Inflation and Rocky: Down But Not Out

The table below explains why people are saying, what’s up with inflation? In the decade including 2007 to 2016, the US inflation rate averaged 1.9% per year. If we compare that to any of the full decades from 1950 to 2010, that 1.9% is lower than any of the 10-year averages. The lowest annual inflation rate for a decade was the 2.3% of the 1950s. The 1.9% is also lower than the average annual rate of about 4.7% per year from 1950 to 2010.

What happened to inflation? Why is it so low? Are we in a new zone wherein low inflation is guaranteed for the foreseeable future? Or is it like Rocky and will bounce off the canvas once he clears his head?

Since only the Tuna knows the future for sure, I can’t really answer those questions. But a good place to start is with an understanding of tires and pumps. No just kidding. A good place to start is with some basic macro. And basic macro says Rocky might be wobbling right now but don’t count him down and out.

Inflation is the percentage change in prices for a nation. We use words like “basket of goods and services” to evoke the idea that inflation is not about the price of pickles or goat cheese. "Basket of goods and services" makes one think of all the goods and services the people of a country might typically buy. Inflation refers to how the cost of that basket of goods and services changes over time. If it cost $100 dollars one year and then rose to $105 the next year, we would call that a national inflation rate of 5%. If that same basket of goods and services fell to $104 in the next year, we would call that a deflation rate of about -1%.

You can see why people might worry about inflation. If your wages did not rise but the inflation rate was 5%, then you would feel poorer because your income would buy fewer goods and services. Ouch. The same goes for all your saving. If you have $1000 in the bank, it too will buy less because the cost of things went up. Double ouch.

That brings me to my first point. How could inflation rise by more than your wages? It doesn’t make much sense that it could go on very long. Sure, greedy businesses might want to raise their prices but if wages don’t rise and people can’t buy as much, then surely the price increases won’t stick for very long.

But look at the table. Inflation has kicked up many times and for as long as a decade or more. How is that possible? The first answer is government. The second is expectations.

Consider how government figures into this. Suppose firms raise prices but not wages. Consumers can't buy as much as before. The economy begins to slow. Governments don’t like recessions, so as the economy slows, the government decides to stimulate spending. Government stimulation thereby replaces the reduction in private spending with an increase. With spending restored, inflation sticks.

So firms raise prices again. What fun! Inflation is on a roll. Meanwhile workers are saying, what’s up? Dudes, you keep raising prices but not wages and we keep getting poorer. Cagey firms might then give in to wage demands. Notice that higher wages mean that workers can buy more and this keeps the inflation party going. But the trick for firms is to NOT raise wages enough to seriously damage their profits.  

For a while (much of the 1960s and part of the 1970s), workers got wage increases but they never quite caught up. And then viola!, workers figured it out and demanded a proper wage increase. In 1979, coal miners asked for a 39% wage increase for their coming three-year contract. Other workers followed. That was like taking a 2x4 to company profits and caused a couple of recessions in the beginning of the 1980s. Once workers expected higher inflation they wanted higher wages. This is the second impetus to higher inflation as firms pass along those new costs into even higher prices for goods and services. 

Those recessions created the incentive for the government to jump in again. Except by 1980 the government had accumulated an ugly national debt and wasn’t prepared to bail out the firms. No bailout? Without the bailout and with a weak economy, firms were much less apt to try to raise prices. The table shows the inflation rate moving in a better direction after 1980. With government stimulus and inflationary expectations falling, it made sense that actual inflation would decrease.

One more point that may seem to fly in the face of all the above. Milton Friedman coined the phrase "money, that's what I want". No wait, that was the Beatles. Forget that.  Friedman said, “inflation is always and everywhere a monetary phenomenon.” Milton Friedman was not simplifying when he said the above. So we have to add a bit to our story to bring in money.

According to Friedman and other monetarists, a government is limited in how much it can stimulate spending. In the above storytelling, I glibly spoke the company line that a government deficit could be used to stimulate spending. But that idea exaggerates their powers. Government deficit spending is less powerful if people believe that a deficit will be temporary. The more people think that the government will soon either retract spending or raise taxes, the more they adjust their spending (downward) to that expected reality.

So it is not the government deficit itself that permits spending and inflation to increase. It is the act of the Central Bank monetizing the government debt that seals the deal. Government deficits cause interest rates to rise. The Central Bank reacts to those rising rates by flooding the economy with money. And that money is the magic grease to keep the spending and inflation going. The money is not the cherry on the top – the money is the ice cream, the cherry, the bowl, and the JD.

That brings us to today. Workers are too worried about a weak economy to push for higher wages. The government has no more bullets and can’t increase spending. Thus, inflation is at bay. But that’s not the whole story. The rest of the story is the money that is sitting in bank excess reserve accounts. So long as the money sits in those accounts, we are at risk of them turning into real loans and real spending power. It won’t take a huge change to get all that green moving. The Fed is scared to death to drain those reserves from the system. They are ready to be spent. The unemployment rate is down and labor markets are tightening worldwide. Thus workers will soon feel their oats and will be ready to jump on higher wages.

It won’t take a forest fire to get things started. Little bits of information flow that make us more optimistic about the future. That growing optimism combined with a forest full of money can suddenly spark a spending spree. And that could ignite inflation expectations and lead to workers demanding higher wages. None of that could happen without all that money sitting around. With government stimulus stuck in neutral, a stronger economy can't cause a sustainable rise in inflation. With government stimulus unchanged, inflationary expectations can't unleash a wave of higher wages. It's the money that is the risk today. With trillions of dollars in excess reserves, spending can expand elastically, wages can grow without limit, and inflation will rear its ugly head. To Janet Yellen: Get rid of that money before it comes back to bite us all. Let's keep Rocky on the mat. 

Inflation Rate of the

Consumer Price Index

By Decade (In Annual % Change)

1950s                           2.3

1960s                           3.1

1970s                         11.2

1980s                           5.9

1990s                           3.2

2000s                           2.7

2007 to 2016               1.9