There are persuasive reasons why we’d be better off today with an inflation rate higher than what we’ve seen over the last six months. But while a uniform expansion that raised all wages and prices by the same amount would be helpful, what the Fed could actually achieve in the present situation may be something less desirable.
When academic economists talk about inflation, we often think in terms of a single-good economy in which the concept refers unambiguously to an increase in the dollar price of that good. But in the real world, in any given month some prices rise and others fall, and we can only measure inflation in terms of the broad central tendency behind those individual price changes.
A recent research paper by Columbia Professor Ricardo Reis and Princeton Professor Mark Watson suggests that real-world measured inflation may behave very little like the textbook ideal. Reis and Watson introduce the hypothetical concept of a pure inflation shock as something that changes every price by x(t) percent, where in any given quarter t the magnitude x(t) is the same number for every item in the economy. Reis and Watson show how such a shock can be measured for any given quarter by observing the behavior of separate components of the PCE deflator. Their principal finding is that this concept of pure inflation in fact plays very little role in quarterly changes in broad price indexes such as the GDP deflator or the consumer price index, accounting for only 15-20% of measured inflation. The authors instead find that changes in relative prices are much more important than pure inflation for determining what happens to the broad CPI. For example, the measured deflation over the last 6 months is heavily influenced by falling energy prices.
If you think that the Federal Reserve is responsible for more than 15-20% of the variation in the CPI, the implication is that part of its influence comes from changes it causes in relative prices. But changes in relative prices– such as the huge run-up in energy prices in the first half of 2008– can be much more destabilizing than the textbook pure inflation.
I would therefore think that the Fed might be somewhat concerned by the surge in commodity prices over the last few weeks. The graph below plots the prices of 11 commodities since the Fed’s announcement of quantitative targets on March 18. Gold is the only one of these commodities that hasn’t gone up in price, with the average of these commodities up 13% over the last two months.
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Some increase in relative commodity prices is certainly to be expected if we are indeed about to see a recovery in real economic activity. But this is a trend the Fed needs to watch closely from here, and could prove to be a significant limiting factor on how much the Fed can hope to achieve from monetary stimulus.
Because I for one do not think it’s a good idea to call for a replay of the 2008:H1 commodity market show.
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More reading assignments, but before I do.
I would speculate that it takes a small series of commodity price shocks, each less severe than the previous, before the economy can stabilize its estimate of prices. It is as if the household is successively trying more accurate allocations of purchases after a change in the consumption model, each time the adjustment occurs, the distribution of prices for household necessities becomes ever more smooth and bell shaped. A predictive filter learning process.
Prof. Hamilton,
Generally, I’ve found your posts to be easy to understand for anyone with a decent math background. Unfortunately, I don’t have any formal economics education in my background so I’m a bit out of my depth here but…
One thing that seems to be omitted in the inflation/deflation debate going on is the net effect of the employment situation. It is pretty easy to understand the basic monetary inflation idea but most articles and opinions I’ve read neglect demand destruction due to the labor market and the implications for product price deflation.
Is this a true “stagflation” situation? The wage half of the inflationary spiral doesn’t kick in? What could ultimately happen to prices (commodity, consumer prods, etc.) further down the road in that environment?
We should all have figured this out years ago. The Fed implements an inflationary policy by changing the price of credit, which implies greater demand for interest-sensitive goods (houses, cars, capital equipment) relative to other goods (non-durables, services).
And old truht already well known by the austrian school.
The amount of “new money” is as relevant as the channel of injection (credit boom, expansion of public spending, devaluation etc)
The image of the helicopter has made a great lot of damage to modern economics.
These rising prices threaten to dampen the recovery, and turn a solid recovery into a tepid one.
Is there any reasons to believe that the prices on March 17 are “right?” One could argue that commodity prices overshot to the downside in the second half of 2008 and are now correcting to a new level based on the current level of consumption. Also the graph leaves out the increase in commodity prices prior to March 17, although you could argue that the market was anticipating the Fed’s decision.
I agree that commodity prices need watching but I am less convinced that the increase in commodity pricing has any thing to do with Federal Reserve easing of policy. Indications are it is the easing of loan policy by Chinese banks, which occurred earlier in the year, rather than additional dollar liquidity that is driving commodity prices.
