The View From 1776
Tuesday, January 18, 2011
Inflation And Price Levels
Price increases in goods arising from an imbalance of supply and demand are not inflation. Inflation is over-expansion of the money supply, resulting in the dollar’s declining purchasing power vis a vis the purchasing power of other currencies. Focusing, as the Federal Reserve does, on its index of core inflation - various prices excluding food and fuel - fails to measure the extent of inflation.
As monetary inflation proceeds, prices of different commodities and manufactured goods may or may not rise in the short run. Not all prices respond equally or at the same time.
Higher gasoline prices, for example, are not necessarily a result of general inflation. Summertime increases in gasoline prices are ordinarily a reflection of localized supply and demand.
Oil import price increases in recent years, however, are, to a considerable extent, a function of inflation, i.e., the dollar’s falling purchasing power and traders’ speculation that dollar inflation will continue, perhaps accelerate. World prices for oil, in dollars, have risen much faster than prices measured in gold or other currencies.
Price increases for commodities such as copper have recently reflected high demand in China and other emerging markets. That again is a short term imbalance between available supplies and immediate demand. Over time, more money will be invested in increased copper production, or substitutes for some uses of copper will be found.
General inflation, in contrast, is initially reflected in the price of money: interest rates drop with an inflationary over-expansion of the money supply. Artificially lowered interest rates distort businessmen’s investment calculations, leading toward a boom-and-bust business cycle.
The bust phase occurs when lenders and investors become aware that rapidly rising supplies of money devalue their returns on loans and investments. Each dollar repaid or earned in the future will be worth less than the dollar initially loaned or invested. Lenders and investors will demand higher interest rates and returns on investment to compensate for dollar inflation. Those who borrowed at low interest rates will encounter difficulty in refinancing at the new, higher rates. Increasing numbers of them will default on repayment or will go into bankruptcy.
After interest rates rise, many business expansions funded during the period of cheap money will no longer be economically feasible. Cheap-money profits will vanish, workers will be laid off, and many of the expansions will fail.
Our recent housing bubble is exhibit number one.
No matter what the CPI or the Fed’s core inflation measures show, the United States has been in a period of significant inflation since the Federal Reserve came to the stock market’s rescue in 1987 by expanding the money supply to lower interest rates. The Fed’s current monetary expansion - QE2 - is just more fuel for the inflationary fires.
For a further discussion of prices vs. inflation, read Austrian Economics vs. Bernanke’s Economics.
Hayek’s Nobel Prize