Wednesday, January 26, 2011

Bernanke and Blinders: Making Distinctions Between Inflation and Relative Price Change

There were two articles in the Wall Street Journal on Monday about inflation. The articles raise many questions but central to them is the definition of inflation and what policymakers can do about it.
Most of us who are over 50 know what a colonoscopy is. Of course, we know it primarily from the user’s end – and by that you also know what I mean. But (and I do mean butt) most of us know very little about it from the doctor’s perspective. And while we might read the latest medical web sites, we really don’t have the training to understand all that is going on while we lay there on a cold bed with insufficient coverage of our precious parts.

Inflation is a word that most of us know. We feel the impact of inflation when our local grocer raises the price of bread and when a gallon of gas costs more than a double JD on the rocks. And we are constantly reminded about inflation since governments collect facts about price change and the press takes great glee in spreading the news each month. Then we hear that the Fed absolutely hates inflation almost as much as I hate anchovies and we feel somewhat relieved to know that Ben Bernanke and his colleagues are actively watching the numbers and are ready to attack like a head-butt in a Jets game.

Confusion may arise because inflation has two definitions. The first definition has to do with measurement. A price index is an average of prices. Some prices go up. Some prices go down. But the price index averages the ups and downs of all the items and calculates one number describing price change of all the items in the index. Food might be going up by 2% and horse shoes might be going down by 1%. The index doesn’t much care about individual changes because it averages them all together. Most price indexes are weighted – meaning they count some price changes more than others depending on how important the item is. We spend a lot more money on food than on horse shoes – so food prices are more heavily weighted or count more in the price index.

When we take into account all price changes in an index we get one number. For example, the consumer price index might be 202 this month. Perhaps it was 200 last month. So we would say that consumer prices rose by one percent (from 200 to 202). Or we would say that the inflation rate was 1% this month.
Okay – so the first definition of inflation is a measurement – it is the percentage change of a price index. This measure helps us to understand how far our income is going with respect to a particular basket or bundle of goods and services. Naturally when this measurement is high in a given time period, we don’t like it since it is telling us that our income is not stretching as far as it used to.

The big question is why this measurement of inflation matters for macro or for the Fed. So let’s wake up, do a few pushups, and move on to the second definition of inflation – macro inflation.

Recall that macro is about the national economy or the big picture. Macro is about aggregate supply and demand (If you don’t understand these concepts then I would suggest you go back and read all 60-something posts in my blog. Then you will be REALLY confused, give up, and go back to reading fun stuff.)
The Fed has no magic tool to impact the price of a specific single good or service. If food prices are misbehaving and causing the overall index to increase a lot, the Fed has no food price hammer to knock it back down. The Fed only has an aggregate demand hammer. Using traditional monetary policy to attack food prices would be notoriously inefficient since they would be using a macro tool that impacts ALL PRICES to whack away at food. The Fed’s tools are much better suited to times when the price index is rising because many or most of the items in the price index are rising (or falling) at excessive rates. This discussion gives us to ways to interpret a rise in the price index:

(1)   If it is being caused by only a small number of items, we call this RELATIVE PRICE CHANGE
(2)   If it is caused by many or most of the items rising, then we call that MACRO INFLATION

The hullabaloo in the papers recently is confusing because it is mostly screaming RELATIVE PRICE CHANGE and then wondering what the Fed is going to do about it. The Fed should, I believe, do nothing. Like a horse leading a carriage down a busy street, the Fed should be wearing blinders so it doesn’t get spooked by every little noise that signals a movement in prices.

So here is the fun part. While it is true that the Fed should not be tightening monetary policy because of recent changes in measured inflation – it should be tightening it because of other reasons. First, as the economy continues to improve banks will return to lending and spending and inflation will start to accelerate. Second, there is some risk that the Fed will wait too long to tighten the money supply and an inflation problem would be harder to douse once ingrained. Third, the combination of relative price change and a worry that the Fed will wait too long to address rising inflation can lead to a RISE IN INFLATIONARY EXPECTATIONS.  Fourth, a rise in inflationary expectations today causes behaviors that push up macro inflation today – as workers and other suppliers begin to press for their own wage and price increases. These behaviors are not only bad for inflation but they erode firm profits and could lead to a slowing of output and employment.

In summary – while current changes in the price index are not signaling higher macro inflation today there is, nevertheless, every reason to ask the Fed to immediately begin to lean against inflation. Without a quick return to a normal monetary policy we have the very real risk of a bout of stagflation similar to the kinds we experienced in the 1970s wherein both unemployment and inflation were rising. The only antidote was a virtual squashing of demand by the Fed late in the decade that sent interest rates above 20%. Let’s not go there again please. 

10 comments:

  1. Larry,
    No thanks! I take my colonoscopies with a large dose of the knock-out drug du jour and wake up refreshed and reamed....and blowing gallons of hot air.
    I actually understand the aggregate supply/demand concept and encourage you to read "The Seven Fat Years" to get a real appreciation of how we got smoked in the '70s by "stagflation" due to events which seem to be repeating themselves today. History tends to do that especially when we ignore it. Hey! That sounds like a good platitude. It just needs some polish.

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  2. Dear Crash,

    What is interesting about aging is that while I cannot remember the name of the restaurant where I ate lunch yesterday, I remember just about everything from the 1970s. And being an economist I was preoccupied then with how runaway policy-induced demand can cause incredible havoc. Yes, there is a good chance of that happening again and that's what makes this blog so much fun for me. It gives me a reason to live! :-) Thanks for the tip on the book!

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  3. http://news.yahoo.com/s/ap/20110129/ap_on_bi_ge/eu_davos_forum

    Whatever happened to Bretton Woods?

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  4. Crash,

    Bretton Woods is a place in New Hampshire. I assume it is still where it always has been. :-)

    The Breton Woods Agreement that established the Gold Exchange Standard ended mostly because the US could not uphold its end of the agreement -- wherein it promised to keep the dollar stable against gold. Our rising inflation in the 1960s led to Nixon closing the Gold Window in 1971. It shows that it doesn't really matter whether the world has fixed of flexible exchange rates -- poor macroeconomic management of a major country leads to negative spillover effects on the rest of the world. Focusing on exchange rate regime is a red herring. Focus should be on good policy.

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  5. Good policy and Washington DC are mutually exclusive terms.

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  6. Thanks Crash -- I should have defined my terms more carefully. By good policy I meant policy that is not actually stupid or totally useless when measured on any scale.

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  7. Bretton Woods. Wasn't that a '60s rock band?

    Gotta admit, mate. This thread is pretty slow.

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  8. Crash,

    I am working on the finishing touches of my next posting. It should be more fun than inflation! I guess we will see.

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  9. Just ran across this vid about how Obama is going to cut the budget to fight inflation, thought it was worth a click

    http://www.wimp.com/budgetcuts/

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