Willem Buiter argues that the focus on oil and food price shocks, which economists view as relative price changes rather than inflation, is muddying the discussion about inflation. He sees considerable evidence of widespread inflation and it’s central bankers’ fault.
Inflation is rising just about everywhere. Why is this and what can be done about it?
To get some basic concepts clear: inflation is a sustained rise in the general price level. Both the words ’sustained’ and ‘general price level’ are imprecise and in need of operationalisation. By general price level I mean a broad, representative index of consumer prices. That excludes the (headline) CPI in the UK….
I also exclude as unrepresentative various ‘core’ price indices, which exclude from the headline index such things as food, drink, energy and fuel. Among leading central banks, only the Fed has focused mainly on core inflation rather than on the headline index of consumer goods and services prices. Focusing on core inflation will be misleading unless either the relative price of core and non-core goods and services is expected to remain constant or Americans don’t eat , drink, drive cars and heat their houses or use air conditioning.
Until recently the Fed believed (a) that the best forecast of the future relative price of core and non-core goods and services was the current relative price of these sub-indices and (b) that the prices of non-core goods (mainly energy, fuel and agricultural commodities-based products) were more volatile than those of core goods and services. The volatility point was and remains empirically correct. The random walk or martingale hypothesis for the relative price of core and non-core goods was always a bad assumption empirically. In the most recent phase of globalisation, which has for much of this decade delivered a steady increase in the relative price of non-core goods to core goods and services, the assumption that it is OK to take this relative price as constant in the future is bad statistics and bad economics. Fortunately, the Fed is showing signs of kicking its core inflation habit, although painful withdrawal symptoms still are apparent from time to time. Admitting you have geen wrong is almost as difficult for central bankers as it is for politicians.
By ’sustained’ I mean,…uh, well, you know, something like ‘persistent’. And by ‘persistent’ I mean ’sustained’. Unsustained would be any one-off increase in the level of the price index that is not associated with expectations of further increases. I know this is vague and unsatisfactory, but welcome to the world of applied social science. For practical purposes, a representative price index that rises for more than two years would indicate inflation.
Who or what causes inflation?
This one is easy. In a fiat money world, central banks cause inflation, or, more precisely, only central banks are resposible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank-induced changes in the general price level can always can be offset by the central bank, given enough time, freedom to act and courage.
So, in the medium and long term (at horizons of two years and over, say) central banks choose the average rate of inflation. Not globalisation; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is just inflation. Inflation may be accompanied by changes in key relative prices – in the real prices of oil, of food, of oil and of labour for instance – if other relative demand and supply shocks accompany the inflationary impulses created by the central bank. Large increases in the real price of food will be bad news to food importers (including most urban households) and good news to rural food producers and exporters. But don’t confuse it with inflation.
Sometimes the central bank is the political captive of the fiscal authority. This is most clearly the case in countries with underdeveloped financial systems where seigniorage (the revenues appropriated by the central bank through the issuance of fiat money) is a significant source of government revenue and the central bank is not operationally independent. Sometimes the revenue needs of the government force a non-independent central bank to monetise the governments deficits. Zimbabwe is an example today. This is not a relevant consideration in today’s advanced industrial countries, as the revenue from seigniorage is tiny (around 0.25%-0.5% of GDP or less).
But with an operationally independent, sufficiently well capitalised central bank, the monetary authorities can, on average in the medium and long term, achieve the inflation rate they want. They are responsible, no-one else.
I assume, of course, that the exchange rate either floats or is set by the central bank. With a fixed exchange rate, or an exchange rate whose value is not set by the central bank, there is no substantive central bank independence. Given a floating exchange rate or a central-bank-set exchange rate, the central bank can make inflation in the medium and long term anything it wants it to be.
The central bank pursues its inflation objective by raising its policy rate (a short default-risk-free nominal interest rate) whenever inflation is expected to be above target over the horizon the central bank can influence it in a predictable way (starting between 6 and 12 months from the present), and by lowering the policy rate whenever inflation is expected to be below target. It’s simple, really. In financially repressed systems like India, the interest rate instrument (a) cannot be used freely because of political constraints and (b) has only a very small anvil to hit. So credit controls, including selective credit controls have so supplement the exchange rate as anti-inflationary instruments. It is clear that the Chinese authorities either don’t know the degree of monetary tightening (through credit controls, interest rate increases and yuan appreciation) that is required to bring inflation first under control and then down to a lower level, or that the economically necessary degree of monetary, credit and exchange rate tightening is noty yet politacally feasible.
