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A word about inflation
I've had enough. Sensible people can disagree on a number of issues, but sometimes the dialog itself is distorted by people who really decide they don't agree with someone because they didn't understand what that person was saying to begin with. Inflation's a great one because of the number of myths associated with it. The reason I've decided to post this is because I've been reading financial blogs lately, and frankly there's a lot of deliberate scaremongering going on that relies upon ignorance of inflation and what it is.

So, at the risk of starting a political argument (which would be ironic because this is about avoiding unnecessary arguments) I'm going to explain a few things.

Here are some points that are, to the best of my knowledge, objectively correct.
  • The role of most Western central banks is to control inflation and unemployment.
  • Both problems have to be measured according to defined metrics.
  • No metric is perfect, but it's reasonable to suppose that if an organization is consistent in its use of a metric, using it to guide its decisions, it's not trying to pull a fast one.
Now, let's continue with this and talk about the situation in the US
  • So-called "Headline inflation" appears to be growing
  • Oil is going up in price
  • Gold is going up in price
  • Many foods are going up in price
  • Consumer electronics are going down in price
  • Wages are dropping
  • House prices are dropping
  • Cable TV services are going up, for some reason
  • Uh
  • OK, let's stop on this one, you get the general picture
So some things are going up, others are going down. Of what you might call the three most important metrics in terms of you paying for things, having a roof over your head, energy, and food, two are going up in price, the other is dropping. Your income, used to pay for all of this, is dropping. What gives? Why the disparity?

OK, what's our central bank, the Federal Reserve, doing about this? Wait, it says core inflation isn't going up and it needs to fight inflation! What does that mean?

Wait, they didn't say inflation, they said Core Inflation. Another set of bullet points:
  • Things rise in price for different reasons
  • Oil is up for a number of reasons, one is uncertainty over supplies due to continuing unrest in the Middle East, another is that quite simply demand is growing faster than supply.
  • "Unrest in the Middle East" is a temporary issue (well, this unrest is)
  • Food is up because of food shortages due to droughts and other weather related issues.
  • Weather and droughts are entirely transitory events. Next year food supplies will probably be normal
  • Gold is up in price because of financial uncertainty. Many people are "investing" in Gold because it is perceived as being a "safe haven" for storing wealth.
  • Gold's value looks set to drop once economic conditions stabilize.
And more:
  • The Federal Reserve has a limited number of tools available to it when trying to control inflation
  • Specifically, the Reserve can grow or shrink the "money supply" - that is, the total amount of "money" in the economy, and that's about it.
  • Most mainstream economists, be they Keynesian, Neo-Keynesian, Monetarist, or any other mainstream doctrine, agree that pumping money into an economy will increase growth, and thus employment, at the risk of increasing inflation, and reducing the amount of money will decrease inflation but at the risk of damaging growth, creating more unemployment.
  • The dominance of the above economic consensus means that the Federal Reserve (like all Western Central Banks) uses the money supply to control inflation.
The above may seem to break with my rule that the bullet points are all objective, but actually they are - the third and fourth points aren't that it's my view that mainstream economists are right, it's that the decisions the Fed makes are based upon those points of view. You can disagree with those same economists while acknowledging that Federal Reserve does follow the logic they've come up with. As  it happens, I tend to trust mainstream economists on this, it does make sense to me. But, anyway.

OK, so back to the points. To recap:
  • There are many metrics that define inflation
  • Different things change price (up or down) for different reasons.
  • The Federal Reserve tries to control inflation (and unemployment) by increasing or cutting the money supply
So, you're a central bank, and you want to control inflation. It would follow that you need to measure it in a way that's useful to you. Specifically:
  • The only tool available to you is control over the money supply
  • You believe that If you attack inflation, you also risk increasing unemployment.
  • Some things may rise in price in a way that isn't related to the money supply. For example, a war may destroy a supply of food or energy. You would assume that reducing the money supply would do nothing to reduce prices under such circumstances, but would reduce growth and cause more unemployment.
Note, again, to keep it objective I'm describing the principle that the banks run with, by using terms like "You believe", etc.

Now, it would follow from the above that you have to be very, very, careful about what metric to use to control inflation. So the Federal Reserve uses something called "Core Inflation".

What's "Core Inflation"? Well, it's the same basket of measures as regular, plain old, inflation, minus some items that have a history of being volatile and not terribly useful. The problem is that some of these are also the things that most people see rises for as extremely painful.
  • The price of oil is NOT included in Core Inflation. This is because oil goes up and down in price like a freakin' yo-yo. Its price history has much more to do with politics and supply and demand issues than it does the value of the dollar.
  • The price of food is NOT included in Core Inflation. This is because food prices go up and down like, well, a yo-yo. Its price history has much more to do with temporary issues, like weather patterns, than it does the value of the dollar (at least, in terms of year-on-year changes.)
  • Another big measure that's missing is gold: the price of gold is NOT included in Core Inflation. This is because gold prices also go up and down like... well, you get the idea. Worse still, gold's status as a "thing people think is valuable during hard times" means it tends to go up in value during recessions, which makes it a phenomenally bad measure of inflation.
Actually I think putting gold in an inflation metric is fairly stupid anyway, currencies aren't pegged to it any more, and it has limited utility. While gold is a component of a lot of modern electronics, it's fair to say there's more gold in my wife's jewelry cabinet than in all the electronics put together in the office in which I work. But, that's an aside, let's get back on topic.

OK, but if Core Inflation doesn't include those measures, then is it a useful metric? What if all three are actually going up in price because the underlying economy is inflationary, not because there's a war or two or something similar screwing up the figures?

Well, Core Inflation should still reflect that, it will just take a little longer.
  • People need food and energy
  • Businesses need food and energy
If there's a long term increase in the prices of both commodities, you should see price and wage rises elsewhere, affecting the prices of the other items in "the basket". We saw that explicitly with the rises in gas prices in the early 2000's, where "gas surcharges" started to be added to the prices of many goods and services.

So, while you may be seeing rises in gas and food prices, the Fed is holding steady and refusing to "raise interest rates" (the method by which it shrinks the money supply.)  Why? Because Core Inflation isn't going up. And if Core Inflation isn't going up, then it would be perfectly legitimate for the Fed to believe that it will damage the economy by shrinking the money supply, actually making it harder for us to afford these expensive commodities rather than reducing their prices.

It's not a conspiracy, it's not stupid, and arguing the Fed should use inflation statistics that include measures of prices like gold, food, and oil pretty much implies demanding the Fed should engage in acts it would see as economy destroying simply because there's been a drought in Nebraska, or a war in Saudi Arabia.

Any questions?


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