Haim... Positive Economic Commentary March 3, 2000
What Do You Get When You Mix Oil and the Fed? "Bananas"
Despite the fact that the Consumer Price Index (CPI) increased by 100 basis points last year, there is a perception being perpetuated by many economists and even the chairman of the Federal Reserve, himself, that inflation is not on the rise in the US. Why are they saying, in effect, that it is "day" when it is obvious to anyone who looks outside that it is "night"? Because, as the chart below shows, the CPI excluding energy rose 30 basis points less in 1999 than in 1998. So, because an acceleration in the prices of petroleum products largely accounted for the higher consumer inflation in 1999, opinion leaders would have us believe that inflation is not rising.
You won't be too surprised to hear that I take issue with the conventional wisdom concerning the state of inflation in the United States. I will not argue that an acceleration in price increases of one particular good or service necessarily implies higher inflation. I will, argue, however, that an acceleration in price increases of one particular good or service is likely to result in higher inflation if the central bank is using an interest-rate pegging monetary policy, which our Federal Reserve is.
Energy tends to be a good or service whose quantity demanded is not very sensitive to price changes. After all, we have to drive the kids to their soccer games and we have to adjust the indoor temperature to 72 degrees, regardless of what the outdoor temperature is. So, if the price of energy rises, our nominal expenditures on it rise because of its higher price and because the physical units of it consumed falls very little. But if we are devoting more of our nominal income to the purchase of energy, that leaves less nominal income to be spent on non-energy goods and services. What this means is that the demand for non-energy goods and services falls. Assuming that prices are flexible in a downward direction, the fall in the demand for non-energy goods and services will result in a decline in their prices. Holding nominal income constant and everything else the same, the prices of non-energy goods and services will fall sufficiently to offset the rise in energy prices. Under these circumstances, then, an index of consumer prices will not rise with an increase in energy prices. Rather, all that will happen is that the relationship between energy and non-energy prices will change.
What if the prices of non-energy goods and services are not flexible in a downward direction? In this case, an index of consumer prices will rise. What will happen to the production of non-energy goods and services? Because of the fall in their demand and the downward inflexibility of their prices, the physical output of non-energy goods and services will decline and unemployment in these industries will increase. This is an example of stagflation. Presumably, as unemployment persisted, wages in the non-energy sectors would decline, allowing for a drop in prices, too. Eventually, then, the index of consumer prices would gravitate back down toward the level that prevailed prior to increase in energy prices.
Now, let's not hold everything else the same. Let's assume that households believe that the rise in energy prices will be temporary. So, rather than cutting back on their nominal expenditures for non-energy goods and services, they cut back on their current saving. After all, aren't rainy days a motivation for saving? And doesn't this temporary increase in energy prices constitute a rainy day? But this decline in saving will increase interest rates. The rise in interest rates will induce some of us not to cut back on our saving after all. Others will cut back on their borrowing and spending because of the higher interest rates. If non-energy goods and services prices are downwardly flexible, then again, there will be no increase in the index of consumer prices. If prices are not downwardly flexible, there will be an increase in the index of consumer prices and an increase in unemployment. The only different effect coming from the decrease in saving is that interest rates will be higher.
Now, enter interest-rate pegging Alan Greenspan. Observing that interest rates are moving above his target, Chairman Greenspan directs his subordinate, Bill McDonough at the New York Fed branch, to bring interest rates back down to their targeted level by creating some extra credit for the economy via the open market purchase of Treasury securities. By the Fed creating this extra credit in order to prevent a rise in interest rates, there is no reason for anyone to reconsider his decreased-saving decision and there is no reason for anyone to cut back on his borrowing. Thus, the nominal demand for non-energy goods and services need not decline, and, therefore, the prices of non-energy goods and services also need not decline. It follows, then, that the index of consumer prices will rise. Once again, we see that inflation is a monetary phenomenon.
During the days of the Carter administration, the chairman of the president's Council of Economic Advisers was forbidden to use the term "recession." So, when referring to a business downturn, Chairman Kahn used the word "banana." Fed Chairman Greenspan seems reluctant to refer to last year's faster rise in the CPI as an increase in inflation. Following Chairman Kahn's lead, we will call last year's higher CPI inflation accompanied by rising energy prices "bananas." And, so, to paraphrase the title of an old song, yes, Alan, we have some bananas.
Paul L. Kasriel
Chief Domestic Economist
ntrs.com
I saw an analyst on one of the financial shows on television
last night... he said the only risk with the stock market right now is the risk of not being in it. Fantastic...<g>
Best Wishes for a good weekend,
JM |