Inflation is rising (almost) everywhere
The UK just got a nasty inflation shock. On the Bank of Englan’s official target, the CPI, year-on-year inflation in April came out at 3.0 percent, a full percent above the 2.0 percent target. Any higher and we would have had another Letter of St. Mervyn to the Tresorians. We are likely be see another couple of espistels again this year. The increase from 2.5 to3.0 percent was both large and larger than expected. It was preceded by a slew of data showing manufacturers costs and prices rising at alarming rates. The imminent interest rate cuts that had been anticipated by markets because the marked economic slowdown that is under way will reduce capacity utilisation and bring inflation down, are likely to be shelved for the time being. If the coming months confirm the pattern of higher than expected inflation, interest rate hikes must be on the cards for the UK, as even quite sharp increases in excess capacity may not be enough to bring inflation back to its target sufficiently quickly.
The reporting of the increase in UK inflation has been abominable, even in papers that still credit their readers with IQs in double digits. The Financial Times contained a deeply misleading article headed “Familiar culprits drive surprise jump in bills”, with above it “7.2% food, 8.3% household energy,…., 18.7% fuel for transport…” etc. This is major-league disinformation as regards the drivers of inflation. There is indeed a familiar culprit for the increase in the cost of living – the Bank of England’s Monetary Policy Committee. The fact that this rise in inflation is accompanied by shocks that cause major changes in relative prices, including a nasty adverse terms of trade shock for the British consumer, is neither here nor there as regards the overall rate of inflation. If fuel for transport, food and household energy had not gone up at all, other prices would have gone up by more to produce pretty much the same overall rate of inflation.
I am willing to grant the old-Keynesians and new-Keynesians among us, the empirical regularity that at very high frequencies, the fact that most nominal commodity prices (and prices of non-core goods in general) are flexible (both ways), while most nominal core goods and services are sticky in the short run. So relative demand or supply shocks that cause the relative price of non-core goods to go up will tend to do so in the first instance through an increase in the nominal price of non-core goods rather than through a reduction in the nominal price of core goods and services; likewise relative demand or supply shocks that cause the relative price of non-core goods to do down will tend to do so in the first instance through a decline in the nominal price of non-core goods rather than through an increase in the nominal price of core goods and services.
So for a given stance of past, current and future monetary policy (as measured by the sequence of past, present and contingent future policy rates), relative demand and supply shocks that cause an increase in the relative price of non-core goods (the kind of shocks we are seeing globally today), will temporarily raise inflation above the level at which it would have been without these relative demand and supply shocks but with aggregate demand and supply at the same level. Such general price level blips work their way through the system quite swiftly; much of it is gone within a year, virtually all of it within two years. The do not ’cause inflation’.
In the Euro Area inflation has come down a little to 3.3 % year-on-year (on the inadequate HICP index, admittedly), from last month’s peak at 3.6%. For a central bank that aims at inflation in the medium term of below but close to 2 percent, this is not a great or even an acceptable performance. Unless the Euro Area level of activity slows down sharply, higher interest rates from the ECB cannot be ruled out.
Inflation in the US is running at 4.0 percent on the headline CPI inflation (which does include housing costs). This is way above what should be the Fed’s comfort zone. The die-hard core inflationists there will point out that core inflation is only 2.4%, but the only appropriate answer to that is: so what? Core inflation is of interest only to the extent that it is a superior predictor of future headline inflation. If it ever was, it has ceased to be so this millennium. The Fed has let inflation get away from it even more than the ECB and the Bank of England.
Even in Japan, inflation is positive again and rising.
In the BRICS, inflation is high and rising. China’s inflation rate just went up to 8.5 percent; and no, it’s not rice, chickens, pigs or energy, it’s inflation made by lax monetary policy in the short and medium term and a positive output gap in the short term. In fact, if we allow for inflation suppressed by price controls, the equivalent open inflation rate in China is probably above 10 percent. In Russia, inflation is well into double digits and rising. In India inflation is above 5 percent and rising. Only Brazil appears to have inflation reasonably steady at 4.73%, close to its target value.
Inflation is rising in countries that are tied to a weak currency, like the Gulf Cooperation Council States. Inflation is rising in countries tied to a strong currency. Latvia’s inflation rate came in at 17.8 percent. Inflation is rising in countries that have a floating exchange rate, like Iceland.
Central banks across the world have had it too easy for too long. It is time to bring inflation down to tolerable levels through appropriate restrictive policy. Fiscal tightening cannot reduce the short-run paid, but it can bias the composition of the necessary contraction in favour of the protection of investment. Unfortunaltely, both in the UK and in the US, discretionary stimuli instaed primarily support a still excessively buoy level of consumer demand.
