Do We Have Inflation? Or Not?

Posted by Jeff Carter
on April 12th, 2011

The Federal Reserve is out on the street trying to persuade people there isn’t any real inflation. The far right wing is telling people to start canning food and to keep buying gold because we are going back to stone age/hyperinflation Weimar Republic economics. The far left is strangely silent on the topic of inflation, because they don’t want to criticize their President’s policies.

From the linked WSJ article, here are some quotes from Fed governors on inflation. Janet Yellen,

Recent increases in prices of oil, grain and other commodities are “unlikely to have persistent effects on consumer inflation or to derail the economic recovery” and are “not likely to warrant any substantial shift in the stance of monetary policy,” she said. The key, Ms. Yellen added, is that households and businesses don’t expect inflation to take off in the long run.

William Dudley (he of the iPad fame)

William Dudley, president of the Federal Reserve Bank of New York, said, “We think that it’s important not to overreact to a rise in headline inflation because the increase in commodity prices is probably going to be temporary rather than persistent”—a sentiment Ms. Yellen echoed.

But, can you believe them?

PIMCO is the world’s largest bond fund. They announced that they are short US Treasuries. This means that they think interest rates will rise, or following the logic, we ought to be having a bit of inflation in the US that will drive the cost of money higher. Combine that market based fact with the rise in commodity prices over the last year and it seems that the Fed is spinning, not basing their decisions in fact.

DBC Stock Chart by YCharts

It can be reasonably argued that the rise in commodity prices were supported by some out of the normal events. Last year’s drought caused a loss in the wheat, cotton, coffee and cocoa crops which ignited revolutions in the Middle East, which led to a rise in the price of crude oil. The shortages of grain caused hoarding to ensue, and we are taking grain out of storage at five times the normal rate. The recent series of earthquakes in Japan are also out of the ordinary.

Quantitative easing has also been extremely controversial. The Fed has monetized billions in US debt. In effect, printing money from thin air. This should be inflationary. However, at the onset of QE1, the Fed was more concerned with deflation than inflation. Our economy was in recession, savings rates were higher, credit wasn’t flowing and the Fed felt it needed to be really active in the marketplace.

But, inflation isn’t simply an increase in commodity prices. It’s a lot more complex than that. Barry Ritholz has a nice post illustrating many of the other pieces of the inflation puzzle. Many signs like the turnover of money (multiplier effect), rising wages, slack in productive resources, and employment numbers don’t point to inflation.

A lot of our inflation DNA comes from the 1970′s. Anyone of a certain age remembers the uncontrolled price rises of that decade, and higher oil prices in the later 1970′s combined with bad Fed/fiscal policy caused the misery index to spike. However, in 1972, we went off the gold standard and allowed currencies to float. Nixon, instead of allowing prices to find a level used centralized planning and implemented a price freeze. Demographically, the baby boom generation was beginning to graduate from college and starting to consume, increasing demand.

Today, the boomers are consuming less as they reach retirement. The boomlet is still in college. We have had some atrocious fiscal policy over the last eleven years, as Federal spending has reached unsustainable levels. But the real driver of inflation has been the rise of the middle class in places like China, India and Brazil. There is more demand for all resources, with relatively static supply. The only place for prices to move are up.

Business formation is lagging. Consumer spending isn’t high. Business lending isn’t happening. Our housing market still is a huge lag on the economy because it hasn’t cleared yet. State and local governments are broke. As Instapundit has chronicled, college tuition is the only place where we are seeing really large increases in prices! And tuition is heavily subsidized by the government.

Economist Mark Perry at Carpe Diem recently had a post on inflation. Price increases of raw materials don’t necessarily translate into increases in the price of physical goods. His conclusion is, “We find that since the mid-1980s, after the big oil shocks and the tenure of Paul Volcker as chairman of the Federal Open Market Committee (FOMC), the reactions of both core inflation and the federal funds rate (the monetary policy instrument) to shocks in oil and other commodity prices have been extremely modest.”

My conclusion. We are going to have some inflation. Much of it will be driven by expansion of the global economy. The rapid increase of federal spending and the monetization of debt over the last three years will cause inflation. However, I don’t think it will be as bad as many expect. Remember, the Fed targets an inflation rate of 2%, with a GDP growth rate of 3%. We will go over that 2% mark. But, it’s not going to be debilitating like many would have you think.

tip of the hat to Take A Report, I think hyperinflation can TAFR

Thanks for the link Forex Factory.

Appreciate the link Business Insider.

Instapundit linked to the same post at Business Insider, thanks.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.