Inflation vs. Deflation: A Matter of Money Supply and Demand

July CPI data came out on Friday, and it was a little below expectations. Year over year, the CPI fell 2%, while overall prices held steady in July and core prices (excluding food and energy) rose a mere 0.1%. That's pretty tame, on the surface, and a source of concern to all those who have been worrying about deflation.

Most of the decline in the CPI over the past year has been due to the collapse in energy prices. That's just about run its course, however, since oil prices have doubled from their lows of last December and have been flat since the beginning of June. In the past three weeks, in fact, gasoline prices at the pump have risen 8%, which means we should see energy adding to the CPI in August.

The volatility of oil prices has been of an extreme nature in recent years, so there is plenty of justification for excluding energy and focusing on core prices instead. As the chart shows, the Core CPI is up 1.6% in the past year, and the year over year pace of price gains has been slowing. But that is deceptive, which is why I've included the 6-mo. annualized change in the Core CPI, which is now 2.1%. And even if you look at the whole CPI, it is up at a 2.4% pace year to date, and up at a 3.4% pace in the past three months. So while inflation was definitely low late last year, is not really negative or moderating now at all, and it's probably in the neighborhood of 2% or so.

That would be fine by most people, even the Fed. Except that the Fed's model of inflation says it should be at least zero or negative by now, given the huge "output gap" that the economy is currently experiencing. Conventional wisdom says that when the economy is as weak as it is now, everyone is under pressure to cut prices, and that leads to the dreaded deflation, of the sort that has plagued Japan for decades. And, as the thinking goes, deflation is very bad for economy, as we saw in the Great Depression, because it causes consumers to stuff money under their mattresses instead of spending it.

My good friend and mentor Art Laffer recently wrote a paper that debunks this notion pretty thoroughly. He points out that in a recession it is of course quite normal for businesses to face great pressure to cut costs. Cutting prices helps them become more competitive, and that is the key to survival in an economic downturn. But is cutting prices at the company level equivalent to an economy-wide deflation? No. To argue that what occurs at the company level is also what occurs at the economy level is to fall for the fallacy of composition.

When a businessperson talks about lowering prices because demand is weak, they’re not talking about dollar prices so much as they are talking about lowering the prices of their products to attract business away from other producers. To attract business away from other companies, the businessperson lowers their product prices relative to the prices of other producers’ products, thus making their goods more competitive in a price sensitive marketplace.

For a business, prices are relative prices, while for an economy, prices are dollar prices. Therefore, it only makes sense that on an economy-wide scale, the money (dollar) price of a representative good will reflect the relative scarcity of money versus goods. The scarcer the money, the lower the price of goods measured in money; the more plentiful money, the higher the money price of goods.

So when we look at inflation from a macro perspective, the price level is determined by whether or not money is scarce relative to goods and services, not by whether businesses have an incentive to cut their prices to gain market share. If there is an excess of money relative to the supply of goods and services (which become intensive during periods of recession), prices in general will tend to rise.

The situation in which we find ourselves today is one of a plentiful supply of money on the part of the Fed, but a reduced volume of goods and services coming from businesses. To date, the extra money has been mostly absorbed (but not entirely, which is why inflation remains positive) by consumers and businesses that want to increase their money balances, but with time this extra demand for money will fade and money will become abundant relative to goods and services unless the Fed takes steps to reduce the supply of money. This combination of reduced output and increased money supply can lead to higher inflation regardless of how weak the economy is, and regardless of the number of businesses that cut prices in order to boost their competitiveness.

And already we see some signs that the supply of money exceeds the demand for it. The value of the dollar relative to other currencies is depressed and falling; the value of the dollar relative to gold is depressed and falling; the prices of sensitive assets such as commodities are rising (see previous post); the yield curve is unusually steep, suggesting that bond market knows that monetary policy is easy and will have to be tightened in the future; and TIPS breakeven spreads are rising. All of these market-driven prices are pointing to a relative excess of money that could become problematic. As confidence in the future improves, as it has been doing in recent months, then the demand for money will decline. If the Fed does not take offsetting actions to reduce the supply of money, then money will become overly abundant and the general price level should start to rise more rapidly.

