For those feeling the vague pangs of inflation anxiety — nothing special, just the plain-old-run-of-the-mill cost of living price increases — this one is for you.
This week’s Consumer Price Index Summary showed signs that rent, health care, but most of all energy prices are rising. Year-over-year, the index increased by 2.8 percent, the fastest pace in six years as the following chart shows:
The key question is whether inflation becoming a problem that will force the Federal Reserve to act above and beyond the plan it has more or less laid out? “Not yet, but” is a fair answer, given this week’s Federal Open Market Committee statement. It notably did not contain a sentence that had been a regular part of its communications for what seems like years: “The Committee expects that economic conditions will evolve in a manner that will warrant additional gradual increases in the federal funds rate” (emphasis added), with “gradual” the key word in that sentence.
In other words, the Fed just put markets on notice that it stands ready to hike rates higher and faster than it had been previously discussing. However, recent trends imply the Fed isn’t behind the curve when it comes to inflation.
You have Milton Friedman to thank for the Fed being somewhat paranoid about inflation. He famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Only that turns out not to be the case. The Friedman thesis was tested by quantitative easing, when according to Friedman’s acolytes there should have been a big rise in prices. Some even sent a stern letter to then-Fed Chairman Ben Bernanke, warning of not just inflation, but of hyperinflation.
Only, not so much. Not only did hyperinflation not result from QE, even ordinary inflation failed to show up at the party. In a 2012 speech, San Francisco Federal Reserve Bank President John Williams called inflation “the dog that didn’t bark.”
Why didn’t the vast increase in monetary base even as output fell fail to cause the predicted Friedmanian spike in inflation? The forces of deflation — technology and automation, globalization and labor arbitrage, and the loss of negotiating power as labor union membership collapsed are all partly to blame. Perhaps the greatest manifestation of deflationary forces has been the falling velocity of money, showing how modest the number of times any given dollar is spent to buy goods and services per each unit of time. The pace has been declining for the past two decades as the chart below shows:
Given those deflationary forces acting as a counterbalance to QE era, what then might cause an uptick in prices? Let’s consider the forces that could potentially goose inflation to levels that might force the Fed to act with more haste: