Inflation Defined

This blog is designed to explain exactly what inflation is. The economics community today is in a very sorry state concerning inflation. Policy mistakes are being made today on the basis of false assumptions concerning inflation. These false assumptions need to be addressed with clear logic and facts.

Tuesday, January 02, 2007

Making Accurate Predictions About the Economy

With the new year upon us, so too are the predictions for the United States Economy for the new year from all the Economic "Experts" and Pundits. Well, you can take all of those predictions and throw them right out the window (or as my friend is fond of saying as he stands over the trash can and dumps unwanted material, "file them") because they are all worthless. If any of them are accurate, it is due entirely to pure luck. How do I know this?

The overwhelming factor that determines how the Economy will do today is the Federal Reserve. By manipulating the money supply and interest rates, the Federal Reserve causes changes in economic behavior, which causes changes in economic growth rates. The Federal Reserve can, and frequently does, change policy course at moments notice. If someone makes a prediction about the Economy without taking this into consideration, the only way that that person's prediction could possibly be accurate is through sheer dumb luck.

As we head into the new year, no one, including the policy makers at the Federal Reserve, knows what the Federal Reserve is going to do this year. Anybody who tries to predict what the Economy will do over the coming year without knowing, or at least having a very good idea of, what the Federal Reserve will do this year has no hope of being correct, beyond sheer dumb luck (and sheer dumb luck has caused a few prognosticaters to gain unwarrented guru economic status over the years). This is why I have argued for a long time now that the Federal Reserve should follow a crystal clear policy path based upon sound logic and historical facts, and not upon the whim of a handful of Academicians and Bankers, who often make policy decisions based upon the flavor of the month currently popular in economic circles at the time ("anything under 6% unemployment will cause inflation" - God help those in the hands of such people).

When I made an accurate prediction for the Economy back in October of 2005 (see previous posts), it was clear to me what policy course the Federal Reserve was on, and so I was able to make an accurate prediction for the Economy. (Over the years I have had an uncanny knack of accurately predicting what the economy will do, which has caused a number of people to ask me for predictions about the Economy. If I have a clear idea of what the Federal Reserve is going to do I will tell them, but most times my answer is, "Tell me what the Federal Reserve is going to do over the next six months, and I'll tell you what the Economy is going to do.")

In October of 2005, I predicted that the Federal Reserve would likely keep raising interest rates until it had choked off all economic growth. That did not happen. Why? In the weeks prior to when the Federal Reserve stopped raising interest rates, I sent a copy of my October 2005 prediction to the current Federal Reserve Chairman, Ben Bernanke. I also gave him this site's web address. So far, the Federal Reserve changed course before they did choke off all Economic growth. The risk that they may go back to such an unwise, and historically inaccurate, policy remains.

We head into the new year with great uncertainty regarding what policy course, or courses as the case may be, the Federal Reserve will follow over the coming year. Without knowing what the Federal Reserve will do this year, it is impossible to make any accurate forecasts or predictions for the Economy in 2007, beyond sheer dumb luck.

Thursday, September 07, 2006

Wage Inflation and Asset Inflation Do Not Exist in the Real World

Such ideas as wage inflation and asset inflation are misnomers. Wholesale wage or asset inflation cannot happen.


"Wage Inflation"

The idea behind so called wage inflation is that workers demand higher salaries which forces businesses to hike prices which causes inflation. But where are individuals going to get the money to pay the higher prices? From the higher salaries they are demanding? Where are businesses going to get the money to pay the higher salaries? From the higher prices they are charging? Back to the first question, where are individuals going to get the money to pay the higher prices? It’s a ludicrous circle that does not exist in reality, only in the minds of the misguided.

Businesses and individuals have to earn or borrow the money they need to survive, they cannot simply go down to the local copy store and have them run off sheets of twenty dollar bills. No new money is created when workers try to demand higher wages or businesses try to raise prices. Such activity causes no inflating of the amount of money in circulation. If something is not inflating the amount of money in circulation then it cannot cause inflation. Wholesale wage inflation does not exist in the real world.


For a time in the 1990’s, the Federal Reserve was basing monetary policy on the idea that anything below 6% unemployment would cause inflation. This idea is simply ludicrous. It would actually be hilarious, if it did not have such a direct impact on so many people’s lives.

Throughout the 1800’s, the unemployment rate was routinely below 2% in the United States, and, except for war times, there was no inflation. In Japan in the 1980’s, the unemployment rate was below 2%, so, according to the logic the Fed was following during part of the 1990’s, Japan should have had roaring inflation. Did they? Of course not. The unemployment rate is irrelevant to inflation.