Since the Fed keeps insisting that a weak economy will keep inflationary pressures very low, and uses that rationale to maintain its ultra-accommodative monetary stance, we can only infer that they don't understand the monetary nature of inflation. Inflation is not a by-product of the strength of the economy, as the Phillips Curve suggests (see my discussions of the Phillips Curve here), but in a fiat monetary system such as we have today, inflation is rather a by-product of the interaction between the supply of and the demand for money. If the Fed doesn't understand this, then that signficantly raises the risk that inflation will rise in coming years rather than staying very low or turning negative.

Those who worry about deflation when they see businesses cutting prices are therefore missing the forest for the trees.

Comments

[frosty:]

Your analysis is Lafferable.

Aug 17 08:47 AM

[nmelendez:]

You are dead wrong. inflation is not equal to money supply, Inflation is equal to money supply PLUS credit. Just ask those whom saw the value of their homes go down. So if you have 7 trillion dollars and 30 trillion in credit, what happens when credit goes to 5? I think the mv=pt has to be modified to include credit since credit IS real money.
That's the factor everyone is obviating and why gold will go down to 680 and the dollar will rally to 120. Everyone will want real dollars, not credit dollars.

Aug 17 01:04 PM

[svosavvy:]

"but in a fiat monetary system such as we have today, inflation is rather a by-product of the interaction between the supply of and the demand for money. "

Take away the punch bowl and you will create demand for money, vis higher interest rates vis "inflation" no mention of how credit works in the mix of this stew, not wild about this article. Also, no mention as to the fact that you have at least 8 independant variables floating around so you could realistically have at least 64 distinctly different outcomes. More like 64,000 distinctly different outcomes. No amount of chicken gut reading is going to accurately tell the future. Nothing inflates without demand

Aug 17 01:07 PM

[svosavvy:]

I agree with archman's summation of the american consumer, and humbly offer that if costs stabilize but wages continue downward that is also "inflation" as a function of relativity. There could be a distinct possibly that we consolidate our way out of this one with the banks and pay our problems forward another ten years or so. Eventually there won't be any banks left to marry deadbeat banks to, that, and when the chinese consumer comes online for real, our relevance could be pushed to the periphery and this could be the vicious circle of speculative outflows and dollar collapse.

Aug 17 01:16 PM

[carls2cents:]

The author has said nothing about the "real money" (which is phoney money). The government is running up huge amounts of debt, but this is being held by the banks to shore up their reserves in anticipation of all the write-offs that have yet to occur when they realize that not marking to market has meant overstating the strength of their balance sheet. As it becomes evident that many of the loans on their books are definitely bad, the balance sheets will need to take the hit and the reserves will get swallowed up. Also, why should the banks make loans in a market that is currently risky (housing prices are still dropping and the fall of the commercial real estate market is about to hit bigtime) when they can safely earn interest by loaning (ie. parking) this money at the federal reserve. The "real money" is credit not dollar printing...ie. it is the fake money that is based on our fractional reserve system and has contracted so greatly that the present risk is deflation, not inflation. Also, the author has not considered that the rest of the world is still so weak and that there just as well could be a run on dollars again by the currencies of the world.

Aug 17 02:29 PM

[stev53e:]

On Aug 16 09:42 AM verdae wrote:
> Medical care in the US is the biggest anomaly of all. Its rise in
> costs exceed anything else in our economy. Its costs are clearly
> manipulated else why does health care in the US cost 16% of GDP while
> European Union nations average 9% and still manage to insure all
> their citizens?

Lawyers

Aug 17 02:30 PM

[rosey99:]

Ah yes. . .The perpetrator of the Laffer Curve and High Priest of Voodoo Economics. I especially enjoy his remark that "FED policy is spectacular." Thanks for the youtube link, comic relief like that is priceless. And I guess Art is still running around peddling snake oil. Reaganomics, the gift that keeps on giving. . .By taking from tomorrow.


