Getting over inflation

We may have gotten past the point of needing to be afraid of inflation

There are seemingly few things scarier to an economist than inflation. Rising prices are seen as holding the potential to wreak havoc if allowed to get out of control. Yet, these fears are based on past periods of history such as hyperinflation in inter-war Germany and stagflation in the 1970s. Changes in the economy and the experience of loosening monetary policy in the aftermath of the global financial crisis suggests that the threat of inflation may not be worthy of its reputation.

Higher wages or increases in the money supply are two of the main things that keep economist up at night worrying about inflation. An increase in wages acts to push up prices as companies cover the high wage bill. Although an issue in the past, workers’ pay has been stagnating for decades (which may be a side-effect of central banks in reigning in inflation). More money within an economy is also seen as inflationary as extra cash chasing after the same amount of goods will inevitably push up prices. It is seen as a given within economic theory that, for example, a doubling of the money supply will also double prices.

This relationship between money and prices seems strange as it relies on the assumption that consumers will buy more of the same things if they have extra income. Even the notion that more funds will be spend seems dubious considering that some of the money will likely be put aside. As consumers have more money, any further gains in income are more likely to be saved or invested. This would then suggest that an increase in money supply would raise the value of investments rather than the prices for everyday goods.

This is what happened in the aftermath of the financial crisis when central banks raise the money in circulation. This was done through quantitative easing which amounted to pumping extra cash into the financial sector and did not result in the uptick in inflation that many had feared. Even the surge in debt (which also lifts money supply) in the run up to the global financial crisis did not see any inflation (but did see a big jump in house prices.

The key distinction here is between prices for investment assets and for everyday goods and services. The former is not included when calculating inflation, while the latter is. If extra spending tends to go to buy investment assets, more money does not mean higher prices. If any increases in funds flows to wealthier people (which is likely the case), this effect is likely to be even more pronounced. Taking this to an extreme would mean that, in an economy where the consumers have everything they might want, a doubling of the money supply would, in theory, double asset prices with no impact on inflation.

This story seems to suggest that economies can reach a point where they become too prosperous for inflation. Add in other factors such as a global economy and online shopping creating a competitive environment for many of our purchases. Any attempt to increase prices by one company would just result in their customers going elsewhere. Global production is also so vast that increases in demand could (in most cases) be absorbed through a rise in output. Only the odd commodity such as oil tends to be subject to chronic limits on supply.

This all suggests that inflation may not be as tricky to manage as economists once feared. Rising prices still create economic havoc in places such as Venezuela and Zimbabwe, but high levels of consumer spending and global markets seem to insulate many other places. The prominence given to inflation when managing the economy and particularly within monetary policy thus seems out of place. Surely there are more worthy things to worry about.