Tag: anticipated inflation

Econ 101: Inflation –Temporary or Longer Lasting?

Prices of many goods and services have increased in recent months. Are these increases permanent or temporary or will they continue rising in the future? Before exploring those questions, it is important to understand the measures of inflation we are considering. What is the current rate of inflation in the United States? U.S. inflation in September was 3.0% (Compound annual rate of change for Consumer Price Index without food and energy prices over the month of September), or 4.0% (percent change from a year ago) or 5.4% (percent change from a year ago including food and energy prices). What does it mean if this is temporary or long lasting?

If prices remain where they are today after the 5.4% increase from a year ago, inflation going forward would be zero even though the cost of living would be permanently higher. If inflation is long lasting it means that prices will continue to rise for some time (years). What are the factors that influence the future behavior of prices? What should we expect in the U.S.?

The price of a good or service increases when its demand exceeds its supply and similarly for prices in general (when aggregate demand exceeds aggregate supply). As prices are measured in a country’s currency, supplying too much of the currency (generally when the money supply grows more rapidly than the supply of goods and services) causes its value to fall (i.e., prices in the country’s currency to rise).

On the cost side, firms will hire workers and pay them a particular wage (and related benefits) when it adds more to the company’s income than it costs, which includes the cost of the tools they use (capital). Workers will accept a job when its benefits (pecuniary and nonpecuniary) are the best they can find. The inflation expected by the employer and the employee over the period of the wage contract is an important factor in determining what will be offered and what will be accepted.

Because of changes in consumer demands, worker preferences, halving of work visas for immigrants, and supply chain disruptions, labor markets are temporarily in turmoil. September unemployment in the U.S. was 7.674 million while there were 10.4 million job vacancies. Employers are raising wages in an effort to fill those vacancies. As reported by Scott Lincicome: “Goldman Sachs analysts saw a ‘perfect storm of factors that have significantly reduced the supply of workers who are currently looking for jobs at the same time that labor demand—as measured by job openings—has risen to an all-time high.’ This includes… state and federal benefits, early retirements, severely restricted immigration, a switch to self-employment, fear of COVID, and a geographic mismatch between unemployed workers and available jobs. Combined, these factors account for most of the missing workers out there.”  “What if the labor shortage isn’t transitory?”

In short, the labor force has shrunk just as the demand for output is increasing. This excess demand for workers is driving up labor costs and thus pushing up output prices. If the 5 or 6 percent price increase experienced over the present year is expected to be temporary, i.e., if prices are expected to return to their level a year ago, because the supply of labor returns to its pre-pandemic level, wage increases should be temporary as well, falling back to their pre pandemic level and growing thereafter on average with labor productivity plus the 2% inflation target of the central bank once there is full employment and better labor market balance.

More likely, if the inflation is expected to be temporary, i.e., the current 5 to 6 percent inflation stops but prices remain at their increased level, wages will remain at the increased level, but their real (inflation adjusted) value will fall back to their original level. In other words, if these higher prices are expected to be “permanent,” the nominal wage increases now being experienced will not result in any increase in real wages and the worker short fall might remain.

While some of those who withdrew from the labor force will probably return, it is not likely to fully satisfy the demand for various reasons (early retirement, fall in immigration, etc.). Filling (or attempting to fill) the remaining labor shortage will require additional wage increases (unless the public’s demand for goods and services falls–see below). In that case, firms will plan to pass on their higher cost of labor to their customers. If we, the customers, can continue to pay the higher prices, the inflation will continue. Expectations of higher prices and or inflation will be realized.

The Covid-19 pandemic caused a sharp fall in output and thus to most people’s incomes. The government provided extraordinary financial support to temporarily fill the resulting income gap. Such support did not increase the output of goods and services or even prevent their decline but rather temporarily redistributed income from those saving it to avoid hunger and defaults on rents, mortgages, and other financial obligations by those who lost it.  “The new covid-19 support bill”  Because personal incomes were substantially maintained while actual output fell, personal savings rates increased dramatically and continue to be well above pre pandemic levels.

The Federal Reserve pitched in by buying up huge amounts of the resulting government debt increasing its balance sheet from $3.5 trillion in February 2020 to $6.3 trillion in August 2021 (measured by the monetary base, M0). This fueled an increase in board money (M3–M0 plus bank deposits and similar liquid assets of the public) from $15.5.0 trillion in February 2020 to $20.8 trillion in August 2021. This increase, though substantial, was significantly less than the increase in M0 (which almost doubled) because the Fed paid interest to banks for keeping the new base money with the Fed (excess reserves) rather than lending it to the public, by paying banks interest on all bank reserves kept with the central bank.

