Pierre Lemieux has a post explaining the fallacy of assuming that inflation is caused by changes in relative prices.
An increase in the price of used cars cannot generate or “drive” inflation for a simple reason: it works the other way around. Inflation, which is defined as a continuous and sustained increase in the general price level, causes all individual prices (including wages, interest rates, etc.) to rise more or less proportionately, over and above the change in relative prices caused by changes in demand or supply on specific markets. To the extent that used car prices were partially caused by both inflation and a relative price change, they could not be a cause of inflation.
Pierre is correct. Nonetheless, some people might have a nagging doubt about this issue. Consider the following thought experiment. Someone with a crystal ball tells me that the relative price of oil will double in the next three months. How does that change my forecast for the rise in the CPI? I don’t know about you, but I’d raise my forecast of next year’s CPI. So why can’t we say that a rising relative price of oil is inflationary?
Let’s first think about why people often link relative price changes with inflation. One possibility is that some prices are “sticky”, or slow to adjust, while other prices are quite flexible. Thus an inflationary monetary policy might cause the price of commodities such as food and energy to rise immediately, while other prices respond with a delay. To the average person, it looks like rising commodity prices are causing an inflation that is actually caused by an expansionary monetary policy.
Another possibility is that relative price changes are associated with a change in aggregate supply. Here we can also assume that monetary policy targets something like NGDP (although a “flexible inflation target” that “looks through” supply shocks would also work.) If a disruption in the supply of oil causes real GDP to fall, then it will lead to a one-time increase in the price level under NGDP targeting. Strictly speaking, it’s not correct to say that rising oil prices “cause” the inflation (that would be reasoning from a price change), rather the rise in the price level is caused by a combination of falling RGDP and a monetary policy that targets NGDP (or core inflation.) In this particular case, inflation is caused by the thing that causes the relative price of oil to rise.
To summarize, the false belief that rising relative prices cause inflation is due to the correct view that:
1. Most large and sudden relative price changes are caused by supply shocks.
2. Central banks tend to target something like NGDP or core inflation rates.
3. When both #1 and #2 are true, most large and sudden relative price changes will be associated with a one-time movement in the overall CPI in the same direction.
Here it’s important to understand that negative supply shocks only cause even a temporary rise in prices by depressing real GDP. Because real GDP growth in the 1970s was quite respectable (more than 3%/year), we can conclude that relative price changes for products like food and energy played almost no role in the overall inflation rate during the 1970s. If NGDP growth had been 5% during 1971-81 instead of 11%, then inflation would have been 2% instead of 8%. It was easy money that caused the inflation.
At the same time, the inflation rate during the 1971-81 period was not constant, and the Fed’s response to supply shocks led to inflation rates that were higher during periods of depressed oil production than during periods of high oil output. So it looked to the average person (and perhaps even many economists) as if oil were driving the high inflation of the 1970s.
READER COMMENTS
Daniel
Sep 20 2021 at 3:49pm
I think it comes down to whether one thinks of “inflation” as an independent beast or a formative construct. Is the CPI a rising wave with buoys that further float above or below them, or is it just a description of the average change in position of those buoys?
Pierre thinks the former: Total category price change = relative category price change + general level change. It is indeed nonsensical to say the total category price change or relative category price change drove the general level change. But perhaps inflation is not an independent beast: General level change = weighted average of total category price changes. Then it makes sense to pick out the “contributors.”
Pierre Lemieux
Sep 20 2021 at 4:07pm
Daniel: I think I answer your objection/question in my answers to other comments on my original post.
Scott Sumner
Sep 20 2021 at 5:29pm
You said:
“But perhaps inflation is not an independent beast: General level change = weighted average of total category price changes. Then it makes sense to pick out the “contributors.””
It is important to distinguish between contributors and causal factors. Individual price changes contribute to the change in the CPI in an accounting sense, but they don’t cause the CPI to change.
Daniel
Sep 21 2021 at 11:36am
Thank you Pierre and Scot!
Pierre’s response in the other comments basically boils down to “CPI is a measurement of inflation, not inflation itself,” but this only pushes the problem up a level (and inflation iiiis?). If you imagine having perfect information on the price level, you’d have CPI*. Changes in CPI* would be inflation by any typical definition (that is, CPI* is P). It’s not clear why you see “relative price changes” and “inflation” as independent beasts that exert pressure on total category prices. Rather, the total category prices change as markets clear, and that results in calculable relative price changes and, overall, a change in the general price level, which we’d call inflation. I sympathize with Scot that we’d call the total category price changes accounting-sense contributors and be hesitant to call them causal factors. They’re endogenous themselves, and really it’s the supply and demand shifts that “cause” the total category price changes that mathematically form the price level changes.
That is a very bottom-up category-level focus, and I have a nagging agreement with Pierre that this seems different from the top-down macroeconomic view. Indeed, the Fed can will more money into existence, which, assuming no path dependencies resulting from short-term movements and ceteris paribus, will just boost the price level. This should hit all category prices proportionally; if it doesn’t, it indicates some independent relative price changes are going on. It seems like “inflation” is generated first, “relative price changes” can also happen, and in the end we get total category price changes that can differ. But it’s odd those relative price changes would happen if the supply and demand dynamics have not changed, which was in our set of assumptions. Violating that, we get back into supply and demand dynamics in response to monetary policy, and “the price level” comes out of that. That is, I feel the notions of the price level and inflation are much more accounting entities, and it is not quite right to say that inflation exists antecedent.
Pierre Lemieux
Sep 20 2021 at 3:52pm
Thanks for this useful addendum and the oil illustration, Scott. I was trying to keep clear of monetary policy and the causes of inflation—which, of course, one must introduce in the analysis at some point.
Scott H.
Sep 23 2021 at 12:23am
CPI — It’s like trying to determine a sea level when you can only measure waves.
Andrew_FL
Sep 20 2021 at 6:24pm
CPI also seems to overweight energy goods prices compared to other indexes like PCE and the GDP deflator
Alan Goldhammer
Sep 20 2021 at 9:28pm
I don’t pay any attention to inflation as long as it is moderate (e.g, I can afford to buy food which thankfully has always been the case) and only then late in the year when my Social Security adjustment is announced and I know what the increase will be.
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