cost than the one before. This can be a problem. As prices fall, people will defer their demand for goods, knowing that goods which they buy today will be more expensive than if they bought them tomorrow. To combat this "Paradox of Thrift", the Fed has to make cash a kind of "perishable good", like milk or eggs: something that must be used relatively quickly, once acquired. By slowly lowering the value of each dollar, the economy can continue to grow, increase in productivity, and maintain relative price stability in the long run. 

Since the 80s, when the Fed quashed inflation through incredibly high interest rates, the central bank has been trying to create more inflation. Typically, 2% inflation is the benchmark for a healthy economy and the US rate has been under that for some time. This new inflation is a breath of fresh air for the Fed- which is probably why it hasn't yet responded.

It Probably Isn't Hyperinflation

Runaway inflation is nasty. During a "hyperinflation" businesses and consumers are expecting higher prices. Hence, firms increase the selling prices of their goods and services while workers demand higher wages to compensate. These upward pressures typically occur during a recession and so the central bank prints money to encourage lending. This creates a cycle where the money supply increases and the general price level rises to meet it. At the same time, economic growth is not keeping pace with either increase, thus people become poorer in real terms.

Hyperinflation is an extreme example. The majority of inflation is transitory, meaning it usually resolves once underlying conditions are corrected. The Fed believes (as do I), that the current bout of inflation is transitory.

We can elucidate this point by using current inflation data.

For all of the bluster emanating from certain political figures, it is important to note that Core Inflation, a measure which omits volatile prices to generate a more realistic inflation rate, has only reached 3.8% as of May 2021. When compared to the last few months, this might seem like an extreme jump:

But if you compare it to the inflation of the 70s and 80s, it is barely a blip:

As you can see, inflation is not (currently) at extreme levels. Of course, its potential for extremity relies on it being temporary.

It's Probably Temporary

There are a handful of reasons to believe that the current inflation isn't here to stay: temporary supply bottlenecks, mixed consumer expectations, and a significant lack of worker power. Indeed, to understand how a particular phase of inflation behaves, it's important to understand its causes and how those causes might persist or diminish over time.

Our current bout is largely driven by the recovery from COVID-19. Resources which are used as inputs for final goods and services have become scarce as pent-up demand floods the economy. As we know, increases in demand and supply typically correspond with price increases. As mentioned, shortages are only exacerbating the problem. When there are too many firms seeking the necessary resources to meet higher levels of demand, there are shortages. Thus, many firms bid against one another to get limited resources and resource costs increase. In turn, firms charge higher prices to make up for their losses. 

However, these shortages are one reason the Fed believes inflation is transitory. As markets respond to higher demand, resources are produced more quickly, prices come down, and firms lower prices for final goods. In the US, this process has already begun.

Early on, a major driver of inflation was lumber. When things had just begun to reopen, lumber prices skyrocketed and prices at retailers like Home Depot rose. Now, lumber supply rigidities seem to be subsiding: 

As lumber becomes affordable, firms which use lumber inputs should decrease their prices. There will likely be a lag, as firms like Home Depot hold oligopolistic market power.

While supply bottlenecks can be temporary, inflation expectations can extend inflation beyond its material causes. If inflation expectations are high, firms will charge higher prices and workers will demand higher wages. So then, we must understand expectations to predict whether the resolution of bottlenecks will bring inflation down.

There are generally two ways to capture inflation expectations: survey data and market data. The first is just what it sounds like: what do people think inflation will look like in the future? The second is derived from market behavior: what does it look like markets think about inflation? Market dispositions are typically linked to Treasury Yields.

Currently, it seems that while more people say they are concerned about inflation, markets remain relatively optimistic. Indeed, bond prices have gone up, forcing yields down: indicating that the market believes inflation will subside. This may sound a bit confusing, but it is fairly straightforward: when inflation risk increases, bond yields will rise to compensate. When people buy more bonds, the price for said bonds increases in the present moment, forcing yields downward (think of a see-saw). Thus, declining yields indicate low inflation expectations. 

Of course, neither bond yields nor surveys are a perfect predictor for inflation. But, this nuance tells us that for all of the poltical posturing, the markets are pricing-in low inflation in the future.

The final reason one can reasonably expect transitory inflation is the lack of genuine worker power in the modern economy. A central component of inflation analysis is the upward pressure of wages when other prices begin to rise. This creates a cycle in which prices rise from higher labor costs, then wages to afford goods, then prices again, etc. 

However, to raise wages, workers must have the bargaining power to demand them. Unfortunatley, since the 1980s worker power and share in profits have declined steadily. This could dampen the inflation typically associated with tight labor markets. Indeed, as suggested by a report from VoxEU (a policy website regularly producing recommendations and research by economists), declining worker power could cause central banks to regularly undershoot their inflation targets. While this is bad news for workers, it indicates that runaway inflation is quite unlikely. 

Back to Basics

Earlier, I mentioned the quantity theory of money (QTM) or, M*V=P*T. And as I said, this is the predominant theory underlying many inflation predictions. But even this equivalence is more or less up for debate.

John Maynard Keynes was quite critical of the QTM. He claimed it relied on unrealistic assumptions. Namely, that the economy be at full employment. Indeed, according to Keynes, prices could only move as a function of the money suppply in the "special case" of full employment. Whereas in underemployment, the money supply would not shift prices, but output and employment. Put another way, unless the economy is operating at "full capacity", increases in the money supply will employ more people and increase output.

There are many other criticisms of the QTM, but I believe Keynes' is most illustrative here. Especially since the American economy has not operated under full employment for quite some time. In fact, a study by the Institute for New Economic Thinking (admittedly left-wing), seems to indicate that money supply growth (in the 47 observed countries) was rarely followed by inflation. This is by no means definitive, but it serves to further illustrate Keynes' point.

As I have often written on this blog, economic theory (especially as taught in econ 101) is only as useful as the data supporting it and the real-world experiences reflecting it. This is not to say that the QTM is defunct. On the contrary, it was an elegant discovery-- one still used to great effect today. What is important, is to understand its limitations. In the end then, we must be wary of simple models-- especially when they are robbed of their context.

A Final Note

This bout of inflation will not lead to catastrophy. And while it is always hard to predict the future, one can be nearly certain that America is not headed down the road of Zimbabwe, Weimar, or Venezuela.

What is important to remember is that no one pundit has the monopoly on truth. If the hyperbolic statements from political operatives are scaring you, make sure you understand why they are saying what they are. Many people are using the language of economics to scare you-- without any understanding of its underlying dynamics. They seek to undermine changes in our society which would make it more equitable, dynamic, and resilient. They wish to scare you, to deny even the most marginal improvement of the peoples' material conditions. 

Thus, now is not the time to be timid. If we indulge this scaremongering, we will lose a once-in-a-generation chance to reshape our economy and invest meaningfully in our future.