Sometimes Inflation Is Less (Or More) Than It Seems

Inflation is uncomplicated… most of the time. But sometimes economic conditions turn it into a vexing subject. The American mindset is conditioned to treat high/rising inflation as forever bad, and low and falling inflation as perennially good. Thinking in these terms is understandable, given the inflationary bias through time for a fiat monetary system. Most of the time the relevant analysis can be reduced to a simple rule: higher inflation is bad; lower inflation is good. The trouble arises in those rare periods when disinflation/deflation dominates. Recent history is one of those periods.

Hold that thought as you consider an article in today’s Wall Street Journal:

U.S. inflation is slowing after a surge early in the year.

This is good news for Americans, as it means the money in their pockets goes further. It also is welcome at the Federal Reserve, which has been counting on an inflation slowdown. It gives the Fed some maneuvering room in 2012 if central-bank officials want to take steps to bolster economic growth.

In normal times—such as the 40 years or so through 2008—the statement above would be regarded as a self-evident truth. But a few things changed in 2008 and so the standard narrative for inflation and the economy no longer applies. Economist David Glasner complains that equating falling inflation with “good news for Americans” harbors an “unstated assumption that the number of dollars people have in their pockets has nothing to do with how much inflation there is.” Glasner charges that “it is inexcusable to ignore the truism that rising prices necessarily put more dollars in people’s pockets and simultaneously assert, as if it were a truism, that rising prices reduce real income.”
The inherent conflicts in the Journal story become clear when the reporter notes that the slowing inflation of late “is welcome at the Federal Reserve, which has been counting on an inflation slowdown. It gives the Fed some maneuvering room in 2012 if central-bank officials want to take steps to bolster economic growth.” Glasner responds:

Well now, we are switching theories, aren’t we? According to that assessment of the Fed’s options, falling inflation means that the Fed could ease monetary policy, thereby helping the economy grow more rapidly than it is now growing. How, one wonders, could the Fed do that? Um, maybe by preventing the rate of inflation from falling even faster? In other words, maybe inflation would drop down to zero or even to a negative rate, i.e., deflation. Don’t want that. But if falling inflation is good news, then, really, why not let inflation keep falling? In fact, why not go for deflation? How does falling inflation turn suddenly from being good to being bad?

The answer is that whether inflation is good or bad depends on the circumstances.

It can be easily demonstrated that falling inflation in recent years is no longer in the “good news” camp. A few months ago I reviewed some of the evidence, including the stock market’s recent tendency to fall when inflation expectations declined, and vice versa–the “new abnormal,” as I dubbed it. The new abnormal has also altered gold’s traditional role as an inflation hedge to one that offers a defense against the blowback from debt deflation, courtesy of the transmission process via shifting conditions for the real yield.
Professor Harlan Platt of Northeastern adds a fresh dimension to this issue with a new research paper that asks: Where Did All the Inflation Go? When Will The Real Estate Market Recover?

Until the American economy again experiences inflation, it is unlikely that real estate prices will change at a rate sufficient to give the average investor a real rate of return, i.e., when the rate of nominal profit is greater than the rate of inflation. Put another way, real estate won’t be a good investment until the economy heats up and creates more jobs, more income, and more inflation.

As Scott Sumner reminds, deciding if inflation is good or bad depends on the circumstances. We just happen to be in one of those rare periods when higher inflation is almost surely a good thing. Eventually, it’ll be a bad thing again, and that’ll be good. Got it?
The dynamic aspect of inflation can be confusing, but it’s hardly inexplicable. But some observers make the task harder than it should be. For instance, there’s a widespread assumption that the demand for money—liquidity—is constant. Okay, it’s true that most folks don’t think about money demand in formal terms, if at all, but they act as if they do and the implied theoretical assumption is that the appetite for liquidity is written in stone. If you accept that premise, consciously or not, then you must conclude that a rise in money supply is always inflationary. But as The Wall Street Journal tells us, inflation isn’t soaring and perhaps its pace is slowing.
That’s extraordinary if monetary demand is constant. Reality tells us different, of course. Indeed, the annualized rate of M2 money supply has been growing two to three times as fast as consumer price inflation in recent years. For the year through last month, for instance, M2 money supply is higher by 9.8% while CPI is up 3.4%, or slightly below the inflation rate that prevailed when the Great Recession began in December 2007. Why hasn’t inflation soared in the wake of a large rise in money supply? Because money demand has surged. A crude measure of money demand can be calculated with the inverse of what’s known as M2 velocity (the ratio of nominal GDP to a measure of the money supply). By this benchmark, it’s easy to see that the demand for money has been in a powerful bull market.
Reading the inflation signals, in other words, is highly dependent on current macro conditions. It’s easy to overlook this point because money demand doesn’t usually soar. But sometimes it does and the usual guidelines take a holiday. As David Beckworth recently advised, “we have rapid growth in M2 coming from a surge in money demand. This is a big deal, because money is the one asset on every market and an increased demand for it will thus affect every other market. The more money demand there is, the less nominal spending there will be on goods, services, and other assets. This development means the economic slump is being prolonged.”
Now that we’ve got that straight, we can all focus on the more-pressing questions: Does the recent drop in jobless claims signal a stronger labor market? Or is the cycle set to fall victim to a slowdown in the growth rate of personal income?