Tuesday, March 5, 2013

Inflation, Unemployment, and Bonnie & Clyde

One of the most frequently discussed indicators of a country’s economic well being is inflation, yet I am finding that hardly any two people would agree on its definition much less its measurement. It is sort of like sex. Remember when a past US president said he did not have sex with that woman? Perhaps according to some definitions of sex he didn’t but we all knew he did something that sounded like sex. No matter how you define inflation – seems to me it is on its way but it is not too late to head it off at the pass.

Wikipedia uses the following words in a paragraph about inflation, “general rise in the level of prices of goods and services… erosion in the purchasing power of money… the loss of real value in the internal medium of exchange.”

In March of 2013 why should you care about inflation? For one thing, when the price level of goods and services is rising, you care. No one loves paying more for beer and pork rinds at the 7/11. But alas, beer and pork rinds are only a part of what I buy and who knows what you buy? That is, when prices of beer and pork rinds increase, the impact on you could be very different than the impact on me. And that gets us back to some seemingly innocuous words in the definition – “general price level.” In this case “general” is referring to someone but if your name isn’t General, then one wonders what that means. Another reason we care about inflation relates to policy. Our Fed and our government is telling us that since inflation is so low presently we ought to have a policy that stimulates spending enough so that inflation goes back to a more normal level. This policy of stimulation will have many impacts on us through its effects on prices, interest rates, employment and more. But I will get back to this second point below.

A general price level is something that you and I will never experience. That is because it is a mathematical expression or an equation. The general price level of goods and services averages together the prices that we pay for goods and services. A general price level for the USA then is based on some average person’s purchases. That “average person” is not me and it is not you. It is the average of me, you, Paul Krugman, Peter Wachtel and a lot of other people. So if you eat Peter Pan peanut butter seven times a day, then your own personal price level is going to be quite different from the general price level. If this month found that peanut butter prices fell by 20% you might be happy as a clam about your price level even while the nation’s price level was increasing and making most people frown.

To make things even more complicated, there is not just one general price level. There is a very broad national price level called the GDP Price Deflator that averages together the prices of all final goods and services bought by consumers, businesses, governments, the foreign sector, and inter-planetary travelers. It not only includes the prices of peanut butter, beer, and pork rinds, but also the steel purchased by manufacturing companies, and the tanks purchased by the defense department. A more popular and commonly used level of prices in the US is the consumer price index or the CPI.  But the CPI has several versions. One applies to urban consumers while a different one is focused on urban wage earners. Apparently urban workers and urban consumers do not buy the same things in the same proportions.   These are both called an “all items” index because they are measuring the prices of all the goods and services that urban consumers and/or workers buy. The list includes goods in the following categories: food, beverages, housing, apparel, transportation, medical care, recreation, education, communication, and others. Let’s agree – that’s a mountain of stuff being averaged together each month!

In December of 2012 the CPI all items index for urban consumers had a value of about 230. In December of 2011 its value was 226. Looking at this all items CPI index you would conclude that the general level of prices in the USA rose in 2012. From that one comparison you do not know which prices went up because the overall increase is a result of averaging together changes in the prices of food, beverages, housing, etc. If you use go to the Bureau of Labor Statistics Website (http://data.bls.gov/cgi-bin/surveymost?cu ) you will find a lot of data and you can try to figure out which of those categories of goods and services contributed most to the rise in the general level of prices.

It turns out that there are two categories of the all items index that are bad actors. These two categories are the Bonnie and Clyde components of price indexes. Food and Energy (F&E) misbehave frequently. They stay out late and then sleep it off in the morning. While the prices of all the other categories of goods and services typically rise and fall more or less together from month to month and year to year – F&E prices tend to leap around like jack rabbits. You just never know which direction they are going to move and by how much. Because F&E behave this way, they have to go to timeout. 

