Practical Dad

Just What Is Inflation Anyway?

It's been more than five years since the start of the ongoing financial mess and one blogger, Jesse, was spot on in his description of this period as reminiscent of Samuel Beckett's Waiting For Godot.  While he was commenting on waiting for the arrival of any real recovery, the analogy holds for the controversy of inflation versus deflation and price stability. Contemporary American economic policy is predicated upon three points: first, that any policy actions have to be monetary in nature since the fiscal policy mechanism - Congress and the budget -  is simply broken; second, that flooding the economy with sufficient liquidity will ultimately spur enough activity to jumpstart consumer spending; third, that the financial sector - which really controls monetary policy since the Federal Reserve System is actually privately owned by the constituent member banks - should be protected from its errors and ultimately enriched by siphoning off from the liquidity that flows first through it's conduits and pipelines.  The near-economic collapse on the heels of Lehman's failure in 2008 was deflationary and everything that's been done since is designed to be inflationary.  But since everyone's talking about inflation, what precisely is it and how will we know it if and when it arrives...assuming that it hasn't already?

Inflation is essentially a decrease in the value of any currency, as measured by it's ability to purchase goods and services; likewise, deflation could loosely be considered an increase in the ability of any currency to purchase goods and services (although a deflationary environment often exists in tandem with periods of economic depression).  But there are multiple causes of rising prices and they can arise from different circumstances and in a massive economy with billions of transactions daily, it's possible for prices of different items to rise and decline simultaneously.  But to say that a price increase is inflationary is too simplistic since the key component of an inflationary environment is the amount of liquidity in the economic system.  For example, if I attend a charity auction and wind up in a bidding war with two others for a handmade quilt, the price of the item will rise but that doesn't mean that we're living in an inflationary environment.  The next item that comes up for bid might not even sell; it proves that no one wanted the item, not that there's deflation.

So what are sources of rising prices?

  • Demand is what occurs to prices of items when there are enough buyers in the marketplace to bid up the price for a particular item, whether it's a Beanie Baby or a Bugatti.  This is the situation that producers like because it means that there's sufficient money in the system that people have it to spend and more importantly, they can control the prices (and profit margins) for their items.  This is the environment that the Federal Reserve seeks to spur with loose monetary policy such that people believe that they have enough that they can spend, producers can sell and in turn, expand and hire others which then creates even more jobs in a positive cycle.
  • Supply-shock is what occurs when there's a shortage of a particular item with no immediate lessening of demand so that the item's owner/producer can raise the price.  The immediate onset of the 1973 Arab oil embargo is a classic example of pricing when the supply is sundered.  In that instance, the Arab producers significantly cut sales to the United States so that drivers had to pay increased prices for the remaining gasoline stocks.  In this case, the oil embargo was inflationary because the effects of the fuel shortage rippled through the entire economy and affected the great majority of other products due to increased transportation costs. 
  • Hyper-inflation is the scenario about which many doomers despair because the value of a currency drops significantly and occasionally, cataclysmically as it loses all value whatsoever.  This scenario is a result of political actions as well as economic circumstances and is best known from the German Weimar Republic experience of the early 1920s and Zimbabwe's implosion in the 1990s.

What worries most economic pundits about the actions of the Federal Reserve is what could occur because of the vast increase in the liquidity by that entity. 

The best way to understand inflation is to consider Irving Fisher's "Equation of Exchange", MV = PT.  In this equation:

M = Money Supply, in its various forms such as cash/coin, demand deposits (checking accounts), money market funds, et cetera;

V = Velocity of Money, or literally how many times a dollar is turned over as it flows through the economy for a specified period of time (the higher the velocity, the greater the economic activity while a lower or dropping figure indicates that activity is slowing and folks are moving dollars to their mattresses, as literally occurred during the Great Depression);

P = Prices;

T = Number of Transactions that occur during a specified period of time (although some economists have substituted Y - real income - in lieu of T).

While there's been well-deserved criticism of economists because of their drive to wrap a soft-science, human behavior oriented center in a crunchy hard-science shell, the Equation of Exchange does permit a decent macro level examination of some very large variables.  In this case, it certainly is enhanced since you can control for the effects of fiscal policy due to it's simple present non-existence, which leaves Fisher's equation as a decent starting point. 

The left side of the equation pertains to the variables of monetary policy in it's most elemental aspects, the supply of money provided by the monetary officials (M) and the corresponding use of money by the public (V).  The right side of the equation is composed of the dependent variables affected by the variables on the left:  aggregate price levels (P) and the number of transactions, although honestly, I'll use Y (real income) since that information is readily available. 

Given these highly simplified variables, what should occur when either or both the Money Supply and Velocity variables is altered?  Think of it as closed system, akin to an engineering situation; the money supply on the left is a supply of water and the velocity is heat added to the system while the two variables on the right are gauges that indicate the effect of the water and heat.  If we increase either the water or the heat, the effect should be greater pressure in the system, either from steam or the sheer quantity of water that applies pressure to the system.  If we decrease either the water or the heat, there should be a corresponding decrease in the system.  In this particular case, if the money supply (M) increases and there's little change in the velocity (V) of money - again, velocity is an indicator of how readily people are willing to spend money - then there should be some increase in either prices (P) or income (Y).  There can certainly be offsetting movements in either prices or income, but one and/or the other should be affected to the upside.

So what exactly has occurred in the past five years with our two variables, M and V? 

