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To: lee kramer who wrote (72945)	11/23/1999 8:00:00 AM
From: kendall harmon	Respond to of 120523

LEE, LOL, you have me seeing in sixes this morning!!

To: lee kramer who wrote (72945)	11/23/1999 3:15:00 PM
From: Lane Hall-Witt	Read Replies (2) \| Respond to of 120523

LOL! It looks like SI had too much coffee this morning. I've never quite known what to think about the claim, which I have run across many times, that inflation is not rising prices. I need to read up on the issue to see exactly how inflation is defined. From my naive perspective, it appears to me that inflation is in fact rising prices. When we gauge inflation, we measure prices. When prices increase, we say inflation increases. When prices don't increase, we say that inflation doesn't increase. Regardless of the precise definitions, it seems that the Fed ultimately concerns itself with price levels. So the issue is: what causes price increases? I typically see this question handled in any of three ways. (1) Phillips Curve -- rising corporate costs will lead to price increases as producers pass their costs along to consumers. (2) Money Supply -- growth in money supply will lead to price increases (as in the U.S. in the '60s and '70s, Germany after World War I, Europe in the 1500s with the influx of New World bullion). (3) Consumer Demand -- expansion of consumer spending will lead to price increases as demand puts pressure on supply. None of these approaches seems satisfactory to me. (1) The problem with the Phillips Curve is that it assumes sellers can pass higher production costs along to buyers. In short, it assumes that sellers have pricing power. It has been a long time since I've seen any CEOs on CNBC or in Barron's say that their company has pricing power, though. Even if they started to get squeezed on the cost side, could these companies raise prices to compensate? By the way, strictly speaking, when I conjectured about rising interest rates leading to inflation the other day, I should have said that rising interest rates increase the risk that producer costs will escalate. Whether or not this results in higher prices depends on the ability of these producers to pass price increases on to their customers. If they can't, then the result would be declining profits, not inflation. (2) The problem with the money-supply argument is that it assumes consumers will use the money to run up prices. During the past several years, however, we've witnessed immense growth in the money supply, without accompanying price increases. This raises the question: how is that immense supply of money being allocated? In part, as we appreciate, it's flooding into the financial markets. It also is driving a consumer spending spree that's without precedent in global history: aggregate demand is soaring through the roof. (3) The problem with the consumer-demand argument is that it treats consumer spending in the aggregate, rather than looking at the details of spending patterns. While we've witnessed a tremendous increase in aggregate demand these past several years, we haven't seen a rise in inflation because consumers are spending their money in an extremely price-sensitive manner. Consumers are spending a ton of money -- at Wal-Mart, which means high aggregate spending within an environment that's deflationary at core. I think the key issue is pricing power. Sellers can only raise prices if they can find buyers who will pay these higher prices. If buyers won't step in to purchase goods and services at the higher prices, then price increases won't stick. During the current economic expansion, the buyers haven't been there to support higher prices. A lot of people say the American consumer has been our economy's hero. But, in fact, they should say the price-sensitive American consumer has been the hero. This theory about consumer behavior obviously works only in cases where demand is elastic -- that is, where consumers can decide not to purchase goods and services if the price rises to an undesirable level. If the prices of inelastic goods like basic foods, energy, and raw materials increase, then we'd likely see inflation take hold because consumers cannot opt not to buy these products, even at higher price points. Fortunately, price competition among producers -- in many industries, intense productive overcapacity -- has helped keep prices in check even in these inelastic areas. The problem with this understanding of inflation, from the perspective of Fed policymakers, is that there's basically nothing they can do to help. The Fed doesn't have a way to enforce consumer price discrimination, and it only has very indirect methods to promote competition among producers. I think that's why the Fed focuses on the Phillips Curve, money supply, and aggregate demand: these are factors that it can affect, even if they aren't necessarily essential to inflation fighting. The concern this raises for me is: will the Fed undermine the economy by manipulating these levers to fight inflation -- even if these levers don't ultimately fight inflation? Like Lawrence "of America" Kudlow, I fear that the Fed is targeting economic growth in a misguided battle against inflation. (I disagree with Kudlow on several specifics, even as I subscribe to this general view of his.) Well, this is just so much idle chatter until we manage to land seats on the FOMC -- but I enjoy thinking about these issues.