What Is Inflation?

IDENTIFYING INFLATION

by Tom Au

Barry Ritholtz opined that the U.S. government isprobably underestimating inflation because it is focusing on the wrongtype of inflation. I would agree with that, having identified no less thanfive different types of inflation: commodity inflation, wage inflation,monetary inflation, fiscal inflation, and foreign exchange inflation.Before discussing “inflation,” it helps to identify which form ofinflation is being talked about. Failure to do so may have caused some ofthe confusion that often surrounds this topic.The inflation that most American economists remember best (from the 1960sand later) is wage inflation, otherwise known as demand-pull inflation.Workers observe rising prices and demand compensation in the form ofhigher wages, which creates a vicious cycle of more inflation and morewage demands. This has not been happening until recently in the UnitedStates, due to the absence of labor unions, and to what Karl Marx calledthe “reserve army of the unemployed” in “offshore” markets. This appearsto be the form of inflation that the Fed and other U.S. governmentauthorities are focusing on, and it has indeed been benign up to now.A less common, but more volatile form of inflation is commodity inflation,better known as cost-push inflation. We can see it today in commodityprices such as energy and metals. Energy and food price changes areexcluded from “core” inflation because of their period-to-periodvolatility. But over time, oil price rises have averaged 6% a year, higherthan other forms of inflation, and assuming that they don’t causeinflation is really assuming away the problem. Other commodities such astimber rise at 3% a year “real” (above the rate of calculated inflation).That’s largely because such rises are (wrongly) excluded from thecalculation. Another form of commodity inflation that is excluded from theofficial statistics has been the parabolic rise in housing prices. (Thegovernment instead uses a calculation of “owner equivalent rents,” whichare basically tied to the benign wage numbers.) Commodity inflation is themost obvious form of inflation today (after having been quiescent in the1990s), as reflected in higher food, gasoline and gas bills, but isseverely understated.Monetary inflation was most famously seen in Weimar Germany during the1920s, when the German government went crazy with the printing presses tothe point where it took billions of marks to equal one dollar. This wipedout the savings of the middle class, most members of which werecompensated with (worthless) “million mark” notes, and eventually led tothe rise of Hitler. Nothing of this sort has happened in the western worldsince, but it is a worry when the United States has a chairman of theFederal Reserve who has talked (hopefully facetiously) of dropping moneyout of helicopters.Fiscal inflation is due to excess government spending, for which thebudget deficit is a reasonably good proxy. It originated in the “guns andbutter” spending of President Lyndon Baines Johnson in the 1960s, andsimilar spending of today’s President George W. Bush. We have war spendingwithout a “war economy” e.g. rationing or wage and price controls, and ifthe 1960s are any guide, we will be paying the price later this decade andin the 2010s.The last type of inflation, foreign exchange inflation, is particularlyscary to me, someone who lived in Mexico before and during the peso crisisin 1994. This happens when the local currency (pesos in this case) fallsdramatically against other world currencies, thereby sharply raising theprice of imported goods, and hence the overall price level. This is a real worry for the United States when the latest annual tradedeficit is somewhere over $760 billion. I’m not looking for anything likethe two-thirds fall of the Mexican peso in 1994-95 as a result, but even a20% across the board drop of the U.S. dollar against the Euro, yen andyuan (the Chinese currency was unpegged from the dollar only in 2005)would be a severe shock stateside.