Good points. The inflation that the Fed wants is a general rise in wages so that debt burden can be reduced. However there is little evidence that would happen. A rise in commodity price would be deflationary outside of the primary producer sector like the surge in oil price was.
So, “pure”, monetary inflation *only* accounts for 15%-20% of measured inflation in the US since 1959?
That is 15%-20% more than it ought to be with good monetary policy. Central banks ought not be conducting experiments to test the quantity theory empirically.
I bet it’s well above 90% in Zimbabwe.
@Rajesh
FRB actions have everything to do with commodity pricing. Don’t be offended by this, but it seems clear that cursory glance at any historical commodity chart (gold being an exception because of it’s dual nature as currency/commodity) would prove the notion.
Please check the following crude oil chart from 1971 to present http://www.chartsrus.com/chart1.php?image=http://www.sharelynx.com/chartstemp/free/chartind1CRUvoi.php?ticker=FUTCL
Crude didn’t respond to significantly until FRB interest rates were in ZIRP mode. Greenspan essentially opened this door for Ben and Ben has pursued that policy in an attempt to prevent deflation.
If you want to note something especially interesting, commodity prices didn’t respond as much to FOREX either (historically as compared to the last 5 years).
To answer the question were prices right? No they should be lower to align with reduced demand levels, credit availability and inventory; but they were becoming more aligned with the reality of the macro situation. QE offsets reality temporarily, but is largely limited to a specific time frame (at some point the presses will stop).
If you read Bens paper from 2002 (or was it 2000?) about battling deflation you can see it’s really been a play by play as per his paper. However I think what has happened that he didn’t count on is the marketplaces reaction to QE, which was essentially calling his bluff of printing ad nauseum. Also I think he found out there is a lot of public resistance to printing ad nauseum as well and the govt doesn’t tolerate it much either (politicians hate to see spending if they aren’t a part of it). The current crisis is amplified by the fact that the yeild curve is steeper, initially it helps banks get better ROI, but as it continues if the job market doesn’t get better it will wreck havoc on option ARM home homeowners and their balance sheets, CRE and C&D loans.
JDH: “The authors instead find that changes in relative prices are much more important than pure inflation for determining what happens to the broad CPI.”
Would it be wrong to conclude that this has rather profound implications for thinking about sticky prices?
I would guess a significant amount of the rise in commodity prices (esp. copper)results from Chinese demand which I don’t think will be sustained.
This climbing will happen in zig zag way, so real average inflation will be edging up rather slowly- slower than graphs indicate, defintely. Oil index 120 would become stable average infaltion vs. March may be in end of summer.
Why? Because people are scared to invest, and even greed will not be enough to pump money in commodities anymore. May be this intial peak will remain the sharpest one, with growth rate 20% over 1 month period.
Thanks a lot for posting this, it is a topic of dinner conversation; are oil prices high enoug now to cause the economy to fall off a cliff again?
I can disagree with some of this. First of all, inflation is a money supply/velocity issue, particularly the inflationary runup to the recent crisis. Velocity is the entire Raison d’etre of and for structured finance. It takes a lot of financial horsepower to inflate the prices of takeover targets or millions of tract houses in Nowheresville, USA.
Second, while energy prices are relatively low in contrast to last summer’s peak, historically they are otherwise very high – this is from IEA data and also EIA. Far from being inflationary the consequence of these high prices is accelerated instability in every sector of the economy as a whole. This instability as it has manifested itself over the past sixteen months or so has proven to be highly deflationary.
Current deflation is from the collapse in credit creation. Said glibly, there are few willing lend into instability. There is Declining asset values which undermine collateral. Credit derived thereby is diminished, leading to … you know what. America is experiencing Margin Call Deflation.
As for the Fed being concerned about input prices; in a credit expansion, the effect of high prices would appear to be inflationary as if there are more dollars chasiing a relatively shrinking pool of goods – or commodities. This is not the case, now … UNLESS, the liquidity is leaking out of the infamous ‘liquidity trap’ and seeping into commodities masquerading as ‘Assets’. The outcome here wlll be unaffordable commodity derived goods and services leading to more business failures as their products are priced into unaffordability.
