GUEST POST: A Counterfactual Look at Inflation [updated]

Guest post by Vedran Vuk of Casey Research.

A Counterfactual Look at Inflation

When I mention central bank-induced inflation [by either the N.Z. Reserve Bank or the U.S. Federal Reserve], I often get the response, "Inflation is really low. You're wrong about ‘The Fed’." And I'm sure many of you have heard the same comments. But this view does not consider the counterfactuals and what-ifs of monetary policy. Ironically, when the Fed wants to defend itself, we're always asked to imagine how much worse the crisis would have been without them. We are never asked to imagine a better scenario without the Fed.

Prior to the creation of the Federal Reserve, deflation was a fairly common occurrence in the business cycle. When a boom builds, inflationary expansion hits the market. After a bubble pops, the economy contracts, often causing deflation. Despite the propaganda, deflation isn't that bad.

One common argument against deflation is falling wages. However, most economists agree that there is some resistance to downward pressure on wages. Have you noticed that wage cuts rarely ever happen in the private sector? Companies either squeeze more effort out of fewer employees or they fire people. Outside the government, furlough days and wage cuts are practically unseen.

Individuals are weird about their pay on the margins. Even a small wage cut will infuriate workers, while a 3% raise to meet inflation will make them very happy -although their purchasing power has remained the same. The disgruntled workforce is usually not worth the savings.

The primary difference between the negative effects of inflation and deflation are who benefits. With inflation, the giant corporations get the low interest rates first and expand before inflation filters through the economy. The guy living on a fixed income or collecting the same salary suffers the most. With deflation, the companies take the hit, but the workers now have higher purchasing power with their salary. Of course if deflation is too rapid or too prolonged, the company will see a significant drop in revenues leading to fewer workers. And that's where problems can arise. But something like a 3 to 4% deflation for a year or two isn't the end of the world. And an even milder deflation isn't a big reason for concern. During the 1800s - a period of amazing growth for the United States - there were some very long deflationary periods.

With this in mind, the topic of 2 to 3% inflation is only a discussion about the tip of the iceberg. The real question is, "What would the CPI be without the Fed?" It's hard to say for sure, but it probably wouldn't be 2 or 3% inflation. It would rather be something like 5 or 6% deflation. If you look at it through this lens, then the Fed is already inflating at 7 to 9% inflation per year. Furthermore, this means things could get out of hand quickly. If the natural contracting of the economy ends, we could suddenly see a rapid pickup in inflation where these numbers are openly evident.

UPDATE:  Further clarification from Doug French at the Bastiat Institute, “Just What is Inflation?”:

Justin Lahart with the Wall Street Journal wrestles with the definition of ‘inflation’ in his article “Using a Dictionary to Define Inflation Can Spell Trouble.”  Lahart writes that up until 2003, Webster’s defined inflation as printing money.  Since the 2003 edition, Webster’s defines inflation as “a continuing rise in the general price level.”
    Mainstream economists say that only those out-of-step define inflation as increased money creation.  “They were quite far behind the times,” says Harvard economist Greg Mankiw. In his widely used economics textbook, he defines inflation simply as “an increase in the overall level of prices in the economy.”
    Lahart traces the I-word back to 1755 when “The state of being swelled with wind; flatulence,” defined inflation.
     In 1864, Webster’s American Dictionary of the English Language defined inflation as “undue expansion or increase, from over-issue; — said of currency.”
    And so on from there until 2003.
    “This semantic innovation is by no means harmless,” Mises wrote in Planning for Freedom.   Mises points out that it’s impossible to fight an evil that you can’t name.  The public gets lost when a detailed analysis is required and continually referring to this analysis is bothersome, besides being ineffective.  “As you cannot name the policy increasing the quantity of the circulating medium, it goes on luxuriantly,”  Mises wrote.
    However, what is most damaging is that when policy makers fight the consequences of inflation–a rise in prices–they make matters worse, not realizing “the causal relation between the increase in money in circulation and credit expansion on the one hand and the rise in prices on another.”
    Mr. Lahart writes that “there has been a shift in American thinking of the purpose of dictionaries: Rather than defining words as some experts thought they should be used, dictionaries have moved toward defining words as people actually use them.”
    So what we have is a generation of people (economists and otherwise) who don’t understand what inflation is.
    When questioned about rising gasoline prices, Fed Chair Ben Bernanke said during the Federal Reserve’s first press conference.

            This is a very adverse development. It accounts for almost all of the inflation. There’s not much
        the Federal Reserve can do about gas prices, per se, without derailing growth entirely.
            The Fed cannot create more oil. What we can do is basically try to keep higher gas prices from
        passing into other prices and wages, and creating a broader inflation that would be harder to
        extinguish. Our view is that gas prices will not continue to rise at the recent pace. That will provide 
        some relief on the inflation front.

Just look it up in Webster’s. The Fed has nothing to do with prices.