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What Is Inflation?

“According to central bankers, inflation is generated by the gap between demand for goods and services and the economy’s ability to supply them.” This is a direct quote from an article that recently appeared in the WSJ, in which central bankers were described at being puzzled over the low rate of inflation that the G-20 has been experiencing. Inflation is a term which has taken on different meanings over time, and which continues to lead to general confusion.

The original meaning of the term was intended to reflect the central bank’s expansion, or inflation, of the money supply. Of course, generally, there is a relation between increased money supply and the price of things, with prices naturally rising for things that are measured in terms of another whose supply has just increased.  In time, the term “inflation became defined as being the secondary effect - rising prices, and not the primary cause – inflated money supply.

However, economic thinkers have over time made connections that are not necessarily always valid. To re-state: inflation is intended to refer to the expansion of money supply, and rising prices are a by-product of inflation, but not inflation itself. A common misunderstanding surrounding inflation is the belief that economic vibrancy leads to inflation. The thinking goes like this: cheap and abundant debt is made available which causes people to borrow and spend, which leads to an increased demand for goods, which causes companies to increase their hiring to produce more goods, which causes the unemployment rate to decline, which places the worker in an advantaged negotiating position which leads to increased wages, with those increased wages leading to more spending, and thus the cycle of rising prices and rising wages goes on. This is the current conventional view of inflation, and is at the root of the confusion at the Fed and other economic think-tanks, as they cannot seem to understand how with the unemployment rate so low today, the cycle of inflation that they defined, know, and love has not happened.

They forget the lesson of pre-WWII Germany, or if you prefer more recent examples the lesson of modern-day Venezuela. In both instances, the economies were in shambles, with very high unemployment rates and no consumer spending power. And yet in both instances, the value of the respective currencies collapsed completely and prices for things as measured in those currencies soared. From these examples, we learn that inflation, and the concurrent devaluation of currencies and soaring prices of things, need not be prompted by a healthy and vibrant economy with strong employment. Money printing in sufficient amounts will do the trick just fine.

We also have come to confuse inflation with necessarily being accompanied by very high levels of interest rates. This is the so because the greatest bout of inflation in modern U.S. history occurred in the decade beginning 1972, and during this time prices and interest rates, both soared. And in the conventional view where a vibrant economy characterized by low unemployment and higher spending leads to inflation, this would be true. But in today’s world, where central bankers have intervened very heavily in the interest rate markets, surely out of a perceived necessity given global debt levels, there is and will continue to be a decoupling of interest rates and inflation.

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