As as regards those analysts and repporters who consider the inflation rate and inform you that, provided you exclude the bundles of goods and services whose prices have increased the most, the inflation rate of the rest is quite modest, cast them out, because they are not your friends.
I think he accuses of confusion and then confuses himself, in excactly the same way.
If I have an index which includes the prices of food, fuels etc. (which he seems to accept as a measure of inflation), then it will move both by supply/demand shocks as well as fiscal measures. Sometimes, it’s hard to tell them apart (as fiscal measures could, ala housing bubble, cause not just wholesale price level increase but rather a targeted one).
Moreover, it’s irrelevant what economist call inflation – people call cost-of-living increase inflation, and it’s irrelevant to them whether its from one-off s/d shocks or stable monetary growth or whatever. They base their wage (and future) expectation on this real-world measure, not on precise but not-real world monetary growth measure (of course, the latter can easily drive the former, so the connection is there – but not in the way that matters to real world people).
One thing that really amused me:”Other shocks, real and nominal, can influence the general price level, but these always can be offset by the central bank, given enough time.”
I’d really, really like to see how CBs can manage supply/demand shocks in base commodities.
Inflation all around. Sounds like a job for the BLS.
At this point, the inflation “debate” strikes me as counterproductive as the “global warming” debate. On my climate blogs, time and energy is wasted on arguing with the deniers, distracting from useful analysis.
What does this remind me of? Oh yes, the Iraq war “debate”…
Yves, love your blog as always and would not ponder a day going by without checking it.
I don’t think Buiter understands how energy prices affect overall prices.
Ultimately, there is no real value in anything but energy. (Another word for energy is “work”.) For example, copper in the ground appears to have value in and of itself, but that’s only because energy has been so cheap for so long. In fact, copper in the ground has no value unless we have the energy to mine it and transform it into something we can use.
As energy becomes the limiting factor on production, the price of everything will come to increase at the same rate as the price of energy. The price of the thing will, in fact, be the cost of the energy to produce it.
We are starting to see the impact of energy supply problems on broad prices, but we haven’t seen the full effect yet because we’re still squeezing out a lot of fluff–the part of each product’s cost that has been going into things like marketing and profits. But for some products, like food and gasoline, there’s not much more fluff to squeeze out.
No central bank can change the effects of energy price on broad prices with monetary policy. The only thing a central bank can do to influence commodity prices is destroy demand by destroying people. If you destroy enough people at the bottom, you can keep things cheap for the people at the top, but that would be, in my opinion, a really sick solution to our problems.
“As energy becomes the limiting factor on production, the price of everything will come to increase at the same rate as the price of energy.”
I don’t mean to be a Marxist, but one thing Das Kapital largely hit on the head is the labor theory of value. But the labor theory of value works only when there is sufficient competitive capacity to drive prices down to the cost of production. This cannot be said with respect to energy, at least at this point in time, and hence the price of energy has become disconnected from the labor necessary to produce it.
Therefor one needs to update the price of goods to reflect the labor and energy theory of value (energy being a substitute for labor in the production of goods).
In that regard I have to agree fully with Moe’s point.
On the other hand, I have long taken the view that the Federal Reserve Bank will tolerate all kinds of inflation, in whatever asset classes, but will not tolerate general wage inflation – i.e., an inflation which does not work to the detriment of the average person (CEO pay inflation, that is fine with the Fed). The Fed, as well as most central banks these days, is completely in the hands of the elite globalists, whose sole goal is to enrich and empower themselves at the expense of everyone else.
However I do disagree with Moe that a central bank can do nothing to combat this inflation. What a central bank can do to constrain prices is to – GASP – reduce the money supply. This renders each monetary unit more valuable. Imagine, if there was a sum total of 1 billion US dollars in existence, would a barrel of oil still cost $125? Of course not. In this sense, Willem is correct: it is in the power of the central bank, at least one which has free reign, to control inflation.
But again: the agenda of the US Federal Reserve Bank is to enrich the wealthy globalists and to generally collapse the middle class. This explains the Fed’s enthusiastic support for “globalisation” (or, as a direct result, the reduction of wages for the middle class), tax cuts targeted toward the wealthy, grossly understated inflation measures (which reduce wage increases for those workers and retirees obtaining cost-of-living adjustments to income), and virtually every other policy you see them pursuing, including, incidentally, the vast run-up in middle class debt-loads and the modifications to the bankruptcy laws. Of course all of this has to be tied to all of the “terrorism” legislation – beware, when the impoverished middle class tries to assert itself, you will quickly see the terrorist label applied to domestic dissent.
Mark my words.
The Volcker-induced recession played a significant, although not exclusive, role in killing the commodities inflation of the mid-late 1970s, including oil price increases.
