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Where is Inflation?

“Inflation is always and everywhere a monetary phenomenon.”
-Milton Friedman


Since the financial crisis of a decade ago, a significant conundrum has perplexed economists, bankers, and many others: Where is inflation? In the wake of “The Great Recession” the Federal Reserve in the U.S. and the Bank of England reduced overnight bank lending rates to zero and the EU has even resorted to negative (nominal) rates! Then in 2011 they all began Quantitative Easing (“QE”), a policy of buying massive amounts (over $4 trillion in the U.S. alone) of government bonds and parking them on their balance sheets, injecting a tremendous amount of liquidity into the financial system. Many economists, particularly those who lived through or came of age in the 1970s, were horrified and predicted a dangerous surge in inflation. But no such surge has as yet come to pass in the U.S. and Europe has even flirted with deflation. What’s going on?

First of all, what is inflation? Inflation is not just rising prices. Prices rise (and fall) for a variety of reasons, including increased demand, supply shortages, and market power. Inflation is a general rise in the price of everything due to an increased supply of money chasing a smaller growing, or shrinking, supply of real goods and services. Easy to define, devilish to determine! We have previously addressed the challenges of measuring macroeconomic quantities like GDP. Inflation is particularly difficult. It is easy to see when at extreme levels such as that in Zimbabwe that took the Zimbabwean dollar down to 1/35 quadrillionth of a U.S. dollar in 2015 and the current hyperinflation in Venezuela, but mild inflation is hard to gauge.

Economists measure inflation by comparing the cost of a representative basket of goods that consumers buy from one period to another. Sounds simple enough. But problems arise immediately. What should be in the “representative” basket? Seniors buy different things than 30-year-olds and rural consumers buy different things than urban dwellers. It is also very difficult to account for sales, coupons, rebates, volume discounts, loyalty discounts (such as at grocery stores and gas stations), etc. Anyone who has ever watched the Price is Right knows that you never pay the “true” retail price of a box of spaghetti (the MSRP or Manufacturer’s Suggested Retail Price).

More difficult still is accounting for changes in quality and product features over time. I remember my 1969 Dodge Dart. It had an AM radio with one speaker and two seatbelts (just lap belts) – no A/C and no power anything. It sold for about $2400 then. Now, fifty years later an “equivalent” midsize car comes not just with A/C but “climate control”, 16 speaker stereos, power seats (that can be heated and cooled), power windows, navigation systems, myriad safety systems including multi-point seatbelts, airbags, crumple zones, lane departure warnings, blind-spot detectors, rear cameras – the list of features goes on and on. How much of the difference between the $23,000 price of such a car and $2400 can be attributed to inflation, as opposed to buying a much more comfortable, safe, and reliable car? Over time a plethora of new products (computers, cellphones, microwave ovens, … ) have changed what people buy and made their lives easier, created new entertainment options, and turned what were once considered luxury goods into mass-market products. Just looking at official inflation statistics, the dollar has lost 85% of its purchasing power in the past 50 years. A more relevant question might be what has happened to the lifestyle of the median wage earner over that period? The answer would, no doubt, paint a rosier picture than bald inflation numbers.

That said, some things, particularly higher education and medical care, have grown dramatically in cost relative to almost everything else. This has not been so much a result of inflation as the very poor economic model by which we deliver these services to consumers, in which real prices are hidden, or unobservable, by providers and consumers alike. Imagine what the restaurant industry would look like if menus had no prices and owners had no idea what it cost to make a meal!

So, where is inflation? A host of factors have combined in recent years to mute inflation in the U.S. (and Europe also). First, the economy is vastly more global than it was in the 70s when we last suffered serious inflation. Money “leaks” into other countries to buy both goods and labor, keeping pressure on domestic prices. Second, firms now store vast amounts of cash (much to shield it from taxes) and use trillions to buy back stock, inducing “inflation” in stocks (which we have seen!) instead of consumer goods. Third, foreign governments, particularly China, have also stored trillions in U.S. dollars (mostly in the form of U.S. Treasuries, which have also been “inflationary”) to avoid driving up their own currencies, this having the add-on effect of keeping their products cheaper in U.S. dollars. Fourth, international criminal syndicates hold trillions in hidden wealth, much in the form of U.S. cash. Arms, human, and drug traffickers and pirates in other goods and intellectual property have grown with the global economy – it’s not your father’s mafia anymore! The cash hoarding has been exacerbated by recent international pressure on banks to weed out illicit deposits. How long these factors will continue to “soak up” inflation is anybody’s guess, but the government seems quite determined to find that limit!

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