Thursday, November 18, 2021

Inflation meditation

The discussion about inflation is pretty confused. There is a lot of confusion about aggregate demand vs. individual demand, aggregate supply vs. supply, and about relative prices vs. inflation. 

My theme: Inflation is entirely about "demand," not "supply." Fixing the ports, the chips, the pipelines, the labor disincentives, the regulations, are all great and good, and the key to economic growth. But they will not on their own do much to slow inflation. We are having inflation because the government printed up a few trillion dollars, and borrowed a few trillion more, and wrote people checks. People are spending the checks. 

At a superficial level this is obvious. If people weren't spending a lot of money, the ports would not be clogged. But it's deeper than that. 

Inflation is all prices and wages going up at the same time. Relative price changes are when one price goes up and other prices go down. Reality combines the two, but let's use terms correctly for each element. 

Supply shocks cause relative price changes, not inflation. Suppose the ports clog up, and you can't get TVs off the boat from China. Then the price of TVs has to rise relative to other prices. The price of TVs has to go up relative to restaurant food, for example, so people buy fewer TVs and go out to eat more. Or the price of TVs has to go up relative to wages, so people buy less overall. 

Now the world is a bit more complex. If prices and wages moved instantly, the price of restaurant food, or wages, would go down, the price of TVs would go up, and the overall price level would not change. In reality the other prices go down slowly. So the price of TVs goes up, and other prices and wages only slowly go down. We measure a little bit of inflation, followed by a slow period of lower measured inflation. 

This is one of the mechanisms people have in mind when they refer to supply shocks, and say inflation will be transitory. But that's clearly not what's happening now. Everything is going up, though some things more than others. 

Likewise what happens if people decide in a pandemic that they want to buy more TVs and go out to dinner less? That's a relative demand shock. It drives up the price of TVs, and down the price of restaurant food with no inflation. But restaurant prices go down more slowly than TV prices go up, so we measure a bit of inflation and then less inflation. But that's not what's happening now. Restaurant prices are going up too. 

"Aggregate supply" is the question, how much more does the economy produce when all prices and wages are moving up at the same rate -- true, pure, inflation? That's a tricky and slippery concept! Sure, if wages rise more than prices, workers might work harder and produce more. If prices rise more than wages, companies might produce more in pursuit of higher profits. Since I told the same story both ways, you can see even this is slippery. But these stories are still about relative prices and wages, not both prices and wages rising together. If prices rise 10% and wages rise 10%, why does anybody do anything different? Welcome to the mysteries of "aggregate supply." 

It only makes sense if you think prices or wages were sticky and one or the other was stuck at too low a level. Then a bit of inflation can unstick one of the two, getting the economy back to a more productive level. Aggregate supply is about sticky prices and wages, not about the actual productive capacity of the economy. Another way to see it: Why was the economy not already producing as much as it could, so that money raises output rather than immediately raising inflation? Well, something had to be wrong that inflation could fix, and in macro theory that's "sticky prices." 

Yes, this is slippery, but let's not get too far down the rabbit hole. The central point, as intuitive as it sounds, it is not true that unclogging the ports will soak up demand and stop pure inflation. It will lower the relative price of TVs, but that "more supply" doesn't do much about all prices and wages rising together. 

All prices and wages rising together means that one thing is falling in value -- money, and government debt. Inflation is a change in the relative price of money and government debt relative to everything else. Inflation comes thus, fundamentally, from the overall supply vs. demand for money and government debt. 

We seem, sadly, to be repeating all the confusion on these affairs that prevailed in the 1970s. Oil price "supply" shocks will surely be "transitory." President Biden is sending the FTC to hound the oil companies to lower prices.  Can "guideposts" be far behind? For a thousand years, inflation has led to a witch hunt after "speculators" and "middlemen" and price rising conspiracies. Here we go. 




39 comments:

  1. This is also my thinking. Everything gets trickier when you add markets and money. One man's demand shock is another man's supply shock. Demand for chips goes up supply of autos goes down. There's a nice graph in that BIS report that Krugman linked to that shows that chip exports from TW and SK are up in real terms. Ditto shipping volumes. In my mind the real supply shock is on the service sector side. This isn't showing up in market prices, Airfairs and hotel rates, but in a bunch of non-market costs, higher cancellation/contagion risk, transaction costs (eg testing), quality deterioration (bars are less fun 1/4 full). When it comes to outright bans the price is effectively infinite. That's the supply gap that needs to close to lower the relative price of goods.
    As for the price level itself, I agree with your assessment. Bottom line is disposable incomes went up but real production went down. TNSTAFL, we can't be magically 7 per cent richer without putting the work in to make the stuff to buy with that 7 per cent. My worry is I'm not sure central banks still has the nerve to provoke a recession if that's what it takes. And if they blink it's trouble.