In today’s deflationary environment, the consequence of high prices isn’t borrowing more but cash reallocation and the return of marginal utility with an attitude that is mad, bad and dangerous to know.
Bottom line: the collapse so far has a large fuel price component – on the upside. The economy is in the oil price danger zone now and there is nothing the Fed or anyone else can do about it.
I’ve noticed that here in SE Michigan, food prices seem very high. Even Ramen is double what I remember from undergrad, less than 10 years ago.
Prof wrote: “There are persuasive reasons why we’d be better off today with an inflation rate higher than what we’ve seen over the last six months. But while a uniform expansion that raised all wages and prices by the same amount would be helpful…”
Does this statement hold if all those who save money in a bank, or all those who have contracts (or IOUs) also had an anti-inflation clause (e.g. banks had to pay, interest rate + CPI, debtors had to pay x% + CPI)? Aren’t you arguing for a transfer of wealth from those who save to those who have debt with the above?
Mr Hamilton,
Dont this evidence from Reis & Stock helps the cost-push view of inflation, i.e. inflation as a non-monetary fenomenon?
Perhaps JPKEs contributors will start citing this paper…
JDH: If you start that graph at January, the price increases in commodities look even more striking. If you start the graph at July 2008, prices look like they’ve bounced off a floor after falling off a steep cliff. Question: do you think commodity price increases in the beginning of 2009, after precipitous declines in 2008, contribute strong inflation pressure?
October 2nd: The Problem with Inflation Right Now
JDH wrote:
There are persuasive reasons why we’d be better off today with an inflation rate higher than what we’ve seen over the last six months.
Because I for one do not think it’s a good idea to call for a replay of the 2008:H1 commodity market show.
Professor,
Thanks for the post. I have not heard anyone else discuss any analysis of commodities. By the time it comes to the attention of the mainstream economics pundits it will be old news.
I do not know if you see the connection between your opening sentence and your closing sentence. The use of aggregate accounting does not drill down to the level necessary to see the implication.
Cantillon writing in the early 1700 observed that when money enters an economy it does not enter evenly. Conditions in the economy will direct new injections of liquidity to certain segments of the economy and because of the complexity of economic events this distribution cannot precisely be determined. For this reason aggregate analysis of the inflaton rate such as the CPI will give very distorted readings of inflation depending on the basket of goods chosen and their weighting (ammong other reasons).
One general observation can be made. When liquidity is injected it will first effect interest sensitive and higher level factors of production (commodities) only later becoming manifest in consumption goods. Since most measures of inflation such as the CPI are weighted more heavily toward measuring consumption, when inflation is finally manifest in the indexes the inflation has been roaring for some time.
While you may not wish for a repeat of the commodity market show of 2008 it is highly probable that the pattern will repeat itself. It is doubtful that the liquidity injections will create another real estate bubble but it is probable that some bubble will arise as – or before – inflation is manifest. Since credit and government interventions have altered the conditions in the economy so significantly, it is very difficult to forecast where the liquidity impact will first become manifest other than to watch commodities.
Based on this I would say that your commodity numbers do seem to imply that liquidity is beginning to flow from the banks into the production cycle. I believe that right now with so much liquidity resting in such things as bank reserves that FED actions will have little impact on measures of inflation.
If congress does implement pro-growth policies the liquidity could be absorbed by the growth, but if taxes are raised and congress and the regulatory agencies force wedges into the production cycle the dollar could rapidly decline bringing on another bout of inflation and an oil price spike, not to mention another market decline.
It’s also interesting that oil prices have been able to rise despite enormous inventories. The storage at Cushing is full and there are tankers floating in the gulf that are full. Natural gas prices even rose pretty dramatically last week and that is in the face of significant new discoveries in Louisiana. Is the commodity market anticipating a surge in demand or responding to monetary conditions?
I would also note that while the dollar/commodity relationship broke down during the crisis, the inverse correlation seems to be reasserting itself. The dollar took a big hit right after the QE announcement, rallied, is now rolling over again and making a new low for the move.
We are not yet at the trough of the cycle, and we are already fretting about oil prices. And not without reason.
