Hyper-Inflation

What happened to all those people who were freaking out about out of control inflation/hyper-inflation? It must have happened by now: crazy people, Ron Paul, some economists, etc. have been preaching inflationary doom since the crisis began. The urgency the matter was discussed with made it seem as if it was our most urgent threat. One which they were happy to trade a slower recovery for.


But wait, its all come to nothing. Inflation[1] since the 2008 financial crisis has been low relative to the rest of the post Gold Standard world. In fact, 2009 actually saw a slight deflation[2] of the Consumer Price Index (CPI).  Here's what's happened to inflation since January 2008:

In the aftermath of the crisis, deflation was the proper thing to worry about as demand contracted. Then the CPI began to increase slightly, stagnated, and has now returned to a pretty much normal rate. And it seems all the people who were yelling about inflation have quieted down, hoping they didn't put their names on too many crazy opinion pieces. Here's a historic look at inflation going back to 1914:

As you can see, inflation has been rather tame in modern times and is certainly not out of control[3]. Given all of this, inflation, while it should be a medium run concern for the Fed, is not and has not been a threat to our economy. If you are curious to know the mechanics of  inflation click "read more"

The thing is rising inflation will only take hold if our capacity utilization (express at a % of our economy's full current output potential) increases towards 100%. Here's how it works: the Fed "prints money" so banks have more of it and lend more of it out and the economy (people) has more money. When you have more money you can express more demand. Demand increases so production increases, raising capacity utilization. If capacity utilization is high enough then the cost of capital and labor increases (since both are in higher demand). This drives up prices and erodes real wages. To compensate and take advantage of higher demand, workers demand higher wages. This drives up prices and erodes real wages. To compensate and take advantage of higher demand, workers demand higher wages. This is called "the Wage / Price Spiral". Current inflation also depends on what people expect future inflation to be.


The Fed expanded the monetary base in a large and unprecedentedly quick manor, so I can see where the concern comes from. However, the Great Recession has been a period of decreased capacity utilization, as any downturn would be. Our labor capacity utilization is also low (think of the unemployment rate) so a wage/price spiral is unlikely to start up until that changes. Though there is a much larger monetary base, if banks aren't lending it and people aren't spending it, it won't increase inflation. Therefore, there is deflationary pressure on the economy to cancel out the inflationary pressure. And as we saw in 2009, the deflationary pressure was the stronger force.


And last, the Fed knows how to control inflation and has taken action to do so numerous times. Often they do so when the economy is healthy and expanding and no one is paying attention. They raise interest rates and reduce the monetary base. In 1979-1980 inflation was a real problem for the United States, and the wage/price spiral had set in. The Fed chairman at the time, Paul Volcker, broke the cycle by reducing the monetary base and driving interest rates up. The country entered a recession and inflation expectations dropped. But it was necessary and beneficial in the long run.


The lesson is simply this: if inflation does become a problem, the Fed has the knowledge and has demonstrated its willingness to tame inflation at whatever cost is necessary for our long run prosperity. But until then it is silly to worry about something which is not a problem, and which can be solved if it becomes one, at the expense of the recovery today.

1. In the case of the numbers I am quoting for the United States I am using the percent change in the Consumer Price Index, rather than the GDP deflator which is what is used for the official inflation rate. I have chosen to do this simply because I found more data on the change in CPI and the data went back further.

2. Deflation is the bigger menace because it dries up demand as consumers wait for prices to fall. Deflation also cannot be tamed by the Federal Reserve.

3.  On a sort of related note: look at how well the Gold Standard controlled inflation/deflation (pre-1971). Think about that next time someone talks about how wonderful it was.