It's not surprising that the Federal Reserve has injected an almost 50% increase in liquidity into the economy since late 2007, so M has risen almost 50%.  But while M has risen, the velocity of money - how often money turns over in the system - has dropped by about a quarter during that same time frame, from a little over 2X to about 1.56X as of late February, 2014.  So the money supply has risen but the amount that people are spending has dropped.

On the other side of the equation, it's clear that the median family income (Y) has dropped significantly both since the start of the 2007 recession and even further since 1999.  It's a certain link that velocity has dropped because people are spending less because of the decline in family income.  But if the money supply has risen so much, offsetting the velocity decline, and it isn't showing up in family incomes, does that mean that it's occurring in the Price (P) variable?

Well, that depends on who you are and whether you're one of the 1%,  From where I sit, not only has income growth split so that the 1% prospers while the remainder decline, but that's what is occurring with inflation as well.  Inflation is now bifurcated as well.  To gain a perspective, go back to the closed system analogy from several paragraphs earlier.  That analogy still holds, but now consider that the water has to be injected into the system in the first place and the plumbing conduit for the pipes is essentially the financial sector for the national economy because in the real world, the banking system is the conduit through which the Federal Reserve injects liquidity into the economy.  Knowing and understanding that the banks are akin to a liquidity supply for the (almost) closed system, what's happening in the analogy is that there's a diversion in the conduit so that more than a fair share of all of that liquidity is being diverted to another system, this one owned and operated by the banks.  The Federal Reserve is injecting trillions of dollars via quantitative easing but much is being siphoned off by the banks for their own use instead of making it to the real economy.

So what's happening with the money that's now powering through this parallel - and powerful - system?

First, understand that one of the primary jobs of the banking system is to spread money throughout via lending.  Yet for all of the recovery talk since 2007, bank loan creation has been essentially moot.  So what's been happening with all of that money siphoned off from the Federal Reserve quantitative easing injections?  The banks have been able to put it in deposit with the Federal Reserve as a means to help repair the damage that they did to themselves from the 2007 Financial Crisis.  What's held with the Fed draws a .25% interest rate and while that's only nominally better than the .1% that my kids get on their passbook savings, it's a chunk of change when you've got deposits in the hundreds of millions and billions of dollars.  This money also serves as the support for all of the proprietary trading that's done on the commodities and stock markets by the banks, now permitted because of the repeal of the 1933 Glass Steagall Act which was passed to keep the banks from playing with money like a couple of gamblers with a briefcase full of blow.  The rise of the various American equity markets - Dow, Nasdaq and Russell 2000 - can be linked clearly to the impact of the effect of banks playing the markets with money siphoned off from the QE injections that were to go to the real economy.  It's this "hot money" that has also fueled the periodic run-ups in commodity prices over the past five years, as financial folks look - running around like meth-addicted terriers - for asset-backed investments in which to park the money for the period until that bubble pops; if you'd like a decent - and interesting - read on this, go to this final Rolling Stone article by Matt Taibbi.

So this diversion of liquidity from the Fed to the economy is leading to bifurcated pricing that matches the bifurcated incomes...Fed-desired inflation for the 1% and deflation for the 99%.  Top-tier inflation is borne out in several ways.  First, there's inflation in the financial asset prices as the institutions use the Fed-provided support to move the stock markets to historic levels, honestly unsupported by the activity within the real economy underpinning them.  As incomes drop, people cash out or borrow against their retirement funds and velocity drops, the market rises are wholly a result of the liquidity injections.  There's also inflation in the aforementioned commodity prices as the hot money flows in search of new and interesting avenues of return.  The producers of high-end luxury items note that sales continue at respectable levels and they're able to maintain - and even increase - prices as those with the income growth are able to spend their money on the items marketed to them.  On the flip side, mass retailers such as Walmart are openly warning of the collapse in their customers' spending because of the squeezed incomes.  Because lending has been a non-factor and there's been no growth, the 99% system is now losing steam simply because there's not enough money coursing through and it's declining until a newer, more stable level of activity is supportable.

It sounds reasonable in a clinical sense, but finding this new level involves foreclosures, more American families having to go on food stamps and the prospect of hunger and harsh choices for more and more Americans.

Since November 2010, I've run a grocery price index with a market-basket of 47 items and it's been demonstrating deflation for the better part of a year, most especially since late 2013.  The market-basket index began as a single index of the 47 items and was later split into two indices, the first for the original basket and then a second for the 37 actual food items within that market-basket.  These indices have both dropped from their all-time highs in December 2012.  What I'm seeing now as I do the monthly pricing on these items is an actual price decline in some items as grocers are finding ways to cut prices in order to maintain sales that allow them to stay in business. : Stealth inflation - holding profit margins by selling smaller amounts while maintaining the same price - will continue to occur, but there are now specific instances of grocery price declines and in significant ways.  Cans of kidney beans and various canned vegetables have dropped and I've even found an instance of stealth deflation as a grocer actually increased the size of a can of generic coffee while maintaining the price (although not back to the original 2010 package size).  The unrelated stores that I survey monthly are each now showing one or more instances of declining prices; I don't price at Trader Joes or Whole Foods, but I doubt that this is price activity that we'd find at such upscale markets.  So it's the Fed-desired inflation for the 1% as liquidity flows through their system and deflation for the rest of us, whose system is increasingly laboring.

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