Inflation’s Split Personality

The consensus forecast for tomorrow’s update on consumer inflation is expected to show that prices rose by a slight 0.1% in November, according to Inflation, in other words, remains a non-event, despite the ongoing howls of protest from the usual suspects.

Inflation hawks have been telling us for some time now that dramatically higher inflation is just around the corner. Eventually they’ll be right, but not yet. The numbers are an inconvenient fact for worrying about pricing pressure at this juncture. Despite massive increases in the Fed’s balance sheet, consumer inflation remains modest by historical standards. In the chart below, the year-over-year percentage change in the broadly defined M2 money supply (green line) has recently soared. Inflation’s pace also increased (blue line is headline CPI, red line is core CPI), but the rise is hardly the hyperinflationary rates that some predicted.

Huh? Haven’t we been told that printing money is a sure path to dangerously high inflation? If so, why isn’t inflation responding in kind? Some conspiracy theorists charge that the government manipulates the data and so the official inflation numbers vastly understate the true rate. Perhaps, but independent estimates of inflation are also relatively mild. MIT’s Billion Prices Project, for instance, generally tracks the government’s CPI numbers. As Rex Nutting at MarketWatch reminds,

The fact is, we’ve got plenty of independent sources of information to double-check the government bean counters.

If you don’t believe the government’s data on job creation, you can verify the numbers through other sources, such as Gallup’s polls, reports from ADP, Intuit, Monster and Manpower, or the surveys from the Institute for Supply Management and the National Federation of Independent Business. The government itself produces alternative data on the labor market in the daily tax receipts report, the weekly jobless claims report and the monthly household survey.

If inflation really is contained, one might wonder what’s going on with the relationship between the money supply and prices. The short answer is that money supply is only half of the equation. There’s also money demand. As Professor John Cochrane recently explained, “money-stock measures are not well correlated with nominal GDP; they do not forecast changes in inflation, either. The correlation is no better than the one between unemployment and inflation.” He continues:

Why is the correlation between money and inflation so weak? The view that money drives inflation is fundamentally based on the assumption that the demand for money is more or less constant. But in fact, money demand varies greatly. During the recent financial crisis and recession, people and companies suddenly wanted to hold much more cash and much less of any other asset. Thus the sharp rise in M1 and M2 seen in the chart is not best understood as showing that the Fed forced money on an unwilling public. Rather, it shows people clamoring to the Fed to exchange their risky securities for money and the Fed accommodating that demand.

Money demand rose for a second reason: Since the financial crisis, interest rates have been essentially zero, and the Fed has also started paying interest on bank reserves. If people and businesses can earn 10% by holding government bonds, they arrange their affairs to hold little cash. But if bonds earn the same as cash, it makes sense to keep a lot of cash or a high checking-account balance, since cash offers great li¬quidity and no financial cost. Fears about hoards of reserves about to be unleashed on the economy miss this basic point, as do criticisms of businesses “unpatriotically” sitting on piles of cash. Right now, holding cash makes sense.

For another perspective, consider that many economists distinguish between good and bad deflation. It’s well known that a sustained period of falling prices generally can be devastating for an economy, as shown by the experience in the early 1930s and, more recently, Japan’s malaise. But sometimes deflation is helpful. In particular, a bout of deflation that arises from higher productivity can be beneficial. In contrast, deflation born of the blowback of a recession triggered by a financial crisis is toxic. If we recognize two types of deflation, shouldn’t we acknowledge the same for inflation? Scott Sumner thinks that’s reasonable:

I recently attended an economic conference with mostly conservative-leaning economists. Someone had a paper that mentioned how certain types of deflation can actually be good, as when rapid productivity growth helped reduce prices in the late 1800s.

I agree with this, and mentioned that I rarely hear conservatives talk about “good inflation.” Well I might as well have thrown a skunk into the middle of the room. Let’s just say that the idea of “good inflation” didn’t go over too well.

And isn’t that the problem? Isn’t that why we are where we are? We have all sorts of models that are basically symmetrical. You might argue that a stable price level is ideal, and that any inflation or deflation is bad. But if you argue that some deflation is bad and some is good, then you implicitly have a model that distinguishes between demand and supply shocks. So supply or productivity-driven deflation is good. Of course those models imply that inflation caused by a fall in aggregate supply is also good. The models are completely symmetrical. This shouldn’t even be controversial.

This brings us to the current challenge for the global economy, which may be set for a new round of trouble due to the euro crisis and the German-led effort to prevent the European Central Bank from acting as a lender of last resort to counteract the Continental surge in money demand. As The Economist warns, “The move to austerity is most dramatic within the euro zone—which can least afford it. Operating without floating currencies or a lender of last resort, its present predicament carries painful echoes of the gold-standard world of the early 1930s.”
Higher inflation shouldn’t be considered a cure-all in all situations. Focusing on inflation, in fact, misses the larger point, according to a small but growing band of economists who recommend what they say is a better policy: nominal GDP targeting. But to the extent we’re talking about inflation, it’s crucial (especially now) to put the topic into proper historical perspective. It’s wrong to assume that an economy can inflate its way to prosperity. But as Paul Krugman reminds, sometimes there’s a critical nuance to this caveat: “Nobody thinks that an economy operating somewhere near full employment can inflate its way to higher output. But under depression conditions — which is what we have now — inflation is very much a positive thing.”
Richard Koo, an economist at Nomura and author of The Holy Grail of Macroeconomics: Lessons from Japans Great Recession , warns in a new research note that the risk is rising that Europe and the U.S. “may be headed toward a Japan-like lost decade.”
Inflation at this point, in other words, is the least of our macro troubles. That too will change… one day. But for now there are (still) more pressing challenges ahead.