Is It Inflation, or Are Relative Prices Increasing?

Skeptics of the Federal Reserve's intervention have already begun raising their voices about inflation. They point to commodities, as food and energy prices have soared in recent months. Is it time for the Fed to clamp down and prevent additional inflation? Not if these relative price changes are just that -- relative price changes due to normal growth. If they aren't caused by additional money creation, should the Fed attempt to reduce prices by cutting the money supply?

Food and energy prices are generally volatile, which is why they are excluded by the Fed when it considers inflation. This decision causes some controversy. Some people sarcastically remark, "Well yeah, there's no inflation unless you eat or drive a car." But it seems sensible to exclude these factors if they swing upwards due to a temporary economic shock only to fall downwards when the shock subsides.

On Friday, however, I wrote a post arguing that food and energy prices can result in a more general rise in prices if they are the result of permanent supply or demand shifts. So in cases where food and energy price shifts appear permanent, economists might want to take them more seriously.

University of Oregon economist Mark Thoma commented on the post, saying that this assertion confuses relative prices with pure inflation. He wrote:

A rise in the price of food and energy due to rising demand relative to supply changes relative prices, and increases the cost of living, but it is not technically inflation.

I followed up with Thoma, and he expanded on the point. He said that if the prices of certain goods are rising due to normal growth, then there's little reason to try to change them, as this accurately reflects scarcity in the market. But if excessive money growth is causing prices to change, then the Fed can step in to curb the inflation.

But really, it's kind of unlikely that money supply expansion would drive up the price of just one or a few goods. That's why some economists argue that relative price changes should be ignored by monetary policy. Only when all prices move upwards more or less in sync is pure inflation actually occurring. This may be caused by too much monetary stimulus.

Let's apply this to food and energy prices today. If you think about it, the idea that too much money in the financial system could cause the prices of food and energy to rise much more than others seems implausible. Why would they be the only ones affected by the Fed's quantitative easing? If there's too much money in the system, shouldn't the prices of shoes, furniture, computers, and other goods also be rising at a similar rate?

When the relative price of a good rises permanently, it does increase the cost of living for Americans. That's not insignificant, and perhaps the Federal Reserve should take action in those cases to attempt to lower prices as a result. While one could argue in favor of monetary contraction on the grounds that prices are rising for only a few goods, if those prices aren't rising because of previous Fed action, then it's a much harder argument to make.

This might leave you with a question: how can the Fed possibly pump trillions of dollars into the financial system without prices eventually rising? Money that was in the financial system before the Fed intervention is sitting on the sidelines, so this new money actually only replaces old money that's put to rest temporarily while the economy is weak. If the Fed times its exit exactly right, then it can remove its support as that money comes back into the system and avoid inflation.

Because inflation expectations remain very low, this shows that the market actually has pretty strong confidence that the Fed can execute its exit strategy in this manner. If it acts too late to remove the money it's injected over the past couple of years, then inflation will result. If that occurs, we should see prices rise broadly, not just for a few select goods.

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For further reading on this topic, Thoma provided the following links:

Should the Fed Respond to Commodity Price Increases?

Inflation can be pure too

Inflation and relative prices

Relative Goods' Prices, Pure Inflation, and the Phillips Correlation (very technical, .pdf)