Milton Friedman wouldn't have been confused
By Scott Sumner
Stephen Kirchner pointed me to a very infuriating Financial Times article on inflation. Here is the title:
Nobody seems to know why there’s no US inflation
How about market monetarists who point to the very slow growth of NGDP, caused by a contractionary monetary policy?
At times it seems we’ve gone back to the 1970s, as completely discredited theories of cost-push inflation are being revived:
A five-month-long string of weak figures this year has prompted some Fed policymakers, including Bill Dudley of the New York Fed and Rob Kaplan of the Dallas Fed, to start asking searching questions. Are globalisation and technological advances restraining inflation at a time when a cyclical pick-up might otherwise drive it higher?
“These two forces are colliding,” Mr Kaplan told the Financial Times last month. “The cyclical forces we have understood historically; the structural forces are somewhat new, particularly technology-enabled disruption.”
Some policymakers cite the increased ease with which shoppers can compare prices on the internet and the impact these changes have on brand loyalty and pricing power. Amazon is entering grocery retail via Whole Foods, while the hotel sector is being overturned by Airbnb.
If inflation were held down by rising aggregate supply, then you’d expect rapid GDP growth. Instead we have the opposite.
Fortunately some media outlets seem to get it. Here’s Caroline Baum at MarketWatch:
Almost every discussion on this subject begins with a statement of fact that the tight labor market, as evidenced by the 4.4% unemployment rate, should be lifting wages and prices.
Note the order: wages and prices. A tight labor market leads to higher wages, which lead to higher prices. This is one of those myths that never dies: cost-push inflation. Milton Friedman was adamant that both prices and costs rise in response to an increase in aggregate demand, which is a function of the Fed’s money creation. Wage and price increases are a reflection of inflation, not a cause of it.
As to the relationship between prices and wages, they generally move together. But prices lead wages, not the other way around. You can read about the relationship in academic literature, or you can think about how businesses operate.
Let’s start with a small-business owner whose company produces widgets. He begins to see a pickup in sales. Pretty soon, his products are flying off the shelf, and he can’t accommodate the increased demand.
What does he do? A rational businessman raises his prices to allocate the limited supply. If he still can’t satisfy the demand for widgets, he may try to increase output using his existing staff, paying overtime if necessary. If he still can’t meet his customers’ demand for widgets at the higher price, he will most likely look to add staff.
In the mythical cost-push-inflation world, a businessman responds to increased demand by paying a higher wage to attract additional workers — and then tries to raise prices to preserve his profit margins.
Which of those examples describes how businesses operate? Good. Let’s move on.
It’s kind of scary when top Fed officials have forgotten that inflation is a monetary phenomenon.
I was also puzzled by this comment in the FT:
Despite a recovery that is now the third-longest on record, America is trapped not in a 1970s-style, double-digit inflationary upsurge, but a slow-inflation quandary.
I suppose it seems like a “trap” if you don’t believe that monetary policy determines the inflation rate. Fed officials look everywhere for the culprit behind “lowflation”, when all they need to do is look in the mirror.
PS. I’ve continued my discussion of modern art over at TheMoneyIllusion.