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  2. If TV are in short supply for supply-side reasons then their price will probably rise. But quite likely total spending on TVs will go down. If the supply of other goods is fixed jn the short term and people still spend the same amount overall then the price of goods other than TVs will go up too. The overall price level may rise as well as the relative price of TVs.

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    1. Exactly. It's the income or substitution effect. Grumpy Economist seems to be assuming it's an income effect, in which case people will spend less on meals in response to higher tv prices, thus no inflation. But it could just as well be that the substitution effect dominates, which would play out exactly as you describe.

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  3. From the Bureau of Economic Analysis website–

    PCE Core:

    Change From Month One Year Ago

    September 2021 3.6 percent
    August 2021 3.6 percent
    July 2021 3.6 percent
    June 2021 3.6 percent

    OK, we are running at 3.6% PCE core, and I think the worst is over. Oil perhaps topped out. Property zoning has helped restrict supply, but again prices appear to be topping out (no housing inflation in Japan, btw).

    Low wage workers have been gaining. The Fed has managed to sidestep a C19 depression.

    Not so bad.

    Add on: For the bottom third of the workforce, about 50 million to 60 million people, these are the best labor markets in 60 years. Is this so easily dismissed?

    If moderate inflation is the cost of tight labor markets, then bring unto me tight labor markets for 100 years.

    The globe has been in a 40-year long disinflationary trend. Are we so sure that trend will not reassert itself within 24 months?

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    1. Do we have a theory that predicts that labor wages can be kept tight for 100 years with this policy, without incurring steadily increasing inflation? Which theory is that?

      I'm not an economist. My econ 102 class taught me that workers would adjust to steady inflation by negotiating higher and increasing wages, which would negate the long-term effects of a moderate inflationary policy. Could be wrong, but what is right?

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    2. Who gives a dog poop about a theory predicting wages for the next 100 years?

      Inflation is easily managed through several tools including
      1) down payment and margin requirements on real estate and securities,
      2) targeted supply chain actions, and
      3) broad based tax increases/decreases.

      For example, the Job Gty/Green New Deal law should include AUTOMATIC across-the-board tax increases that kick in when certain monthly wage inflation targets are hit-say for 6 months in a row. These can include:
      a) Income Taxes,
      b) Sales/VAT Taxes
      c) Asset Value (or Wealth) Taxes
      That'll cool things off pronto. When inflation has cooled, the taxes automatically return to a base level.

      Easy Peasy. These policies would be part of a Job Gty which in turn is part of a Full Employment Fiscal Policy.

      I would go ahead and plow ahead to Econ 103.

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    3. Being just a little rude apparently works. Your comment gets approved, but most people wouldn't want to answer you, so you get the last word. Enjoy it.

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  4. John,

    If people were spending the checks as you seem to believe then you shouldn't see this:

    https://fred.stlouisfed.org/series/WDDNS

    Ben,

    "Add on: For the bottom third of the workforce, about 50 million to 60 million people, these are the best labor markets in 60 years. Is this so easily dismissed?"

    Why should any third of the "workforce" go into the job market when Joe Biden and the Democratic Party are happy to pay people to sit at home or even force companies to do the same? Why stop at 4 weeks paid leave, how about 20 or 30 instead?

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    1. This is better, seasonaly adjusted: https://fred.stlouisfed.org/series/DEMDEPSL. My point exactly. There is a lot of "stimulus" left to go. They're only getting going on spending the checks!

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    2. See permanent income hypothesis:

      https://en.wikipedia.org/wiki/Permanent_income_hypothesis

      "The theory was developed by Milton Friedman and published in his A Theory of Consumption Function, published in 1957 and subsequently formalized by Robert Hall in a rational expectations model. Originally applied to consumption and income, the process of future expectations is thought to influence other phenomena. In its simplest form, the hypothesis states changes in permanent income (human capital, property, assets), rather than changes in temporary income (unexpected income), are what drive changes in consumption."