When businesses hire new workers they cannot simply create money out of thin air to pay those workers. If businesses try to raise prices to pay the new workers, individuals cannot create money out of thin air to pay the higher prices. Individuals and businesses cannot create money, meaning they cannot inflate the amount of money in circulation. Individuals and businesses cannot cause inflation.

If "Wage Inflation" did exist in the real world, there would be a direct correlation between unemployment levels and inflation. When unemployment levels are low, inflation levels would be high, and when unemployment leves are high, inflation would be low. In the real world, the correlation is the exact opposite.

Japan had 2% unemployment during the 1980's with little or no corresponding inflation, while Mexico and Brazil had high unemployment levels with corresponding high inflation levels.

Only the Federal Reserve can inflate the amount of money in circulation in the United States. Only the Federal Reserve can cause inflation in the United States. To blame workers for causing inflation, especially considering what inflation does to workers labors, is ludicrous beyond belief. To base policy on such an idea is the absolute height of incompetence.


"Asset Inflation"

The idea behind asset inflation is that if assets are bid up to high levels, whoever owns those assets will have much more money to spend which will raise prices for all goods and services. This is just not true. No matter how high an asset is bid up, no new money is being created by that act.

If you buy a stock for $10 and it goes to $100 or $200, no new money has been created. When you go to sell the stock for $100 or $200, someone else is paying that price for the stock with money they had to have earned or borrowed, not created out of thin air.

The same is true if you want to borrow money against an asset that has been bid up. If your home has risen in value from $200,000 to $400,000, you must reealize that gain before you can spend it, either by selling your home or by borrowing against the equity. If you sell, whoever buys the house has to pay you money they have either earned or borrowed. If you borrow against the equity, whoever loans you the money must also have earned or borrowed the money to loan you. No new money is created when an asset is bid up in price.

Like wage inflation, wholesale asset inflation does not exist. Both will appear to exist when the Federal Reserve inflates the amount of money in circulation, but neither really does.


Why Real Inflation Causes Higher Wages and Higher Asset Prices

When money loses its value, which is what inflation causes, individuals need more of it to survive and must demand higher wages. (Their labor is not changing, the value of the money they are working for is.)

When that happens it may appear as if wage inflation is happening, but it’s not. It’s simply individuals adjusting to the loss in money’s value, caused by the inflating of the amount of money in circulation, by demanding higher wages to compensate for the loss.

When money loses its value, the prices of assets must also be adjusted to account for the loss in the medium we are using to price the assets, money. Again, it may appear as if asset inflation is occurring but, again, it’s not. It’s simply individuals adjusting to the loss in money’s value caused by the inflating of the amount of money in circulation.


Whenever someone talks about "wage inflation" or "asset inflation" as if they are real, you can pretty much ignore whatever that person says concerning economics. If he or she has no idea what inflation really is, the person has no clue about economics or how economies work.

Thursday, August 24, 2006

Making an Accurate Prediction About the Economy

When one understands what really causes inflation, and what effect inflation has on an economy, making accurate predictions about how the economy is going to do going forward becomes much easier. That is why today most economists predictions about the economy are worthless. Most economists today do not understand what inflation really is, so they have little or no hope of making accurate economic predictions consistently.

I wrote the following last October about the economy:


As is starting to become evident, our economy is slowing down rather dramatically. The Federal Reserve will, of course, blame higher energy prices and the hurricanes as the causes. Complete and utter nonsense.

It is the Federal Reserve’s actions over the past year and a half which are now causing the slowdown. The Federal Reserve has nearly Quadrupled the fed funds rate over this short time frame, which is the overwhelming factor in the economy slowing. The main questions going forward are how much will the economy slow and will the Federal Reserve continue on until it causes yet another recession?

The stated purposes of the Federal Reserve for raising the fed funds rate so dramatically are price stability and to contain inflation. The facts clearly show that the Federal Reserve’s actions and its stated reasons for those actions are at cross purposes. In order to show this let’s look at two economies.

Japan for well over a decade has had nominal interest rates. Rates that the Federal Reserve would call “accommodative”. According to the logic the Federal Reserve is following today, Japan must have had high inflation and no price stability. In fact, just the opposite is the case as Japan has had no inflation and relative price stability.

