Especially with this morning’s CPI release – up 8.6% over the past year – a new forty year high – the news is flooded with stories about rising prices and inflation. But they’re usually talked about as if they’re the same thing. This is unfortunate, because it confuses not only financial reporters and the general public but economists and policymakers as well.
Rising prices need no definition. But here at Financology, inflation refers to depreciation of the currency, or the excessive production of currency that causes that depreciation.
Why distinguish between the two? Currency depreciation practically tautologically means higher prices … lower the value of a dollar and it takes more of them to buy the same stuff. Goods and services aren’t increasing in cost or value. Talking about things “going up” is like standing on the deck of the Titanic and talking about the ocean rising.
But goods can rise, too. If an earthquake destroys a major semiconductor fab or bad weather an orange crop, that reduces the supply of these goods, and if people try to buy the same amounts as before they can’t succeed. Prices rise to balance the amount bought with the amount available for sale. If the population doubles while the amount of coastline remains the same, the real value of oceanfront property rises. These price increases have nothing to do with inflation, they’re real increases.
With many goods, however, the real cost declines over time as technology allows more to be produced with each hour of labor. This is not deflation. It is not an offset to inflation. This is a real decline in prices. Inflation is a monetary phenomenon.
It’s vital to distinguish between the two because monetary policy cannot and should not attempt to compensate for non monetary price changes. It should however vigorously oppose changes in the value of the currency.
What confuses most financial analysts right now is that both of these things are happening at once. We have had immense inflation via production of money over the past decade or so, and an unprecedented explosion over the past couple of years as central banks and governments foolishly tried to offset the effects of economic shutdowns by producing and distributing currency. These shutdowns gave way to other shutdowns of production and flow of trade by war and sanctions. So we have real cost increases on top of currency depreciation.
Further confusing matters is that shortages can be produced by monetary inflation alone. Given the extreme monetary inflation that has taken place, we would have experienced shortages even in the absence of pandemic or war related production and trade obstacles. Prices are the medium through which supply and demand, or production and consumption, are balanced. If for whatever reason prices are impeded from adjusting, this balance is disrupted and either surpluses or shortages develop. If prices are above market clearing levels, surpluses develop. If they’re below, you get shortages.
There are all kinds of impediments to the free movement of prices. A common one results in surpluses of labor. When central banks inflate, it can take a long time before consumer prices broadly rise, and because inflation has built up in the pipeline, they must adopt a deflationary policy to counter it. This produces an increase in the value of the currency. Real wages rise. So in order for real wages to remain the same, nominal wages would have to decline. They often don’t, because people resist declines in nominal wages. Labor contracts may prevent them. This results in artificially high prices for labor, inducing labor surpluses. Otherwise known as unemployment. In other words, widespread unemployment only occurs because wages fail to adjust … if they did, unemployment would never be a systemic issue.
Conversely, if prices are artificially low, shortages develop. In times of rapid inflation, a similar phenomenon arises in which sellers are reluctant to raise prices rapidly enough to balance supply and demand. There may be industry or government polices designed to limit price increases. But there is no free lunch. If prices fail to keep up with inflation, shortages occur.
How much of these rising prices and shortages are due to inflation? Most of them. Labor shortages and rising housing prices for instance are almost solely due to inflation.
This complicates policymaking. But most of the complication is self induced. How? By trying to use goods and services prices as the sole measure of inflation. As we’ve discussed before, confusing consumer price increases with inflation causes real problems. And this is one reason why Financology rejects this widespread fallacy and instead adopts the axiom that the true unit of value is not stuff, but human time.