My take on the situation: http://www.aspousa.org/index.php/2009/05/peak-oil-not-speculation/
The earlier recovery of oil from $35 to $50 was a result of aggressive production cuts by the Saudis and other Arab producers. The recent rise to near $60 was speculation in the futures markets, which given the high inventories seems impossible to sustain.
When academic economists talk about inflation, we often think in terms of a single-good economy in which the concept refers unambiguously to an increase in the dollar price of that good.
I could two goods in that situation. Guess what the second is.
Oops. Make that:
When academic economists talk about inflation, we often think in terms of a single-good economy in which the concept refers unambiguously to an increase in the dollar price of that good.
I count two goods in that situation. Guess what the second is.
While you may not wish for a repeat of the commodity market show of 2008 it is highly probable that the pattern will repeat itself. -DickF
I generally agree. The expectation is for GDP to turn positive later this year, and I think it will primarily due to fiscal stimulus (lower payroll taxes, SS boost, etc.) and mortgage refis (increased discretionary income) propping up demand. Thus, many people are looking at commodities to invest in (again), and I think they are going to get burnt (again) because people are too loaded with debt and we are still shedding jobs and hours. So the demand is going to leak away faster than the government can prop it up. But, I wouldn’t be surprised that we get another bubble going mid year and it pops again, and another shock hits the economy and sends GDP tumbling in the fall/winter.
Jim,
Good subject matter.
I know that you’re aware of what I’m about to say, but it probably needs to be stated based on some of the narrow comments on this thread. There is not much of an international focus in this discussion.
Any meaningful analysis of commodities should be performed based on global demand and supply. A failure to do so misses the big picture. Granted, it takes some work but it still must be done if the discussion or presentation is to have any significant meaning.
Each of the key commodities should be analyzed based on existing as well as projected demand relative to available supply. There are indications that the supply of various commodities is down considerably and that lead times to bring back available supply necessary to support anticipated growing demand will be very long, say 12-18 months at a minimum for certain commodities.
Moreover, a proper analysis should take into consideration the principal investors in the various commodities markets. The econ blogs and some in the news media have essentially ignored this consideration as commodities have rallied. (link below)
Is speculation driving the surge in commodities prices? Mostly likely. Is the speculation justified? That depends on how far one takes his or her thinking. There are significant supply shortages in various commodities at this time that will not cover anticipated demand growth in the near term. Aside from the known and anticipated supply shortages, there is ever reason to expect that the principal commodity investors are very much in need of restoring profits to their investment plans. Therefore, shifting to commodities on the way up makes sense.
The problems of supply of various commodities are quite significant should demand surge within the next year. Supply delivery recovery will take time. Demand growth may not be strong enough to justify the commodity price runup, but that probably won’t prevent investors from seeking the higher returns offered in commoditiy prices as the rally continues.
I expect, though, that the general rally in commodities prices will be excessive and that the likelihood of a double dip recession is now growing.
Here’s an example of a commodity supply problem:
http://economictimes.indiatimes.com/Features/Investors-Guide/Falling-supplies-push-sugar-prices-up/articleshow/4507941.cms
Who are the principal commodity investors? Here’s an overview:
http://www.thepeninsulaqatar.com/Display_news.asp?section=Business_News&subsection=market+news&month=May2009&file=Business_News2009051064814.xml
Mr. Sparkle: It’s too early to call this “stagflation”; (see also observations by sjp at 7:02 a.m. below). I simply raise this at the present time as a development worth watching.
Robert Bell: The result that I summarized could indeed be attributed to sticky prices (i.e., some goods prices respond more slowly than others). However, the paper also looks at correlations at different frequencies with a pretty similar conclusion.
Rob: Yes, unanticipated deflation represents a transfer from debtors to creditors, and I regard such transfer as counterproductive in the current environment. In addition, I think there are a number of problems for the Fed and everybody else to operate with nominal Tbill rates near the zero floor. Historically, deflationary episodes have proven less than desirable for the creditor class (e.g., U.S. in 1930s, Japan in 1990s). I do not think it is in the interests of those with wealth to repeat those experiences.
I second the anonymous post that the Austrian school of economics explains this well. It emphasizes that the macroeconomic tendency to higher prices plays out differently by industry (and, indeed, by company), and so also plays out differently in time.
