Inflation and Monetary Confusion

If you want to read an analysis that perfectly captures the confused thinking that predominates on inflation, monetary policy and the economy, then check out “Cooler yet the pressure rises: Why a Seventies-style whiff of stagflation may soon be in the air” by Krishna Guha in the December 3 Financial Times.

The piece is rich in the kind of waffling “on the one, but on the other hand” economics that just drives people crazy. And in a quite lengthy piece about inflation, it manages to avoid clearly touching on the actual cause of inflation.

Consider a few points:

• The title of the piece and a few points within the article highlight risks of stagflation, yet it opens noting that “world inflation is uncomfortably high,” but such concerns “would swiftly disappear if the US plunged into a deep recession.” Hmmm. But I thought stagflation was high inflation tied to a no-growth or recessionary economy?

• The piece does an adequate job at explaining a key difference or debate among central bankers – with one camp (mainly the U.S.) focused on core inflation (less food and energy) and others looking at headline inflation. Obviously, the focus should be on headline inflation. After all, inflation, by definition, is a rise in the general price level – not a rise in prices excluding food and energy, which tend to be rather important to individuals and businesses.

• However, the article buys into the mistaken notion that economic growth is bad for inflation. For example, there is a good deal of talk about central bankers being worried about factory capacity utilization and unemployment rates. The notion that the economy is dynamic – for example, that investment and innovation occur, productive capacity expands, the labor force grows, and workers become more efficient – is not considered. For good measure, it is noted: “If growth slows very sharply in any or all of the main economies, unemployment will rise and capacity utilisation will fall, making it less likely that inflation will stay high or move higher.” Hey, what happened to stagflation?

• There was a hint of understanding when the piece mentioned a weaker dollar pushing up the price of oil and adding to U.S. inflation. For good measure, the importance of keeping inflation expectations in check was highlighted. But these points were largely undeveloped.

• Finally, the author wrote: “Indeed, the big debate within central banks today - deeper than, though related to the argument about headline versus core inflation - is the extent to which they can exploit the apparent stability of inflation expectations to cut rates aggressively, at least for a while, in response to any threats to growth.” Guha is correct in saying that this is a major debate. Unfortunately, it speaks to how far astray thinking about monetary policy can wander from sound fundamentals.

Let’s straighten out a few things here. First, inflation is caused by money supply growth outpacing money demand. That is, too much money chasing too few goods. So, economic growth is good, not bad, on the inflation front. Second, higher energy prices do not cause inflation. Rather, either higher energy prices result from inflationary monetary policy, or higher energy prices get monetized with inflation then accelerating. Third, and critical, monetary policy should be exclusively focused on maintaining price stability. By establishing price stability, monetary policy in turn helps economic growth. Monetary policy should not be concerned with, and is ill-equipped to be fine-tuning or manipulating economic growth.

Policy changes directed at economic growth are the domain of fiscal policy – such as tax relief, rolling back costly regulations, expanding free trade, and slashing wasteful government spending – not monetary policy.

When monetary authorities – such as the U.S. Federal Reserve – try to do both inflation and growth, the results tend to be quite ugly.