No just kidding but it is almost true. Because they behave so erratically we have another price index called the All Items Less F&E for All Urban Consumers.
You are frowning because you understand that removing F&E prices makes this index less comprehensive and representative. And you would be right. But keep in mind that a general price index is supposed to be telling us about the thrust of all goods and services. An index containing food and energy is misleading for three reasons. First, the F&E swings the all-items index and misrepresents the movements in the other goods and services categories. Second, because F&E changes are so erratic from month to month – they misrepresent the general direction of prices. For example, because of food and energy prices we saw dramatic swings in the all items index – 4% increase in 2008, -0.5 % decrease in 2009 and then a 3% increase in 2011. Meanwhile the all items less food and energy showed some variability but hugged an average of about 1.8% per year.   Most prices were growing at a little less than 2% per year. The All items index showed a very different and extreme pattern – a very misleading pattern of the general thrust of the prices of most things you buy. Third, when F&E prices swing wildly we often react and change our purchasing patterns. When F&E prices are rising rapidly we find ways to reduce our purchases of these items and that reduces the impacts on us in ways that are not captured in the all items index.

In early 2013 we are wondering where future inflation is headed. If we look at the All items CPI index we see a blur of upward and downward movements dominated by F&E price changes over the last 10 years with no clear direction. If instead we look at the all items CPI less F&E we see what looks like a wave rising and falling gently over time. After showing a declining inflation rate from about 2006 to 2010, this inflation rate has been trending upward – measuring about 2% in 2012 but portending future increases in the coming years. 

This gets us back to government policy. Our national goal is to bring the unemployment rate down. Policy stimulus is one way to do that but it has great risks. If the stimulus leads to more inflation then it sets off all kinds of alarm bells that are very bad for employment. With the inflation rate rising in a growing economy, it is not hard to predict that continued stimulus will increase current inflation and expectations about future inflation. We learned in the past that stimulus raises interest rates, oil and other commodity prices, increases wages and other business costs, and generally creates adverse conditions for output and employment growth. Inflation might be in the 2% range today but all indications are that the best way to reduce the unemployment rate is to have less stimulus and lower inflation.


  1. Hey Professor,
    Wanted to get your thoughts on the large cash balances that are being held by our major corporations. Apple for example, has built up its cash position to over $137 billion, and has put very little of that capital to use or in the pockets of its shareholders. There has been lots of talk on the Street that Apple needs to either return this money to its shareholders or start to put it to work to continue to grow.

    If it were to invest the money in PP&E or R&D, this of course would create jobs and act as a stimulus for the region. This would lead to growth and also to inflation later on. This type of positive growth and future inflation would be able to be controlled through interest rates and other means. I think that most would believe that this would be a better alternative than the FED continuing to pump money into an economy with very little planning on how the money is supposed to be designed to improve our stagnant growth.

    However, if Apple starts to return a majority of its war chest to its shareholders (probably more likely to happen) through buybacks and dividends, it would be injecting a vast amount of money into a select few's pockets (mine included). This would basically be increasing the available cash in the market and thus act like a stimulus. I of course could invest my new windfall or spend it. If I decide to spend it though and a large number of my fellow shareholders also spend it we would be able to drive up demand for more products. This would be great in the short term, it would stimulate growth and more companies would want to earn my new money so they would be forced to invest. However, this would also create inflation because even more cash is being injected into our economy.

    Now if Apple was alone in this kind of policy it would be fine, but the moment that Apple decides it is going to increase its dividend to lets say 4%, Wall Street will demand that Google start to pay a dividend, and other companies with enormous cash positions start to distribute more and more cash to their shareholders. Today, Qualcomm decided to raise its dividend 40% and increase its share buyback policy.

    Many software companies have built their cash positions so high, and have little need to invest it to continue to grow, that eventually people will demand that they distribute it to its shareholders.

    What I fear is that when this does happen and you add over $2 trillion that the FED has and continues to print, that we will have so much available cash that inflation soars.

    Any thoughts?

    1. Hi Dan,

      Nice to hear from you. I cannot find much fault in your analysis. There is a lot of money sitting on the sidelines. As the economy continues to strengthen more and more of that money will be spent -- in one way or another. You didn't mention banks -- they too are sitting on piles of money which they would love to lend if conditions when conditions are better. This is why I want the Fed to begin reversing policy now. All that money could hit like an explosion. It will be good for spending but it could also cause a large spike in prices. Bernanke thinks the main risk is that growth will slow in the near-term. I don't agree. The bigger risk is that it won't and your analysis helps to explain why. Thanks!