Garrison’s “Time and Money” explains it very well.
For those of you more familiar with finance than economics, you might analogize to alpha and beta in descriptions of what drives stock prices.
Max
Since both the US economy and the global enconomy are currently experiencing structural changes, we can’t very well expect prices to follow some easily recognizable pattern of coordinated changes (or “inflation”). Instead we are seeing, and will continue to see, various rates of price increase in various kinds of commodities, as well as in consumer goods and eventually even in wages. This last will signal that “normal,” self-sustaining inflation has begun.
I just had a general question on inflation unrelated to this post and was hoping someone could help me out.
I was reading an article in the New York Times called “Inflation Nation” (http://www.nytimes.com/2009/05/04/opinion/04meltzer.html?emc=eta1) and in it the author expresses concern about the growing risk of inflation. Towards the end he talks about how Obama’s policies don’t increase productivity and how slow productivity and slow growth will lead to inflation. The author, Allan Meltzer, writes that, “All these actions can slow productive investment and the economys underlying growth rate, which, in turn, increases the inflation rate.”
My question is I can’t fully understand why policies that slow down productivity and growth would be inflationary? If someone could help me out with this that would be very much appreciated, thanks.
Qayam,
Think in terms of growth. As growth increases production increases and the ratio of goods to money shifts more to the goods side. This implies a fall in prices.
You can see this in a real way by looking at Reagan’s tax cuts. Many give Volker credit for bringing down inflation because he reduced the money supply, but actually his actions caused the recession of ’81-2. It was not until Reagan’s tax cuts began to increase production and growth that the currency began to recover from the chronic inflation of the 1970s.
Similarly when the economy slows the supply of goods is reduced in the overall economy. You have the same fixed manufacturing base competing for a smaller supply of factors of production and profit margins get squeezed. Prices are increased in an attempt to recover lost profit as well as the smaller supply of goods being bid for with the same supply of money.
The main reason this is confusing is that you have been taught by the economic pundits that consumption is the key and they totally ignore production of the goods needed by society.
Remember that inflation and deflation are monetary events while expansion and contraction are fiscal events.
Perhaps the Fed is signaling caution by not becoming more aggressive with quantitative easing considering rates rising.
The money being printed to finance the purchase of agency MBS is the most obvious stimulus to inflation down the road.
But isn’t it jumping the gun to presume this move in commodity prices signals out of control inflation ? I mean, if you look at some perspective, we just crashed. Same for equities. Everyone is trying to outclever everyone else, saying equities have come too far too fast (some 30%+), but last time I checked, the S&P moved from 1200+ to the present levels in a handful (count 7 or so) of trading days in late September and early October. It took the bond markets another two months to agree that this was deflation (when long bond launched to 2.5% in late December). Then those markets too changed their mind, with everyone again “outclevering” eachother calling yet another “bubble” in bonds.
The Fed doesn’t enforce the money multiplier must be at a certain level, only sets its maximum. That is where all of the confusion comes from. We just don’t know how much money is out there. All of the M3, MZM, etc. are trailing at best data. They don’t tell us what is happening on the margin with lending -right now-. That is the most important piece of money supply data out there.
On that thought, has anyone out there done work on quantifying what the effective money multiplier is in real time based on some aggregation of data from latest bank quarterly earnings, estimating real value of bank assets against capital and existing liabilities to determine the real money multiplier ?
This is something that one would assume the Fed would have developed.
Economic growth begets inflation, NOT induced-inflation begets economic growth!!! Stupid & wishful-thinking Ben!
Roy,
Economic growth begets inflation only if it is spurred by excessive money/credit growth. Natural economic growth inscreases the supply of goods & services available to buy relative to the $s chasing them & therefore tends to lower prices. (Observe pre-Fed America.)
Cudos to Anonymous & DickF for their comments.
Nice point. That’s why 2001 to 2003 inflation didn’t bother people. For the lower quintiles, prices were flat or falling. Inflation pretty much focused on luxury goods and affected upper quintiles. It was due to increased money supply and income inequality growing after 2003 (mostly after 2005). It was 2005, when gas prices began rising, that inflation kicked in for the broader population.
