Is Inflation Coming Soon?

Most economists will tell you that there’s a tradeoff between inflation and unemployment (called the Phillips Curve), making it unlikely that a high unemployment economy generates unemployment. Well, expect to see the unlikely happen soon.

Here’s a chart of monthly inflation, as measured by the Consumer Price Index, since 2007:

The Federal Reserve is waging war against deflation, funnelling trillions of new dollars into the financial system in an attempt to defeat deflation.

The Fed will win; in fact, they’re already winning. Inflation has simply been channeled into the stock market. Oil has doubled in price. Gold has recovered from its low of the fall of 2008, when it dipped below $700, and is currently pushing $950. These are early signs of inflation.

An interesting feature of the CPI is that it’s not designed to measure changes in the cost of living. It’s designed to provide a measure of how much money it takes to maintain a constant level of satisfaction. That means the Bureau of Labor Statistics must do a very difficult thing: instead of merely measuring prices, they must measure our satisfaction. They do this by imputing value to technological changes, and by using sophisticated averaging techniques which attempt to measure how consumers make substitutions between products in response to price changes. The outcome of this fancy guessing-game is the most widely-quoted measure of inflation in the US, but CPI has little to do with what most think the CPI measures.

My guess is that we’re already seeing the kind of inflation that the Fed so fears: consumer price inflation. Prices ought to fall during a recession, and some have. But I think prices have not fallen as much as they should, given the extreme weakness in consumer demand. If the effect of money creation is the prevention of falling prices, that’s inflation, it just doesn’t look like it when we look at the CPI.

It’s clear that the Federal government would prefer inflation to deflation. With the ten-year deficit now officially projected to add $9 tril to the public debt (which would bring it above $20 tril), some inflation sure makes the interest easier to pay in depreciated dollars. I wonder if the American consumer will go along for this ride. Sure, inflation will probably kill your real wages, but it can also zap the value of your debts. Perhaps the average American won’t complain too much if inflation begins to roar. Much depends of what happens to the unemployment numbers as we move forward.