The German economy, especially prior to the formation of the European Union, has had high interest rates. According to the logic the Federal Reserve is following today, Germany must have no inflation and price stability. In fact, Germany, despite the high rates, has been struggling with persistent inflation above what it wants.

Both economies have been struggling with low growth and high unemployment.

The reason why both Japan and Germany have had economic problems is simple. Both are trying to control interest rates instead of letting the market do so. By setting interest rates, and not letting the market do so, both are interfering with the natural growth rate of money.

In Japan’s case, by keeping rates too low, all of the trillions of yen in financial institutions are earning little or no interest, causing very little natural money supply growth.

In Germany’s case, the above market rates are causing all the marks in financial institutions to earn more interest than they should, causing natural money growth to be higher than it should be, causing the nagging inflation that is higher than Germany wants.

In our economy over the last year and a half, we have seen both sides of the coin. The Federal Reserve had interest rates too low, causing money growth to be low as well as inflation and job growth to be low. Since, the Federal Reserve has raised rates, to the point where they are now too high, which will cause persistent and nagging inflation to be above what the Federal Reserve would like, and slowing growth and, unfortunately and almost certainly, causing job growth to disappear.

Today the Federal Reserve has trapped itself. It raised short term rates to keep inflation in check, but by raising rates above where they belong the Federal Reserve is also causing natural money growth to be higher than it should be. Once again we see a case where the Federal Reserve is fighting itself. Going forward, as inflation numbers stay persistently above what the Federal Reserve wants, the Federal Reserve will continue to raise rates, eventually choking off all economic growth.

The facts are clear. If the Federal Reserve really wants to keep inflation low, it should LOWER the fed funds rate today. A year and half ago I wrote that in order for the economy to have better economic and job growth the Federal Reserve needed to RAISE the fed funds rate, not lower it to zero (as the Fed said it would do at the time and almost all economists at the time said it should do). Today, in order to accomplish its stated goals of price stability and no inflation, the Federal Reserve needs to LOWER short term rates to where they would naturally go if the Federal Reserve was not trying to manipulate them.

As the facts turned out I was right a year and half ago, as the Federal Reserve raised short term rates and economic and job growth picked up smartly. Unfortunately, and it saddens me greatly, but I will be shown to be right again.


- October 11, 2005

Raising Interest Rates to Stop or Control Inflation Makes NO Sense in the Real World

The idea that raising interest rates will stop or prevent inflation is pure folly. Anyone who actually believes that inflation can be prevented or slowed by raising interest rates would be very hard pressed to prove that in the Real World. As the Federal Reserve kept raising interest rates to "stop or prevent inflation", I wrote the following:



The Federal Reserve is raising interest rates to slow or stop inflation. According to the Federal Reserve’s logic, economies that have the highest interest rates MUST have the lowest inflation rates. Conversely, economies with the lowest interest rates, MUST have the highest inflation rates.

Japan, for well over a decade, has had the lowest interest rates on the planet, almost non-existent interest rates at times. Therefore, according to the Federal Reserve’s brilliant logic, Japan MUST have had, and still have, the highest inflation rates in the world. Do they?

Mexico and Brazil, over the last decade, have had some of the highest interest rates in the world. So, according to the Federal Reserve’s brilliant logic, Mexico and Brazil MUST have had, and still have, the lowest inflation rates in the world. Do they?

- March 22, 2005

High Oil Prices Will Not Cause Inflation or a Recession

When oil prices really started to rise a few years ago many economists predicted that the higher oil prices would translate into higher inflation levels and slower economic growth, with more than a few predicting that high oil prices would cause a recession. In response to such ignorant thinking, I wrote the following:


High Oil Prices and Economic Growth

No matter how high oil prices go, when we go to the pump or use oil in any other way, a business transaction is taking place. Economic activity is continuing. Money may be diverted from other transactions to pay for the higher oil prices, but economic activity does not stop.

Economic activity stops when the amount of money in circulation changes, specifically, when the growth rate of money in circulation slows or stops dramatically. Higher oil prices do not effect the amount of money in circulation, or the growth rate of money in circulation. So higher oil prices will not cause economic activity to stop. Higher oil prices, in and of itself, will not cause a recession.

In the 1970’s, the Federal Reserve, due to higher oil prices, inflated the amount of money in circulation. The Fed did this because the leaders at that time believed that in order to pay the higher oil prices there had to be more money in circulation in the economy. All this mistaken logic did was to cause inflation. When the inflation came the Fed stopped inflating the money supply and a recession followed. It was the Federal Reserve’s dramatic slowing of money growth which caused the recession.