“Think in terms of growth. As growth increases production increases and the ratio of goods to money shifts more to the goods side. This implies a fall in prices.” says Anonymous
Sounds reasonable. So today we have a drop (at 6% annualized last look) in production, and we have a drop in prices. All over the place. Different circumstances, same result. At least the same result in price deflation.
I think it’s probably more complicated. Goods that have substitutes have difficulty in raising prices. Monopolies control markets, and can demand higher prices (think health care here, and to a significant degree, agriculture as well). Activities that are hard to change incur big switching costs and products supporting that activity can keep pricing higher than otherwise.
Commodities are industries with very high entry costs. A fair look at these industries don’t indicate competition so pricing reflects simple demand.
Big finance obviously is not a competitive market right now. Unless you consider low interest rate subsidies by Ben and Co. and FDIC insurance on loans by Sheila.
And if demand plunges, for whatever reason, prices will fall, as will production. Base commodity shortages are all over the place. In the long run, we run out of many things. In the mid-term we will effectively run out of petroleum. The next shortage will probably be food, which is actually a shortage of water.
We’re going to be running between no or slow growth for a signficant time period.
Basically, we’re screwed until people start producing more of these overpriced commodities.
Qayam,
The first answer you received is a “Reaganomics” answer. It is not necessary true. Supply-siders love to credit Reagans tax cuts with good results, but you may have noticed the lack of evidence for the claim that Volcker deserves no credit for any good news on productivity, while Reagan deserves all the credit.
The answer you got about inflation is correct, as far as it goes. On the assumption that “nominal” GDP continues to rise at a certain pace, regardless of what happens to productivity, then a fall in productivity is likely to produce inflation. It is not automatic. Meltzer is prone to resist expansionary policies. That’s just who he is. He is very smart and there is logic to what he says, but he left out a bunch of assumptions that, if made explicit, would have helped you understand his claim that slow productivity growth leads to inflation.
You can stop reading now, but here’s just a bit more. We can’t measure productivity growth directly, not in the sense that productivity growth means doing things better. What we can measure is inputs and outputs. So, when productivity growth slows as we measure it, we don’t know if it’s just noise or a real problem in getting new output-improving ideas into the economy. We might mistake a slower pace of productivity for a cyclical slowdown in growth. (Work hours grow faster than output => measured productivity falls.) Policy makers try to resist the cyclical slowdown through monetary and fiscal policy expansion. Uh oh, it was really a slowing in underlying improvements in our capacity to make stuff. Policy doesn’t work very well to boost growth, but it has to boost something. That something is prices.
I got through my first read of the paper, and I get the gist of how he derived his result. I need another two reads, but here I go.
The best way to understand the result is to think of the economy as a series of production chains, commodities going in the top of a chain and consumer goods emitted from the bottom.
The next part of the framework is to consider liquidity (money) as just another good at each level of the chain.
Now, each vertex in the chain seeks to adjust a finite vector of goods (including liquidity) such that the distribution of elasticities is smooth and bell shaped. This result is in conformance with Hayek’s minimization of transactions, and yields, at equilibrium, a Gaussian output of random noise. That is, there is no discernable bottlenecks at equilibrium, and the economies of scale yield maximum output for minimum input.
Given this framework we can hypothesize the effect of a positive productivity shock at some mid-point in the chain. The effect of better production methods in the middle of the chain is to pass elasticity down the chain to the consumer for a segment of goods; and pass inelasticity up the chain for a segment on inputs. Hence, initially, up the chain there is a distortion in the distribution of elasticities, and a complementary distortion down the chain. These distortions must be equilibriated out of the system over time, and during each step of equilibriation the distribution of elasticities at each vertex vibrates.
Under this formulation, then, the authors discovered that liquidity makes up about 10-15% of the vector of elasticities. But, overall, there is no such thing as monetary inflation in the sense of Uncle Milt. There may be productivity shocks in the financial sector, but these shocks, like all other shocks simply travel up and down the system settling over time in complementary fashion. At equilibrium, regardless of the shock the system always reverts to the same distribution (or tries to) at each level of the system.
What we see as inflation at one level must always be counter balanced by deflation at another level.
Uncle Milt was getting to this theory with his plucking theorem.