July CPI data came out yesterday, and it was a little below expectations. Year over year, the CPI fell 2%, while overall prices held steady in July and core prices (excluding food and energy) rose a mere 0.1%. That's pretty tame, on the surface, and a source of concern to all those who have been worrying about deflation.
Most of the decline in the CPI over the past year has been due to the collapse in energy prices. That's just about run its course, however, since oil prices have doubled from their lows of last December and have been flat since the beginning of June. In the past three weeks, in fact, gasoline prices at the pump have risen 8%, which means we should see energy adding to the CPI in August.
The volatility of oil prices has been of an extreme nature in recent years, so there is plenty of justification for excluding energy and focusing on core prices instead. As the chart shows, the Core CPI is up 1.6% in the past year, and the year over year pace of price gains has been slowing. But that is deceptive, which is why I've included the 6-mo. annualized change in the Core CPI, which is now 2.1%. And even if you look at the whole CPI, it is up at a 2.4% pace year to date, and up at a 3.4% pace in the past three months. So while inflation was definitely low late last year, is not really negative or moderating now at all, and it's probably in the neighborhood of 2% or so.
That would be fine by most people, even the Fed. Except that the Fed's model of inflation says it should be at least zero or negative by now, given the huge "output gap" that the economy is currently experiencing. Conventional wisdom says that when the economy is as weak as it is now, everyone is under pressure to cut prices, and that leads to the dreaded deflation, of the sort that has plagued Japan for decades. And, as the thinking goes, deflation is very bad for economy, as we saw in the Great Depression, because it causes consumers to stuff money under their mattresses instead of spending it.
My good friend and mentor Art Laffer recently wrote a paper that debunks this notion pretty thoroughly. He points out that in a recession it is of course quite normal for businesses to face great pressure to cut costs. Cutting prices helps them become more competitive, and that is the key to survival in an economic downturn. But is cutting prices at the company level equivalent to an economy-wide deflation? No. To argue that what occurs at the company level is also what occurs at the economy level is to fall for the fallacy of composition.
When a businessperson talks about lowering prices because demand is weak, they’re not talking about dollar prices so much as they are talking about lowering the prices of their products to attract business away from other producers. To attract business away from other companies, the businessperson lowers their product prices relative to the prices of other producers’ products, thus making their goods more competitive in a price sensitive marketplace.
For a business, prices are relative prices, while for an economy, prices are dollar prices. Therefore, it only makes sense that on an economy-wide scale, the money (dollar) price of a representative good will reflect the relative scarcity of money versus goods. The scarcer the money, the lower the price of goods measured in money; the more plentiful money, the higher the money price of goods.
So when we look at inflation from a macro perspective, the price level is determined by whether or not money is scarce relative to goods and services, not by whether businesses have an incentive to cut their prices to gain market share. If there is an excess of money relative to the supply of goods and services (which become intensive during periods of recession), prices in general will tend to rise. The situation in which we find ourselves today is one of a plentiful supply of money on the part of the Fed, but a reduced volume of goods and services coming from businesses. To date, the extra money has been mostly absorbed (but not entirely, which is why inflation remains positive) by consumers and businesses that want to increase their money balances, but with time this extra demand for money will fade and money will become abundant relative to goods and services unless the Fed takes steps to reduce the supply of money. This combination of reduced output and increased money supply can lead to higher inflation regardless of how weak the economy is, and regardless of the number of businesses that cut prices in order to boost their competitiveness.
And already we see some signs that the supply of money exceeds the demand for it. The value of the dollar relative to other currencies is depressed and falling; the value of the dollar relative to gold is depressed and falling; the prices of sensitive assets such as commodities are rising (see previous post); the yield curve is unusually steep, suggesting that bond market knows that monetary policy is easy and will have to be tightened in the future; and TIPS breakeven spreads are rising. All of these market-driven prices are pointing to a relative excess of money that could become problematic. As confidence in the future improves, as it has been doing in recent months, then the demand for money will decline. If the Fed does not take offsetting actions to reduce the supply of money, then money will become overly abundant and the general price level should start to rise more rapidly.
Since the Fed keeps insisting that a weak economy will keep inflationary pressures very low, and uses that rationale to maintain its ultra-accommodative monetary stance, we can only infer that they don't understand the monetary nature of inflation. Inflation is not a by-product of the strength of the economy, as the Phillips Curve suggests (see my discussions of the Phillips Curve here), but in a fiat monetary system such as we have today, inflation is rather a by-product of the interaction between the supply of and the demand for money. If the Fed doesn't understand this, then that signficantly raises the risk that inflation will rise in coming years rather than staying very low or turning negative.
Those who worry about deflation when they see businesses cutting prices are therefore missing the forest for the trees.