      If people were going to spend the checks, they would have been spent already. Unless of course there are supply constraints causing orders to be cancelled.

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    3. And the way a government might mop up that excess liquidity would be for it to sell illiquid "public" goods that are both non-rivalrous and non-exclusionary.

      But I am afraid that is too far over the head of today's economists.

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    4. Frisky and Grump: Again, with measuring the wrong things. Demand Deposits are up as a result of Fed Open Market Operations and QE. It has very little effect on propensity to spend as it just sits on financial institutions' balance sheets. It's irrelevant.

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    5. FRestly:

      Verily, I am much more of a fan of tax cuts on workers to stimulate, rather than more social welfare. A Social Security tax holiday, offset by Fed purchases of Treasurues that are placed into the SS fund, is a good idea.

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    6. And over your head as well.
      As usual you don't know what you are talking about.
      Check the following:

      https://www.federalreserve.gov/releases/z1/20210923/z1.pdf
      B101 - Balance Sheet of Households and Non-Profit Organizations

      Checkable Deposits and Currency:
      2018 - $1.208 Trillion
      2021 (2nd Qtr) - $3.642 Trillion

      It sits on individual balance sheets as a spendable asset (that hasn't been spent).
      It's sits on financial institution balance sheets as a liability.

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    7. Ben,

      "Verily, I am much more of a fan of tax cuts on workers to stimulate, rather than more social welfare."

      Please read the Blog that I wrote concerning equity sold by the US Treasury department. It is a common misconception that a government "must" borrow / sell bonds.

      "A Social Security tax holiday, offset by Fed purchases of Treasuries that are placed into the SS fund, is a good idea."

      Fed purchases and Treasury bonds are not necessary.

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    8. Frisky: You need to up your game a little bit.
      The increase in private sector bank deposits is a result of Govt Deficit Spending. QE has no effect on private sector bank deposits held by the nonbank public. If the Govt buys a Gvt bond held by a bank, it has no effect on nonbank players. A bank is unlikely to go on a shopping spree.

      Delete
    9. Here is your first statement:

      "Frisky and Grump: Again, with measuring the wrong things. Demand Deposits are up as a result of Fed Open Market Operations and QE."

      Incorrect. Here is your amended statement:

      "The increase in private sector bank deposits is a result of Govt Deficit Spending."

      Correct.

      Delete
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  6. This comment has been removed by the author.

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  7. If the supply of all goods fell wouldn't you have inflation without additional monetary accommodation (I realize this is not necessarily a realistic scenario).

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    1. Seems quite likely actually. It's not necessary for all prices to appreciate at the same time. Isn't some inflation the expected result of wars, socialist revolutions, climate change, increase in the dependency ratio, or widespread lockdowns?

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    2. Absolutely! Just as the oil price hikes amounted to generalized, though surely uneven,supply shocks, on average the decline in productivity and output would have raised the price level even without an increase in the money supply.

      Just like today: Covid is first and foremost a supply shock -- people are not allowed to work as usual. This would raise the price level even without an increase in the money supply.

      Using government expenditure, even if deficit financed, to ameliorate the pain of some people was the right thing to do, for they could not borrow on their own. Monetary expansion was also correct because the demand for money exploded, as everyone was scared out of their brains.

      As always, the trick is knowing when to stop.

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  8. When it comes to inflation, I have tried to beat the drum on separating out cost-push vs. demand-pull inflation. Seems to me we got a bit of both piling on top of one another. Separating these out might shed more light where the majority of inflation is coming from.

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  9. Indeed it all is about the seigniorage tax. Seigniorage is not free in the government's budget constraint.

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  10. Like a lot of dogs with small paws, monetarists and Austrians often end up measuring the wrong things. You can’t make an assessment on inflation based on 3 months of stats. As even the Grump points out, there are timing differences in spending. We are still going through a once-in-a-lifetime pandemic with dramatic impact on the economy. The government responded very well, essentially paying folks not to work to get this behind us. (with limited effect due to libertarian/conservatives exacerbating the recovery through encouraging the ant-vaxxers, not to mention supporting the Trumpian head in the sand response.)

