An Inflation Conspiracy?

Those of us who have been hawkish on inflation have been lonely for several months now. However, recent data has suggested that the Federal Reserve may soon start raising rates again. Nevertheless, there are a group of individuals who believe that the inflation numbers are actually worse. Our friend Barry Ritholtz has been leading the charge claiming that BLS data is understating inflation and unemployment (some have referred to these claims as conspiracy theories). I think that Barry is correct to assert that inflation is worse than the numbers indicate, however, I do not think that the numbers are the problem.

The real problem is that our focus is always on the overall price level rather than relative prices. Commodity prices are on the rise, and will continue to be, so long as the world remains awash in liquidity and real interest rates remain low. The former stokes the demand fire and the latter provides a disincentive for discovery and investment. Looking at the overall price level, it seems as though inflation is quite modest all things considered (albeit above most economists comfort level). The reason that inflation seems so much worse than the numbers indicate is because the prices of things that most consumers consider necessities, like gasoline and food, are experiencing the most rapid increases. In an economy where homeowners were (are?) more leveraged than they have ever been, they are now seeing their wealth decline due to falling home prices while simultaneously experiencing an increase in the costs of food and gasoline.

The world has largely been awash in liquidity for the better part of this decade. Despite this increase in liquidity, price indices have largely been held down by the rapid productivity growth beginning at the end of the 1990s and continuing through the first half of this decade. These low levels of inflation, however, were providing incorrect signals to central banks and fears of deflation reinforced the easy money policies. The proverbial chickens, however, are now coming home to roost. Productivity has begun to slow and can no longer be counted on to hold down prices.

What can the Fed do?

The best solution that the Fed can provide is to begin raising the Federal funds rate. Aggressively raising rates should start to reign in liquidity and lower inflation expectations. Higher real interest rates should provide the incentive for an increase in oil production and reigning in liquidity should reduce demand thereby putting downward pressure on oil prices and likely other commodities as well. Critics may charge that the economy cannot cope with higher interest rates. However, so long as the Fed stands ready to act as lender of last resort (a role they have performed well thus far), the U.S. economy should be able to weather the storm.

There may not be an inflation conspiracy, but inflation is a much bigger problem than the numbers indicate. It is time for the Fed to reverse course and start raising interest rates.

Originally published at The Everyday Economist and reproduced here with the author’s permission.

4 Responses to "An Inflation Conspiracy?"

  1. Guest   June 24, 2008 at 6:23 am

    The Federal Reserve will do nothing until after the election. Inflation — in food and energy — eats away at the discretionary income of the little people in the US. 80% of Obama’s fund raising came in the form of $100 or less from the little people — mostly before the sudden surge in gas and food prices. Now the little people have a choice — put food on the table or gas in the car vs. sending some money via a credit card charge to Obama. To help the little people make the right choices in the future (meaning stay out of the way of the big kids) their credit limits will be reduced by about $3 trillion. The Republicans are not behind this little bit of planning.

  2. Guest   June 24, 2008 at 4:04 pm

    Decreasing M2 velocity suggests Fed policy is already restrictive though.

  3. Cassandra   June 29, 2008 at 8:18 am

    I can’t see how raising interest rates would lead to an increased incentive for oil production. As the writer points out in the next sentence slower demand would lower the price of oil. How is this an incentive? I don’t think we can escape the inevitable. Interest rates will rise to avoid hyperinflation and this will keep growth slow or at worst lead to a severe recession – which is maybe what we need. This will make Obama a sure one termer.

  4. Chips All In   June 30, 2008 at 5:36 pm

    The inflation conspiracy exists. Hot money from Fed garbage loans to IBs and PDs comes with an understanding. Hit commodities, PMs, basic mat’ls. Hit ’em hard. Keep driving and driving it up. Window closes otherwise. Intent? Counteract the accelerating and soon to avalanche deflation. US monetary policy may not thrive but can do some good at the margins with an inflationary background. But with deflation of any scale? Zero interest rates for perpetuity cannot entice either lenders or borrowers in deflation. Defaults are exacerbated by deflation more than inflation. Fed toolbox rendered completely ineffective in deflationary depression. So…inflate, inflate, inflate. All necessities–inflated. All luxuries and discretionary consumables–deflating hard. All present inventory–deflating. All future inventory builds–hyperinflating. Ability to service loans? Difficult but not impossible as under pure deflation.What will be final verdict? This inflation conspiracy may actually amplify the harmful effects of coming depression. Attempts by Central Bankers to mitigate collapse may actually amplify and exponentially doppelgang the coming hard landing.