11 December 2021

They're Making Inflation Sound Worse Than It Is

Inflation after a year of sharp contraction followed by a year of record growth is about as shocking as squealing tires on a car that goes from 75 mph to 25 mph to 65 mph within a couple of minutes.

A couple of thoughts about inflation.

One, inflation is typically overstated. Here's why.

Let's say that you have a local grocery store called Smith's in your town of River Run. They sell eggs for $4 a dozen. Then a Walmart opens in town. They sell a dozen eggs for $2.50. Lots of folks start shopping there. So, obviously this means prices have dropped, right? Nope. For consistency, the folks tracking prices now track the change in prices at Smith's separately from the prices at Walmart. If Smith's lowers their prices to $3.50 to compete, the official price drop will be 13%. If they don't drop their prices at all, the official inflation will be zero. What the officials don't do is calculate the price of eggs as dropping by more than a third in River Run. And then they track price changes for eggs at Smith's and Walmart over time. Or if you find a great supplier online who sells something for half of what they charge at your local hardware store, inflation measures don't show a drop of 50%.

The pandemic has changed buying habits. People are seeking out higher quality, greater convenience or lower prices from any of a number of retail sources - local brick and mortar or online. To the extent that this involves them finding better bargains (higher quality at the same price or lower prices for same quality) from new retailers, that shift is not showing up in measures of inflation. The period from 2020 to 2021 may have involved the most change in who people buy from of any year. That change is not reflected in inflation numbers.

Also, prices measured do not allow for changes in quality. In Robert Gordon's magisterial economics history book The Rise and Fall of American Growth, he compares the TV of his youth with one available in 2014. Electricity costs dropped as they became more efficient. They were so reliable they no longer required a service contract of $50 a year. The 1950 set was $350 for a black and white, 9 inch. By 2014, for $418 one could buy a 40" high-definition with theater surround sound and internet streaming capability. He compared two sets from 1952 and 1983 to make adjustments for quality differences. The official annual inflation rate for TVs in this period was -1.0%, prices dropping by 1% a year. His adjustment for quality improvements suggested a more dramatic annual price drop of 4.3%, a huge difference.

What's the point? Inflation is almost always overstated. It doesn't track changes in sources over time as people seek out cheaper products of the same quality from a different vendor or better quality products for the same price.

Second, stagflation is highly unlikely.

It seems to me that the great period of stagflation in the 1970s always misses a really important event. Stagflation is the worst fear of policy makers. Before the 1970s, people thought that you could have the problem of inflation with low unemployment or the problem of high unemployment with low inflation. There was a tradeoff. But in the 1970s, we had both high unemployment AND high inflation. This was called stagflation.

There were a lot of theories bandied about but I've never heard that one that makes the most sense to me. Throughout the world, former colonies were being transformed by rising nationalism. As the British and French empires were being unwound after WWI and WWII, new nation-states were emerging. Places like Iraq and Saudi Arabia that had huge oil deposits had previously gotten a token fee for their oil as companies like British Petroleum and Standard Oil operated drilling rigs there and shipped the oil to the West. In the 1970s, rising nationalism included the notion that the peoples in a country should be the ones who benefitted from their own land. They insisted on keeping a much, much larger portion of the oil revenue. This amounted to a shift in GDP from countries like the US and UK to countries like Saudi Arabia and Iraq. What happened in the US? Prices went up. (Oil was used for making and distributing a huge portion of the goods we enjoyed and now we were paying more.) GNP stagnated. (A portion of GNP that counted "their" oil as ours was shifted from the US to foreign countries.) Stagflation - it seems to me - wasn't so much a change in the tradeoff between unemployment and inflation as it was an oil shock that came from a shift in international GNP.

What does all this mean? Inflation is not as high as you think. And it is highly unlikely that we'll experience anything like stagflation over the next few years. As we start lowering unemployment less dramatically, measured inflation will probably drop.  Prices are higher now but job creation is at its highest rate on record. Monetary and fiscal policy stimuli have been huge - and rightfully so. That's going to taper off and as new job creation / reinstatement rates lower, the rate of inflation will likely taper off as well. There is still a relationship between inflation and unemployment and the 1970s don't seem to me proof that the relationship has changed.  

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