    The inflation is largely the result of:

    • the economic recovery, focused especially on goods after months of not producing anything – not that we produce anything anymore – and services increasing prices in an attempt to recover their fixed costs in the face of lower volume. The notion that services prices will drop in short order to reflect the lower demand is preposterous. Spending is affected by both income and credit availability. Returning dining and drinking customers will gladly pay a premium in the short term, even if they have to put it on their credit cards. That won’t last in the intermediate term.

    • Oil price. Saudi Arabia and Putin would love to have Trump back in the White House, or at least as Speaker of the House; So they are curtailing supply to pinch Biden’s reelection chances. I know, I know, conservatives would like nothing better than a sharp increase in interest rates to create unemployment so their business-owner clients can make more money.

    • Housing. The real estate crash is coming. THAT will cause a drop in inflation.

    The inflation hysterics are going to look very silly in 9 months.

    What a Grump!

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    1. DoDeals,

      "Housing. The real estate crash is coming. THAT will cause a drop in inflation."

      Not exactly. The CPI includes a component called OER (Owner's Equivalent Rent).
      When more people choose to rent vs. purchase a home that put's upward pressure on rental costs and downward pressure on home prices which RAISES the inflation component of the CPI.

      Learn how inflation (CPI) is actually measured before calling it hysterics.

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    2. Frisky: I'm familiar with CPI, thanks. When real estate crashes, folks buy properties for less and have less of a nut to cover. They can use this improved cashflow to lower rents to maintain their buildings filled.

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    3. "Services increasing prices in an attempt to recover their fixed costs in the face of lower volume. The notion that services prices will drop in short order to reflect the lower demand is preposterous."

      That's at odds with the reality of what we see in measures such as restaurant and hotels CPI - https://fred.stlouisfed.org/series/USACP110000GYQ . The period of very restrained inflation for these sectors was the months in 2020 when they faced a combination of consumer reluctance to use their services and government restrictions. Inflation has then increased as business came back. It's been from Q2 2021 onward that this subset of CPI has been increasing at rates higher than pre-March 2020.

      That makes sense because "we aren't seeing much customer demand, so let's increase prices" would be a strange strategy to pursue. Overcapacity in industries very rarely (if ever) leads to short-term higher prices to "recover fixed costs". The competitive dynamics of chasing fewer customers instead lead to lower prices and profits.

      Overall U.S. restaurant spending also don't support the underlying claim that these businesses are now having to chase lower volume. In nominal dollars, U.S. restaurant spending in Sept. 2021 was 16% above the same month in 2019. https://fred.stlouisfed.org/series/MRTSSM7225USN

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    4. Surrealist: Actually, service providers have taken steep losses in 2020 and are doing whatever they can to recover their fixed costs incurred and incurring. Yes of course they are now enjoying higher volume (although it's hard to confirm that since your graph outlines spending, which may in fact consist largely of higher prices - to recover losses/costs from period of lower volume. Yes, after very low demand, increasing prices makes total sense.

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  11. Why government debt in particular in this quote? Doesn't the value of all debt decline with inflation? "All prices and wages rising together means that one thing is falling in value -- money, and government debt. Inflation is a change in the relative price of money and government debt relative to everything else."

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    1. ReaderThinker,

      "Doesn't the value of all debt decline with inflation?"

      Not exactly. Government debt is different in that taxation (the means by which government pays back it's debt) is not completely correlated to changes in the price level (inflation).

      It is entirely possible for inflation to rise and tax revenue to fall in which case not even inflation relieves the government of it's obligations.

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    2. Also bear in mind a large portion of government liabilities are essentially indexed to inflation: TIPS, social security, Medicare, military expenditures, etc. This notion that the US can inflation away it's obligations is just wrong.

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    3. Anonymous,

      TIPs are a special case. Because the inflation component was not legislated into existence, Congress and / or Treasury can change the terms on those at any time as they see fit.

      For instance, to reduce expenditures, Congress / Treasury could set the inflation component at 0%, -3%, -7%, etc. regardless of the actual CPI.

      Also, Congress has several times over the past 30 years redefined how the CPI is calculated - first in 1983 with OER replacing housing prices, again in 1997 with the introduction of hedonic adjustments.

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  12. "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. ... A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society." Milton Friedman

    The solution it seems would be to reduce government spending to a level that removes the pressure on monetary expansion and allow the markets to clear products and services at appropriate prices.

