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In today's context of financial disarray, verbal clarity is vital. Many financial commentators, and even some serious economists, make grave errors that sprout from the misuse of terminology.

One of the most mangled of these terms is "inflation." This word has come to mean two different things over the last century, both in the understanding of the public and in the mind of otherwise highly erudite scientific economists. Some speakers and writers mix the two variations within the same paragraph.

Here are the two distinct meanings that they often confuse:

1. [Price] Inflation: The degree of increase in the CPI and other price indices. More and more, this is the meaning used by some of the most influential people in the world today, among them even most of the Federal Reserve Board members, legislators, and former and future presidents. It's the one we all understand when we see the word "inflation" in the news media.

However, there is another, in fact more precise, economic meaning of the term:

2. [Monetary] Inflation: The rise in money supply, i.e. of money and credit, over and above what the market requires, leading always to eventual price distortions. These distortions may manifest themselves in CPI increases, or they may not. They may appear instead as speculative bubbles such as the real estate bubble of 2006. Such bubbles reduce consumer purchasing power, relative to what it would be if there were no bubbles, through the siphoning off of corporate wealth to speculative activity, rather than towards increasing worker wages and funding solid new capital ventures.

This may come as a surprise to you, but this second meaning is the one in Webster's New World College Dictionary, 4th ed., as I noted in my May 2007 post. Here is the exact Webster's quote:

"inflation ... 2a) an increase in the amount of money and credit in relation to the supply of goods and services b) an increase in the general price level, resulting from this, specif., an excessive or persistent increase, causing a decline in purchasing power. [emphasis added]."

How amazing to find that Webster's is more precise and on point than most economists today, including the research staff and board of the Federal Reserve, the very people harnessed with the responsibility for controlling the same phenomenon that they cannot define or use correctly in their research--with dire consequences.

In a recent article by Krishna Guha of the Financial Times, we learn that the U.S. Federal Reserve is moving "to establish a de facto inflation target in order to shore up inflation expectations and reduce the risk of deflation." This "inflation target" would be based on a measurement of the "personal consumption expenditure deflator on average over the medium term." The "personal consumption expenditure deflator" [PCECTPI] is the measuring stick used by the Fed to calculation the "rate of inflation."

Admittedly, the Federal Reserve has an impossibly fuzzy mandate. (See my Los Angeles Business Journal article, Page 1, Page 2, and Page 3.) They are supposed to (1) maintain full employment, and (2) control "inflation." But which one? The text of the law is unclear.

My cursory study of a number of the Federal Reserve's research papers, including this one written by Ben Bernanke, allows us to draw the conclusion that the Fed believes they can best fulfill their dual mission by maintaining "price stability," and that they see a clear cause-and-effect relationship between "zero inflation" and "price stability."

It would seem, then, that the Fed does not see any other way of measuring the appropriate amount of money and credit the system needs other than by trying to interpret the effects of their monetary adjustments on general prices, as seen in their version of the CPI, the above-mentioned PCECTPI.

Is that the way to measure the efficacy of their monetary interventions? I don't think so.

For example, I can think of a number of situations that would show zero inflation on the PCECTPI statistics, i.e. perfect "price stability" according to the Fed, but where the public would be the victim of monetary theft through reduction of purchasing power (which is mentioned in the text of law, if my memory serves). Here's one:

Imagine a new technology that cuts the cost of production of all manufactured things in half. (Over a period of a few decades, such advances have done exactly that, if not more.) Imagine that the Fed, by targeting "price stability," allows the money supply to reach a point where it causes the price index to read zero, or perfect price stability. (They currently are not aiming at zero, but rather 2 percent annual increase.) Isn't it clear that, over time, at price stabilization, their actions would be forcing us all to pay at least twice as much as our products are worth?

This sounds like an exaggeration, and I realize that it doesn't take into account the increases in our wages. But this is essentially what the Federal Reserve has done. And have our wages truly kept pace with price inflation? Certainly not in the last few years.

But where has monetary excess gone if it isn't in general prices? It has gone into the hands of our more playful producers and speculators, to create the dot-com boom and the more recent real estate and Wall Street bubbles. Why work for a living when you can make more money so much more easily by playing poker?

The Fed's major booboo in economic analysis stems from--well, first of all from their lack of humility, but also from their underlying confusion of the difference between Price Inflation and Monetary Inflation.

What the Fed needs to fight is "inflation" as defined in Webster's dictionary, i.e. excessive money and credit creation; and targeting price stability will just not do the trick.

However, they are bankers, not supermen. We may have given them an impossible task. And if they can't find a modern tool to do a better job, they should reinstate one that has functioned pretty well for centuries, a monetary measuring stick (gold has worked pretty well), so that the market can find money-and-credit equilibrium itself.

Source: Target for Inflation: Getting It Right