Yes, class struggle is alive and well. The working class has been duped by bogus satistics, wealth envy, and American Idol diversions. A day is approaching when the submission hold on the working class will weaken and the reality of the ongoing struggle will become clear to all.
yves, it was partly the Volcker-induced recession and partly massive increases in oil production in the 80s (the North Sea) that killed that commodity boom. But the supply restrictions of the 70s were overwhelmingly geopolitical in nature, whereas today the geopolitical component, while present, is increasingly outweighed by the sheer geological difficulty of bringing on new projects.
Anonymous 11:45am points out that the Fed can bring down prices by reducing money supply. I’m sure that’s true, and I don’t want to argue in favor of massive printing. But I’d argue that controlling the money supply is not in itself the solution to the underlying problem.
It’s also true that the abuses perpetrated by our financial sector have been grotesque, and it’s true, as Yves has repeatedly pointed out, that we have to regain some control over these people and redirect our capital from their pockets into productive investment. But I don’t think these people are really our most important problem. They’re more an irritating side show.
I believe the economy has stopped growing because our energy supply has stopped growing. In fact, our energy supply has begun shrinking (very slowly), because the energy inputs required to maintain flat production have been growing. I believe the only way to resume growth (or at least prevent serious contraction) is to increase energy efficiency. It’s going to take a lot of investment, and a functioning economy, to do that.
I believe inflation is better than deflation at this point because if you allow the rich to make money just by stuffing their capital into a mattress, that’s what they will do. They will take no risk whatsoever, and it will be the people at the bottom who get squashed. Inflation is like the antes and blinds in a poker game–it forces capital to stay in the game and take risks.
Buiter makes a good argument but I think the reality is even more extreme than he says: prices overall simply CANNOT go up unless additional money or credit is created to bid them up. Otherwise, a demand “bubble” in one area will be counter-balanced by a drop in demand somewhere else, so overall, price levels will be the same.
One could argue that financial assets don’t really count as “goods”, but that is a sort of willful ignorance. If financial assets are losing favor, then you can bet hard assets are gaining favor (especially with negative real interest rates) to make up for it. The money has to go somewhere or it might be destroyed, in a hot-potato fashion.
A corollary of this point is that there may be little central banks can do now to ameliorate the situation. The money and credit have already been created over past decades of easy policies. Now that the “investment emphasis” has switched from financial assets to hard assets in a likely irreversible fashion, central banks face a veritable busted dam of their own past money creation, spilling into a landscape where it is impossible to hide.
Putting that genie back in the bottle would be a conscious decision to deflate — which governments never willfully pick, if even possible to carry out.
Perhaps we live in a brief, fossil fueled golden age that will disappear in the blink of an eye and leave only our empty highways as memoria.
It’s also possible, as Drucker said, that a resource doesn’t exist until an innovation makes use of it. Without farming, all plants are weeds. Without chemistry, fossil fuels are just smelly poison.
Which means that the true energy of our economy is the innovative and productive capacity of people. The last 10 years has diverted innovation into financing, arbitrage, and (really) theft. Redirecting that innovation into the real economy is the key, and will happen as the smart people on Wall Street decamp to Pittsburgh and actually start doing something useful with their lives.
As far as energy goes, it means pricing it appropriately for its externalities (such as climate change and pollution), and letting the market develop alternatives. The most significant alternative energy program, of course, is simply to use less. Others become more economic as the price of fossil fuels spiral.
Now, that said, the easiest way for Americans to welsh on their debts to the petroleum producer nations is to inflate them away. Yeah, that has horrible economic consequences, but we really owe the Saudis nothing–let’s not forget that they want us dead. Of course, the inevitable consequence is that Americans will need to count on domestic saving for investment capital.
Yves, that was at a time where US was the oil price maker, not taker. If China would float, and at the same time slam 10%+ interest rates, it’s likely that the commodity prices would drop.
– Buiter’s belief in central bank control belongs to another time, one prior to 30 years of national and international deregulation of finance and rise of unregulated non-bank banks which, given their interaction with the traditional sector, created what, in 2001 or ’02, Larry Lindsey termed “nuclear credit fission”.
– He also seems to take a quantity theory of money and price approach. In different forms, this has been debated for over two centuries and remains questionable. Price formation, especially in a regime of credit money and unstable velocity, cannot be reduced to the degree it seems he does but should try to take labor value as mediated through cost of production into account.
– changing levels and types of development also change the dominant money form — the system creates the form of money which it needs and, to degrees, price creates money, which would be no more than a trivial circle were it not for the role of value and its non-identity to price.