There is a debate in financial circles as to whether or not we even have inflation, and, if we do, should we even worry about it. As expected, the chief monetary and fiscal officers of the federal government deny that inflation is a problem or that their policies have anything to do with it. This was reaffirmed by Chairman Bernanke in his talk to The International Monetary Conference on June 7. St. Louis Federal Reserve Bank economists, Chen and Wen, in a recent paper1 using data from prior oil shocks, conclude that while such oil price shocks had significant “inflationary” impacts in the 1970s and in the early 1980s, today, rapidly rising oil prices appear “to have only transitory effects on headline inflation and virtually no impact on measures of underlying inflation”.
Much of the debate centers around semantics and the “meaning” of the word “inflation”. If you adopt one meaning, as Chen and Wen do, then inflation is not an issue. If you happen to believe that inflation in the U.S. is actually measured by the “core” CPI numbers reported by the Bureau of Labor Statistics (BLS), then you, like our government leaders, shouldn’t be concerned. However, despite the fact that Chen and Wen conclude that inflation is not a problem (at least relative to the price of oil), in a footnote there is an admission that their conclusions are based upon their definition of inflation. “Although the effect on inflation [of oil price shocks] is transitory, the effect on the price level is not, because inflation is defined as the rate of change in the price level, not the price level itself” [emphasis added]. An appropriate interpretation of this is that we can have high inflation in the sense of high permanent prices, but we shouldn’t worry about it because it will disappear as soon as the underlying cause disappears.
The Standard of Living Concept
On the other hand, if your definition of inflation is a concept that measures, not prices alone, but “standard of living”, then the rest of this blog may be relevant to you. Under the “standard of living” definition, the general price level can actually be falling but “inflation” can be an issue if incomes are falling faster than prices, and, thus, the standard of living is declining.
In his 1937 book, Seven Kinds of Inflation – and What to do About Them, Richard Skinner identifies four kinds of “absolute” inflations and three kinds of “relative” ones. Absolute inflations include:
1. Rising prices of fixed income securities
2. Rising prices of land, equity securities and business values
3. Rising short-term interest rates
4. Rising general prices and living costs.
Today’s definition of inflation as measured only by the CPI only captures item 4, but we all recognize items 1 and 2 and refer to these as “asset bubbles”. Relative inflations include:
5. Growth in debt compared to wealth
6. Growth in interest charges compared to income
7. Growth in living costs compared with income.
Everybody now recognizes that item 5 describes the last two decades, and it appears that, with rising costs of vital food and energy commodities, item 7 would appear to apply today. As debt costs rise, like those in Greece, we know that item 6 is also real. So, of the seven kinds of inflation described by this 1937 work, we easily recognize six of them. Of those six, two are commonly referred to as “asset bubbles” (items 1 and 2), and three are recognized as economic problems, but not categorized as inflation (items 5, 6 and 7). Only one, rising general prices and living costs (item 4) is, today, actually called “inflation”.
Who is Right?
As could be expected and briefly described above, the government (Geithner, Bernanke) is in the camp that denies that inflation is a real issue. They will defend this position as long as they have an argument that is even mildly credible. And there are a whole set of well respected economists who believe that inflation isn’t an issue to worry about. David Rosenberg (Gluskin Sheff), for example, believes that deflation is a bigger threat because of stagnant real incomes, high debt levels, and significant balance sheet issues for America’s consumers due to the real estate depression. On the other hand, there are those pro-inflationists who point to $4/gallon gasoline and rapidly rising food prices, which they blame on QE1 and QE2, as proof positive that inflation is rampant. So, who is right?
Actually, both are. Rosenberg’s “deflation” is a “standard of living” concept. One might categorize it as close to Skinner’s “relative” inflation concept (item 7 above – incomes not keeping up with prices), while the pro-inflationists are referring to one of Skinner’s “absolute” inflation concepts (item 4 above – rising general prices and living costs).