Historical experience is that the public will not be willing to hold these larger amounts of money for ever. They will eventually attempt to spend them down to their traditional (normal) levels, thus adding to aggregate demand for goods and services (and inflationary pressure).

Eventually, the demand for goods and services (aggregate demand) must fall to match real output, or output must rise to match demand. But if the Federal Reserve continues to print money faster than its real value is being inflated away, the inflationary process will continue or accelerate. Similarly, if the government continues to redistribute income from those with a lower propensity to consume (generally higher income families with a higher savings rate) to those with a higher propensity to consume (generally lower income families that save little), aggregate demand will remain excessive perpetuating inflation.

Historically, hyperinflation episodes invariably exploded in the collapse of the currency.  “Hyperinflation in Zimbabwe”  Turkey has come closest to a high inflation “equilibrium.” From the mid 1980s to the end of the 1990s Turkey’s inflation rate varied between 80 and a 120 percent. A high inflation “equilibrium” would be characterized by nominal interest rates and wage rates that fully incorporate the ongoing expected rate of inflation in order to preserve the appropriate real (inflation adjusted) rates. Interest rates in Turkey in this period generally exceeded 100%, as did wage growth.

In its most recent World Economic Outlook, the International Monetary Fund stated that: “In settings where inflation is rising amid still-subdued employment rates and risks of expectations de-anchoring are becoming concrete, monetary policy may need to be tightened to get ahead of price pressures, even if that delays the employment recovery.” “World Economic Outlook-October 2021”

As stands out clearly from the increasingly but unevenly rising inflation in the 1970, the process of increasing inflation is not linear (see the chart above).  As inflation increased, the Federal Reserve tightened monetary policy (raised interest rates to slow monetary growth) to slow inflation, causing real output to slow or decline. Policy then eased prematurely, and inflation and the expectation of higher inflation took off again, each time reaching a higher peak (until Paul Volcker stepped on the breaks and ended the game in 1979-80–the exciting year I worked at the Federal Reserve Board).

The Federal Reserve is smarter today than it was in the 1970s and has the tools to prevent the acceleration of inflation and the unhinging of inflation expectation. But the excess money balances and personal saving are very large and the government’s seeming willingness to run up unprecedented deficits create a powerful inflationary head wind. The tightening of monetary policy that will be needed (sooner rather than later in my view) will reduce the Fed’s purchases of Treasury debt and increase interest rates. Higher interest rates will increase government spending for debt service on its very large stock of debt, which will further increase government borrowing and debt or require cuts in spending for other programs. This must be added to the economic challenges of confronting climate change, the continuing recovery and adjustments from the Covid-19 pandemic, the deepening and destructive partisan divide that is stifling Congress, and the growing lack of public trust that drives it.

Whether our current inflation is temporary or longer lasting depends on how quickly and decisively the Federal Reserve tightens monetary policy and how quickly people go back to work. Whether the U.S. economy and the government’s large stock of debt continue to enjoy safe haven status around the world depends heavily on whether our government brings its spending and tax policies under better control.

Economics Lesson: Is deflation bad?

Fortunately the key insights about inflation or deflation are fairly intuitive and easy to understand. Stable prices—i.e., zero inflation—is best, fully anticipated inflation (or deflation) is second best, and inflation/deflation surprises are bad. If you would like a bit more detail, read on.

Inflation refers to the rate at which the value of money (average prices usually measure by a consumer price index—CPI) changes over time. Zero inflation, constant purchasing power of a currency over time in its local market (e.g. the value of the US dollar in the US), is best because all of the other factors impacting the supply and demand for individual goods that potentially change their prices relative to other goods and services can be expressed in terms of a constant unit account, a constant measuring rod. This makes comparing prices stated in that unit of account, especially over time, much easier. Imagine if the length or weight of something had to be expressed in units of weights and measure that themselves were always changing. Economic resources are better allocated to the satisfaction of public demand when the relative scarcity of each good and service can be clearly discerned. Decisions about the allocation of resources (whether to build a new factory to produce a new product or more of an old one and/or to hire more workers, etc.) are necessarily forward looking. The entrepreneurs’ question is what will people pay for something next year and the year after and what will it cost to produce it and how does this compare with producing something else. This is more difficult to do when the forecast of prices need to mix in the changing value of the currency in which they are stated.

However, a decent second best is a rate of inflation (positive or negative) that is steady and predictable. The inflation target of 2 percent chosen by many central banks, if reliably achieved, provides an example. If the inflation rate is fully and correctly anticipated, whether positive or negative, all other relative prices, including interest rates and wage contracts, can and will take the anticipated rate into account when setting prices in contracts for the future (e.g., a wage contract). If borrowers and lenders are willing to contract for a loan for five years at 3% per year with zero inflation in the value of the money borrowed and repaid, they would both be willing to undertake the same loan at 5% if they both expected inflation of 2% per year over those five years. If that expectation were rather uncertain, a suitable risk premium would need to be added to the interest rate. If everyone expected with certainty a 2% deflation over the same period, the loan would carry a 1% nominal rate. In both of these examples, the so-called real rate of interest—the rate adjusted for inflation—would be 3%. Thus, modest deflation does no harm if everyone fully and correctly anticipates it.