    My real name is Todd Mora

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  13. I too think that recovery tracing up the supply curve plays a role, see this JE output gap measure: https://outputgapnow.github.io/
    But money-induced demand is not enough to be the whole story: a positively sloped Phillips curve would predict inflation rising quite a bit, but not all the way to +6%. A typical elasticity from a state dependent pricing model would give you (in reduced linearized form) 25 to 50 basis points for each 1 percentage point of output. So +3% output gap would imply 75 to 150 basis points of inflation on top of the 2% aim, so max 3-4%.

    And so supply factors must be responsible for the other 2-3 percentage points of inflation. This doesn't mean inflation would necessarily be short-lived...

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  14. > For a thousand years, inflation has led to a witch hunt after "speculators" and "middlemen" and price rising conspiracies. Here we go.

    In _Economics In One Easy Lesson_, Henry Hazlitt says economics is the study of long-range, indirect, unintended consequences. Our national philosophy, Pragmatism, is a rationalization of short-range, unprincipled, unsystematic thinking.

    "if a building were threatened with collapse and you declared that the crumbling foundation has to be rebuilt, a pragmatist would answer that your solution is too abstract, extreme, unprovable, and that immediate priority must be given to the need of putting ornaments on the balcony railings, because it would make the tenants feel better.

    There was a time when a man would not utter arguments of this sort, for fear of being rightly considered a fool. Today, Pragmatism has not merely given him permission to do it and liberated him from the necessity of thought, but has elevated his mental default into an intellectual virtue, has given him the right to dismiss thinkers (or construction engineers) as naive, and has endowed him with that typically modern quality: the arrogance of the concrete-bound, who takes pride in not seeing the forest fire, or the forest, or the trees, while he is studying one inch of bark on a rotted tree stump."
    -Ayn Rand

    "To stunt a mind means to arrest its conceptual development, its power to use abstractions—and to keep it on a concrete-bound, perceptual method of functioning. John Dewey, the father of modern education (including the Progressive nursery schools), opposed the teaching of theoretical (i.e., conceptual) knowledge, and demanded that it be replaced by concrete, “practical” action, in the form of “class projects” which would develop the students’ social spirit. 'The mere absorbing of facts and truths,” he wrote, “is so exclusively individual an affair that it tends very naturally to pass into selfishness. There is no obvious social motive for the acquirement of mere learning, there is no clear social gain in success thereat.'” (John Dewey, The School and Society, Chicago, The University of Chicago Press, 1956, p. 15.)
    -Ayn Rand, "The Comprachicos"

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  15. If a building were threatened with collapse and you declared that the crumbling foundation has to be rebuilt, a pragmatist would answer that your solution is too abstract, extreme, unprovable, and that immediate priority must be given to the need of putting ornaments on the balcony railings, because it would make the tenants feel better.

    There was a time when a man would not utter arguments of this sort, for fear of being rightly considered a fool. Today, Pragmatism has not merely given him permission to do it and liberated him from the necessity of thought, but has elevated his mental default into an intellectual virtue, has given him the right to dismiss thinkers (or construction engineers) as naive, and has endowed him with that typically modern quality: the arrogance of the concrete-bound, who takes pride in not seeing the forest fire, or the forest, or the trees, while he is studying one inch of bark on a rotted tree stump.
    -Ayn Rand

    To stunt a mind means to arrest its conceptual development, its power to use abstractions—and to keep it on a concrete-bound, perceptual method of
    functioning.
    John Dewey, the father of modern education (including the Progressive nursery schools), opposed the teaching of theoretical (i.e., conceptual) knowledge, and demanded that it be replaced by concrete, “practical” action, in the form of “class projects” which would develop the students’ social spirit.
    “The mere absorbing of facts and truths,” he wrote, “is so exclusively individual an affair that it tends very naturally to pass into selfishness. There is no obvious social motive for the acquirement of mere learning, there is no clear social gain in success thereat.” (John Dewey, The School and Society, Chicago, The University of Chicago Press, 1956, p. 15.)

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  16. There's a supply story for restaurants that doesn't involve inflation. Many restaurants have closed. Social distancing requirements and other restrictions reduce the capacity of the restaurants that remain. The supply of "restaurant experiences" is down, and the reservation price (the lowest price at which a restaurant is willing to provide a meal) of restaurants is up. So restaurant prices could have gone up even without increases in labor and food prices.

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