Cost-push inflation is the kind that some American’s may remember from the 1970s. Cost-push inflation is generally caused by input factor “shortages”, usually labor. These could be real shortages or contrived shortages. They are real if the economy is operating at full or near full employment. And the mild inflation we experienced in the early part of the last decade could possibly be attributed to such shortages. In the 1970s, they were contrived. At that time, unions were much stronger than today, and they could tie wage increases to an increase in the CPI measure. As companies raised prices to protect profit margins from increasing wages, another round of wage increases resulted. A vicious cycle had been created, one that could occur even when the economy was not operating with full employment. Thus, the term “stagflation” was born.
We clearly do not have this type of inflation today. First, unions represent a much smaller percentage of the employed labor force. And, the industries in which they are strong are all either struggling (e.g., autos, or government employees) or are highly cyclical (construction and transportation). Unions, today, do well just to hold wages and benefits at current nominal levels, and, most are making concessions.
The next type of inflation, asset bubbles, has little to do with capacity constraints or restricted production inputs. This generally occurs when a particular asset or class of assets begins to rise in price usually due to some basic economic change (innovation, government policy etc.), and early players in the bubble make “easy” money. A large swath of the public is attracted to the game and asset prices are bid up to a crescendo peak, with each player having little use for the asset itself except to “flip” it for a quick profit. Such bubbles always end in disaster for the late entrants, and oftentimes for those who weren’t even playing. The recent U.S. housing bubble and the dot.com bubble are two good examples. Some say that QE1 and QE2 has turned the current equity market into another such bubble. That remains to be seen.
Depreciation of the currency relative to other currencies is another significant source of inflation. This source could be significant for a country that imports a large amount of vital commodities and other goods and services. The U.S. falls into this category with large importations of oil and manufactured goods. The work of Raphael Auer2, another Fed economist (Dallas), indicates that because of the volume of Chinese imports and their resultant weight in American’s inflation indexes, the appreciation of the Yuan would “substantially alter the competitive environment on many U.S. markets and consequently lend to widespread inflationary dynamics”. Thus, as the dollar falls in value, the dollar cost of imported goods rises. And, since the dollar is the world’s reserve currency, and most international trade is done with dollar payments, dollar weakness is a significant source of inflation. With real wages stagnant and median household income down to 1997 levels in real terms, the increases in the prices of energy and imported manufactured goods have lowered the standard of living for most Americans.
In conclusion, “inflation” in the standard of living sense is clearly a problem today. Unlike cost-push inflation, this is not a self-feeding spiral. So, the statements of government officials, like Geithner and Bernanke, that proclaim that the “inflation” is “temporary”, are not exactly false, but they are misleading. This “temporary” inflation will end when the dollar stops falling in value. But, when will that happen? That will happen when the financial repression of interest rates and money printing by the Federal Reserve ends and a real solution to the structural fiscal deficit is crafted. Given the nature of politics in the U.S., those events may still be a long way off. Unless there is some international disaster that causes a run to the dollar as a safe haven (a phenomenon that appears to be getting weaker and weaker), the “temporary” time frame may be significantly longer than the rhetoric implies.
The price of gasoline can, and as of this writing, has moved downward from its $4/gallon level, due mainly to falling demand. But, because of dollar weakness, it is unlikely to fall to where it was a year ago. And, even if the dollar’s value stabilizes, all this means is that prices stop rising, not that they return to their lower levels. Clearly, without commensurate rises in wage and income levels, the standard of living will continue to fall.
It is a disservice to Americans to assure them that “inflation” is “temporary”, and therefore not a policy issue when there is ample evidence that the very policies of the government (money printing and uncontrollable deficit spending) are the root causes of the declining standard of living and are unlikely to be reversed anytime soon.
Robert Barone, Ph.D.
June 7, 2011
1Mingyu Chen and Yi Wen, Oil Price Shocks and Inflation Risk, Federal Reserve Bank of St. Louis, June, 2011.
2Raphael Auer, “Exchange Rate Pass-Through, Domestic Competition and Inflation: Evidence from the 2005/2008 Devaluation of the Renminbi”, Working Paper No. 8, Federal Reserve bank of Dallas, January, 2011.
Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC, Reno, NV, an SEC Registered Investment Advisor. He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).
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