The Great Inflation Debate: Back To Basics
The June number for the consumer price index in the United States showing a jump of 0.9% month-on-month (in seasonally-adjusted non-annualised terms) and 5.4% year-on-year has added even more fuel to the great inflation debate fire. Surely, the inflation genie is out of the bottle. Not so fast. Going back to inflation basics would suggest otherwise.
In much of the debate, inflation and relative price changes are being conflated. Inflation has to do with the purchasing power of money and movement in the overall price level, as measured by an index (weighted average) of the prices of a representative set of goods and services. Relative price changes, as the term suggests, are changes in the price of individual goods and services, or categories thereof, relative to one another. The two concepts, while linked, are very different.
In a decentralised market economy, the prices of individual goods and services, in absolute terms and therefore relative to one another, are in constant flux in response to changes in supply and demand. These price changes provide invaluable signals to firms about whether they should produce more or less of their output; they are the reason that products just happen to be on the shelf, or used cars in the lot, when consumers go shopping, without any central authority having to give instructions to that effect. We want unimpeded relative price changes so that resources can flow to where they are most needed and the market economy can function.
The inflation rate, on the other hand, has to do with preserving the purchasing power of money. We want that to be stable over time so that the amount of money it takes to purchase a representative basket of goods and services, the weighted average price of consumption, doesn’t increase too much or too fast. For a variety of technical and practical reasons, 2% is taken to be the right inflation rate in most developed economies, a little more in developing economies such as India (where it is 4% with a band of plus-or-minus 2 percentage points).
In principle, inflation and relative price changes are distinct matters. Inflation could be at target with all the necessary relative price changes taking place (the most desirable state of affairs). By the same token, it is possible for there to be no relative price changes but for inflation to deviate from target (imagine that all prices were rising by 10%, for instance).
In reality, relative price changes can and do impact the overall inflation rate. This is happening now. If something is a big enough component in the consumer (or other) price index basket and its (absolute and therefore relative) price moves enough, inflation will be pushed away from target. Case in point: there is a temporary shortage of new cars in the U.S., which is causing a surge in demand for used cars; the price of used cars and trucks in the U.S. in June rose by 10.5% month-on-month (non-annualised) or 45.2% year-on-year, which is one of the reasons headline inflation shot up.
Central bankers, sensibly, ‘look through’ such spikes in inflation because they can be expected to be self-correcting: the best cure for temporary high prices of individual goods and services is high prices. When supply and demand adjust and used car prices in the U.S. fall, as is sure to happen in the coming months, this will be a factor pushing inflation down.
It is not high prices that cause inflation but continuously increasing prices.
For the break-out inflation to happen that some commentators are warning about two things need to happen, and these are the things that inflation-wary investors and others need to focus on.
First, the economy needs to be at or close to full employment or overheating. When an economy hits full employment and demand continues to press up against supply, the absolute price rises that send the necessary signals through the economy to attract more resources hit a roadblock and start to spill over into a generalised rise in prices, that is, inflation.
The U.S. and other Covid-impacted economies are still quite a ways from hitting an overall supply constraint. Real GDP in the U.S. in Q1 was 0.9% below its Q4 2019 level; it was 2.0% below in Japan, 4.9% below in the Euro Area, and 8.8% below in the United Kingdom. The broader (U6) measure of un-/under-employment in the U.S. was 9.8% in June, three percentage points above its pre-Covid trough, when inflation was running a bit below the Fed’s target.
The second, and more important, thing necessary for inflation to get out of hand is for central banks to let it. That is a higher mountain for inflation worrywarts to scale. The working hypothesis of modern monetary policymaking is that future inflation is driven by the inflation expectations of the public and that the central bank can control the inflation rate (over the medium term, with some “noise”) by “anchoring” the public’s inflation expectations at its target inflation rate. That requires the central bank, hopefully with some help from the fiscal authorities, to take the necessary steps to defend its inflation target from below, when circumstances require it, as well as from above, when circumstances require that.
Nothing that the U.S. Federal Reserve or other central banks are doing currently suggests they have departed from this playbook. Ten-year Treasury yields comfortably below 2% and inflation breakeven measures hardly flashing red would suggest most market participants agree. The main future uncertainty is not whether inflation will permanently break out on the upside – that’s very unlikely – but how aggressively central banks will have to tighten monetary policy to ensure that doesn’t happen (by hiking rates and shrinking their balance sheets) and how soon they will have to start.
Paul Sheard is a research fellow at Harvard Kennedy School and former chief economist at S&P Global, Nomura Securities, and Lehman Brothers.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.