As an aside for the more advanced students, Milton Friedman explained why a fully anticipated, mild deflation was actually good because it would reduce or eliminate the opportunity cost of holding money and thus encourage people to hold larger cash balances on average without any cost to themselves or society. The money we hold in our wallets or nightstands or in our checking accounts at the bank is like any other inventory of goods that shop keepers keep on their shelves. Without an adequate inventory of what they sell, they would occasionally run out and miss some potential sales. But it cost money to hold an inventory of something. The cost can be measured by the interest you could have earned investing the money you spent to acquire the inventory (called “opportunity cost” by economists), plus any storage costs. Deflation reduces the opportunity cost of holding money by generating a real return from holding it (it is worth more in the future).

Unanticipated inflation, however, is bad because contracts written in dollar terms (so called “nominal” terms) will turn out to have a different real value than was expected. Normally a voluntary contract benefits both parties to it; it is win win. But when the inflation outcome was not anticipated, it will produce unexpected winners and losers. Debtors benefit from unanticipated inflation and creditors lose. More to the point in our current, over indebted environment, a deflation that was not anticipated when the money was borrowed, will increase the real value of the money that must be repaid. Lenders will benefit from the unexpected windfall only if borrowers actually repay their loans. But the unexpected increase in the real value of the debt being repaid may result in a larger number of defaults. So central banks are trying to avoid deflation, or more accurately are trying to achieve their inflation targets (generally 2%) in order to avoid making the economy’s excessive indebtedness even worse.

The above discussion concerns the value of a currency in its own country. But given the very extensive commerce across borders and the fact that most countries use their own currencies, cross border payments require exchanging one currency for the other. If the exchange rates of all currencies were fixed and never changed, the above analysis would apply globally as well. However, the exchange rates of many currencies, such as the USD/Euro rate, vary continuously and sometimes very significantly. The USD/Euro rate has fallen (i.e., the dollar has appreciated) 30% in the last 12 months (on April 9, 2015). This represents an enormous and very disruptive shock to the value of US trade with Europe, increasing the cost of our exports and reducing the cost of imports from Europe by very large, unpredicted amounts. Following the collapse of the gold standard, which fixed the exchange rates of most currencies, in the early 1970s, a costly financial market of insurance against exchange rate movements has developed. The total daily value of FX related transactions (spot, forwards, swaps, options) are estimated at around 4 trillion US dollars. Yes, that is daily and yes, that is trillions. These added costs of international trade would be eliminated if all or most countries returned to credibly fixed exchange rates or better still one globally used currency. The enormous gains in the standard of living from this trade could be extended even further.

The world is now “blessed” with a variety of monetary policy regimes. All of them aim in one way or another to deliver stable value for their currency either domestically or relative to another currency. The major industrial countries generally target inflation domestically and allow the exchange rates of their currency to float against other currencies. Many smaller countries fix or target the exchange rate of their currency to the US dollar or the Euro or the IMF’s Special Drawing Rights (SDR) thus causing the domestic values of their currencies to reflect the inflation rates of the currency to which they are fixed.

Two major reforms would establish a global monetary system with stable money (zero inflation). The first would be to change the IMF’s international reserve asset, the SDR, from a currency whose value is determined by a basket of key currencies (the USD, Euro, UK pound, and Japanese Yen) and allocated on the basis of political decisions, to a currency whose value is determined by a basket of real goods that is issued on the basis of market demand in accordance with currency board rules. These reforms are explained in more detail in earlier articles such as https://wcoats.wordpress.com/2010/01/21/the-u-s-dollar-and-the-sdr-as-international-reserve-currencies/ and https://wcoats.wordpress.com/2013/07/31/a-hard-anchor-for-the-dollar/. The above reforms in the SDR would include an international agreement to replace the US dollar and Euro in international pricing and payments with the reformed SDR, which I call the Real SDR.  http://works.bepress.com/warren_coats/25/

The second reform would follow naturally given the greater stability of the Real SDR. Countries would fix the exchange rate of their national currencies to the Real SDR or replace them all together with the Real SDR (the equivalent of dollarization). If all or most countries did this, the world would enjoy the benefits described above of a global currency with a completely predictable and stable value relative to a “typical household consumption basket” across the globe. It is worth fighting for.