Tuesday, December 3, 2013

Immaculate Inflation

Written by Modeled Behavior

I should write more on this but for now I’ll get a brief primer on how I think about inflation and how it differs from what I read most other places.

One of my common quips is that “there is no such thing as immaculate inflation” or that “inflation cannot proceed through magic.”

What do I mean by this?

Well, inflation in the common sense of the term is a rise in all wages and prices. In the long run small rates of inflation shouldn’t effect the economy that much. However, in the short run it can cause discomfort or joy depending on your situation. Not all prices rise at the same rate and some people have contracts – mortgages for example – that are specify a certain amount of money to be paid.

Inflation lowers the value of that money and so makes the mortgage easier to pay for the borrower but less profitable for the lender.

That is all well, good and important at a macro level.

However, at the same time inflation must proceed through market processes. Demand for some product must rise or supply must fall. Generally, the inflation we experience is from a rise in demand caused by cheap financing. That cheap financing is a result of the Federal Reserve printing more money.

However, as this money works its way through various markets we should seem them respond as markets respond to increased demand, through an increase in both output and prices.

So when we crack open the BLS report on inflation we can look at different markets. We see for example that are rents rising. This adds to our overall estimation of inflation but it also suggests a tightening rental markets which should make apartment construction more profitable.

We may also see a rise in the prices of automobiles. This summer the increasei in car prices came from a decrease in the supply of automobiles as a result of the Japanese Tsunami. However, as that fades we might be able to interpret future increases in price as a tightening of the car market and expect sales to increase.

We also see used car prices going up. This suggests that natural obsolesce is working its way through the used car market and pushing people into newer cars.

We can take a step back and interpret these events as saying liquidity demand is being satiated. Or, we can take a micro perspective and say that the demand for goods and services in these markets is increasing. Either way we look at it, however, demand driven inflation should be drive a rise in production.

In an economy with little unemployment we would expect this to bid up wages as employers competed for scarce labor. The result would simply be higher prices and wages and a distortion of long term contracts like mortgages.

However, in an economy with high unemployment we should expect some of this to result in an increase in hiring. Thus I see when I see rents rising, I think that means that construction employment will rise. When I see new car prices rising I think that means manufacturing employment will rise.

It is always possible that inflation is actually occurring first in commodity markets. This in turn is causing the supply in various individual goods markets to contract and thereby bidding up prices.

However, by looking at a the economy on a market by market basis we should be able to tell which is which. This is one reason why inflation driven by gasoline prices is “bad.” It almost certainly represents an increase in the price of a commodity – oil and a reduction in the supply of gasoline.

This means that we expect contraction in the gasoline market. In addition through income effects we should expect a contract in the demand in other individual markets.

When inflation is coming through the commodity markets it means that either the commodity is in short supply generally or that it is being pulled away from the US market by demand elsewhere. In either case the result is less real resources available for US households and firms.

However, when inflation is coming through the final goods market it means that real resources are being pulled towards US households and firms. That implies both that US households and firms are trading out of cash and into real goods and that the net effect in each individual market will be an increase in output.

Source: Modeled Behavior
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