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Friday, November 23, 2007

Inflation: Cost push, demand pull, Fed pratfall

Yesterday we looked at what is in the inflation basket, both in core inflation and headline inflation. We saw that the depression of wages over the past 30 years has been the chief inflation-fighting strategy by the Fed.

Today we follow that up with a look at the two dynamics of inflation, cost-push and demand-pull. We’ll give you our conclusion and forecast up front. The Fed will apply the interest rate brakes in error because it does not distinguish between the two dynamics, or if it does, it finds no problem in continuing to call on the middle class to shoulder the inflation-fighting burden for everyone.

First let’s listen to some of the conceptual context. Here’s Fed Chair Ben Bernanke responding to a question from Joint Economic Committee vice-chair Carolyn Maloney on November 8.
“... In all but the shortest of terms the Federal Reserve’s policy determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”
Chairman Bernanke is adamant that the Fed not only can control, but can determine inflation in all but the shortest of terms.

Bernanke is not encumbered by concern for the real world. A practicing economist who spoke to the point was Carl Weinberg, chief economist at High Frequency Economics (November 20, Bloomberg’s “On the Economy with Tom Keene).
“... The Fed is out to control the things it can control. When it comes to goods and services, things that are controlled by labor costs, the Fed is in there keeping an eye on it. It doesn’t mean headline inflation isn’t important, but it means that in terms of the Fed monitoring things in terms of what it can do, I think core inflation is probably the place to look.

“Something else to think about is when you see food prices go up, or you see energy prices go up, that’s not inflation. That’s a relative price change. And in fact, the analysis is very different when you see the price of food go up relative to the price of everything else, because it squeezes out consumption of other things and is actually a depressing impact on the economy as long as we don’t have wage increases to offset those food price increases. So generally speaking a rise in food prices brakes the economy by itself. A rise in energy prices brakes the economy as long as other prices are under control.”
To round it off, here is Marvin Goodfriend, former Fed staffer, now a professor at Carnegie Mellon University and a Bernanke disciple (November 15, Bloomberg):
“...Insofar as inflation forecasts go, as you lengthen the horizon the Fed ought to be able to manage inflation. That is, you can target inflation over the long run. That’s the nature of what Monetary Economics teaches us, that Central Banks determine the rate of inflation over the longer run. So the longer the horizons are, the more these forecasts turn into targets for the Federal Reserve to aim at.

“On the other hand, the longer the forecast horizons are, the more difficult it is to forecast the real GDP numbers and the unemployment, over which the Federal Reserve has less control over the longer run.”
So the clear message is that the Fed under Bernanke feels it has an iron lock on inflation in all but the shortest of terms, and the only part it can really affect is wage growth by sponsoring ongoing slack in the labor economy. (Parenthetically, this is a big reason for the support of free trade in many financial quartes – it ships out wage growth).

But back to cost push vs. demand pull.

There are two reasons prices might go up. One is the price of inputs goes up – commodities like oil, metal, grain, etc. The second is that the supply of the product is insufficient for the demand, and the price is bid up. This second is the market’s very effective means of rationing scarce products.

The last event of demand-pull inflation in the US economy was in the 1960s under Lyndon Johnson, with the Great Society competing with the Vietnam War for labor and capital. It was called “Guns and Butter” inflation. American consumers, flush with cash, pulled prices up. Johnson responded with an income tax surcharge of 10 percent to cool off demand. He was the last president to make a tax increase the central point of economic policy. Since that time taxes have been equated with the vilest of sins, the US has run immense budget deficits, and the economy has generally performed at one-third the Johnson era level.

Also since that time – even in the “New Economy” Dot.Com boom of the 1990s, we have not had demand pull inflation (noting that inflation is a generalized rise in prices).

But we have had cost-push inflation. Beginning under Nixon with the first OPEC oil crisis: Oil supplies were reduced by the OPEC oil cartel for the precise purpose of pushing up the price. The market began to ration the supplies by way of the price mechanism. “Stagflation” began, and plagued the 1970s.

Yes, I said “ration.” Here, too, the supplies are insufficient for the demand, but because the supply is constrained. One is too many dollars chasing goods. The other is too few goods being chased. It’s all the same, you say? Upon reflection, you will see there is the possibility of balance without inflation that lies between the two extremes. But more importantly the events on the ground look different.

In demand-pull inflation, there is a boom. Producers are motivated to generate product in the earlier, lower cost years, further stimulating demand. In cost-push inflation, there is not a boom, because the costs of the commodities are already, as Weinberg says, braking the economy.

In terms of economic policy, stagflation was an important turning point. It was here that the country, under Richard Nixon and Ronald Reagan, took a hard right away from the Keynesian Demand Side policies that had accompanied the great growth of America after the Second World War. The proposition that supposedly refuted the Keynesian conceptual framework was the supposed contention by Keynesians that unemployment and inflation could not co-exist. This connection between inflation and employment began with the so-called Phillips curve, an invention outside Keynesian theory. But that made little difference to ideologues looking for a return to Supply Side dominance.

The inflation-employment connection continues today at the Fed (hardly a Keynesian institution) in the form of NAIRU – the non-accelerating inflation rate of unemployment. NAIRU as a proposition was blown up by Nobelist Robert Eisner, but adhered to anyway by the Fed, who may have realized that tighter employment markets might not accelerate inflation, but slack markets certainly dampened it.

And since the 1960s, in spite of the confusion of pundits, all recessions have been accompanied by inflation.

The Why of this is not difficult to see. Weinberg put his finger on it. If the product of an economy is composed of labor and commodity inputs, and the price of commodities goes up, in order to keep the overall price level constant, the price of labor must go down.

Now as we approach an inflation fueled by higher oil prices, higher commodity prices of all kinds – including food, metals and energy, and higher input prices from a falling dollar, we basically have two options. We can allow inflation; that is allow these pressures to be reflected in the overall price level. Or we can attempt to reduce demand further, put a lid on prices, by raising the interest rate. No matter that demand, as Weinberg says, is already dampened.

The risk is that the Fed will choose the low volatility in the short run, by increasing the downward pressure on the middle class, rather than allow the short-term price volatility that will release the pressure. Complicating the problem is that the asset investor bubble that moved from the Dot.Com boom to Housing has now migrated into commodities. This source of inflation pressure ought to be addressed by an increase in margin requirements.

The Fed has already released its inflation targets, although it refers to them as “forecasts.” And as you heard, the Fed considers itself duty bound to address only inflation, never mind regulating the Wild West of mortgage originators or the Wild West of unregulated securities and investment trusts. Never mind the collapsing dollar or incipient recession. The Fed will raise rates when prices begin to rise. Why raise rates instead of, say, increasing reserve requirements or some other demand-dampening tactic? Because as we’ve seen the Fed knows only one tool – the easy button of interest rates.

Two additional points.

One: Attempts to keep oil prices out of even core inflation are hopeless. Oil leads all energy prices – including coal, electricity and natural gas – as a component or as a substitute. These energy prices must contribute to transportation, power and heating components of other goods and services. A simple example, air travel.

Two: Raising interest rates to fight cost push inflation is similar to the medical practice of bleeding the patient practiced in the pre-scientific era. Higher interest rates contribute to higher costs, not what you want to do with cost-push inflation.

In the end, I suppose, the patient either recovers in spite of the treatment or dies. In either case, the disease is resolved and the Fed can point with pride at its interest rate remedy.

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