No matter how high oil prices go, inflation will not occur unless the Federal Reserve inflates the amount of money in circulation. The higher inflation of the 1970’s was not caused directly by higher oil prices, but by the mistaken policy decisions made by the Federal Reserve at that time regarding higher oil prices.

- October 5, 2004

Monday, February 27, 2006

What is Inflation?

Inflation is inflating the amount of money in circulation. That is all inflation is. Nothing more, nothing less.


WHAT CAUSES INFLATION?

Inflating the amount of money in circulation is different than simply increasing the amount of money in circualtion.

The amount of money in circulation increases naturally each year, mainly through earned interest. If you have $1000 in the bank earning 2% interest, at the end of a year you will have $1020 in the bank. The earned interest causes the money supply to increase naturally. The earned interest in this case does not inflate the amount of money in circulation.

When the Federal Reserve causes interest rates to be above where they belong, you start earning more interest than you should, and the extra, artificial interest, causes the money supply to be inflated, causing inflation.


RAISING INTEREST RATES IS NOT THE ANSWER, IT'S THE CAUSE

This is why it is foolhardy, at best, for monetary authorities to raise interest rates to stop or contain inflation. You cannot put out a fire by throwing the liquid gasoline on it. You cannot stop or contain inflation by doing something that will cause inflation, as raising interest rates above market levels will do. If raising interest rates could stop or contain inflation, then countries like Brazil and Mexico, which have had some of the highest interest rates on the planet over the last two decades, would have had the lowest inflation rates in the world. The opposite has been the case in Brazil and Mexico, because raising interest rates above market levels CAUSES inflation, not prevents it.

Another way to look at it is, if raising interest rates stops inflation, then lowering interest rates causes inflation. That's wrong also. If interest rates are below market levels, the money supply will not grow naturally, as little interest is earned. In Japan for almost two decades now, interest rates have been almost non-existent. If low interest rates causes inflation, then Japan must have had the highest inflation rates in the world over the last two decades. In reality, Japan has had virtually no inflation over the last two decades, as the low interest rates have prevented even natural money growth from occurring much, let alone any inflating of the money supply. By keeping interest rates below market levels, Japan has even had to deal with occasional deflation, as little natural money growth has occurred.

The amount of money in circulation can also be inflated anytime the Federal Reserve decides to. The Federal Reserve can simply release money into the nation's economy through the banking system, anytime it pleases. The extra money released into the economy causes the amount of money to be inflated and causes inflation.

The two ways mentioned are they only ways the money supply can be inflated. The only way to have inflation is when the Federal Reserve causes it to happen. Inflation cannot occur by itself. If the Federal Reserve disappeared tomorrow, and no other money creating government body was created to replace it, we would never have inflation in this country.


INFLATION IS NOT AN UPWARD MOVE IN PRICES

A common misconception popular today is that inflation is an upward move in prices. An upward move in prices is not inflation, it is a by-product of inflation. When inflation occurs, prices will move higher. However, prices can also move higher without inflation. For example: the price of oil can move dramatically higher due to higher demand, wars, supply problems, shipping problems, and a host of other reasons, none of which have anything to do with inflation. The rise in oil prices has no effect upon the amount of money in circulation. The amount of money in circulation is not inflated in any way, shape or form by a rise in oil prices, or any other rise in prices. If something does not cause the amount of money in circulation to be inflated, then it is not causing inflation.

If inflation was a rise in prices or price levels, then a rise in oil would send inflation rates up in every economy. Inflation would be a global phenomenon. The facts say, clearly, that inflation is NOT a global phenomenon. Over the last two decades, Mexico and Brazil have had high rates of inflation, but Japan has not. In the early 1930's, many economies had deflation, but the German economy had massive inflation. Inflation levels are specific to each economy that has its own money supply.

Whenever you hear someone say that inflation is a rise in prices, or price levels, you can totally disregard anything that person says concerning economics. Anyone who does not know what inflation really is, has little hope of understanding anything to do with economics. And yet today, the economics community is filled with simpletons who continually spout the notion that a rise in prices or price levels, is what inflation really is. If that is so, then please explain to me how a rise in prices causes the amount of money in circulation to be inflated? It does not because it cannot. How can a rise in prices cause the amount of money in circulation to be inflated? Only a simpleton, someone completely lacking in cognitive reasoning skills, would spout such nonsense.