On Aug 16 10:39 AM M-F wrote:

> Your argument is missing the concept of velocity of money. If the
> Fed prints 10 Trillion dollars and buries that cash in a mineshaft,
> the money supply goes through the roof, but the effect on inflation
> is zero. You can not just look at money supply numbers and predict
> the rate of inflation.
>
> And Art Laffer is an idiot, sorry to say. There is a classic cIip
> on youtube from 2006 of him arguing with Peter Schiff. Laffer denies
> any fed mistakes, denies a real estate bubble and basically is as
> wrong as can be. I suggest you watch it. He is a fool.
>
> www.youtube.com/watch?...

Aug 17 06:03 PM

[MWRjr:]

Your comment that oil prices are manipulated is clearly wrong. If the oil companies or OPEC could control prices they would never have let them fall from $150 per barrell to $35 in six months. Except for the last 6 months of recession world oil demand (fueled by China) had grown much faster than supply which is why oil prices got to $150 in the first place. The short term reduction in demand caused by the recession is what caused prices to fall, and they are now raising due to the anticipated increase in demand as we (and China) come out of the recession.


On Aug 16 09:42 AM verdae wrote:

> I think that your article assumes that our economy is a closed system,
> operating only within our borders. Most consumer goods are imported
> from Asian countries that peg their currencies to ours. As long as
> that is the case, we will not see much inflation in the price of
> their products. If they de-peg from the dollar, then it is a new
> ball game. The deflation we see now is mostly from retailers taking
> smaller margins.
>
> Most inflation in the US in the past e.g. the 80's was fueled by
> spiraling labor costs. Our labor costs over the last decade or more
> have risen very little. And in the 80's we manufactured much more
> of what we consumed. Manufacturing less means inflation is less sensitive
> to US labor costs. Even if our labor costs rose dramatically, it
> would be felt in more in the services sector where most of our economy
> resides. But even in services, labor costs have been kept low by
> illegal immigrant labor.
>
> The costs of food, oil, drugs, and medical services are anomalies.
> We grow most of our own food and food competes on a world market.
> And food production cost is sensitive to the price of oil and natural
> gas (fertilizer).
>
> The price of oil is clearly manipulated by something other than supply.
> How else can we explain decreasing demand, increasing supply, and
> higher price?
>
> Medical care in the US is the biggest anomaly of all. Its rise in
> costs exceed anything else in our economy. Its costs are clearly
> manipulated else why does health care in the US cost 16% of GDP while
> European Union nations average 9% and still manage to insure all
> their citizens?

Aug 17 06:11 PM

[mlonz:]

I was big time in the inflation camp. The deflationists are starting to make a lot of sense, and im nervous about my PM holdings.

But the deflationists are only right if washington sits back and does nothing and lets it all happen. Unfortunately, they will do everything in their power to inflate the problems away. It is their only way out of the social security nightmare. If you think it looks bad now, think about it after a 10 year period of deflation. They will not let it happen.

Here's how its going to play out. Major shakeout once again in the fall leading to a nice clean double bottom with the March Lows. The government smartly uses this panic to issue an astounding number of 10-20-30 year bonds.

Government then issues some ridiculous programs dwarfing the stimulus and TARP program of the year before, probably cash for clunkers with houses or just send everyone a check to stop the market free fall (We all know they are not just going to let the DOW go to 3000)

Deflation defeated

Inflation initiated

All the bonds the government recently issued, and anything under 4% immediately become worth 50% of their value.

As far as the govt is concerned, problem solved.

Aug 17 06:18 PM

[Value Added:]

Interesting comments (copied below). However, I disagree with point number 2, and your conclusions. The banking industry is teetering. The FDIC is nearly bankrupt. Under NO circumstances can the FDIC or banking system be allowed to collapse, or all bets are off. The Fed will generate whatever cash it must to prevent a failure of either the FDIC or banking as a whole. Therefore, there will be, IMO, a great deal more printing of dollars before another year is out. Collapsing commercial loans and desperate banks will necessitate it. So the dollar may be taking a deep breath, but its continued decline is about as certain as can be. I'd happily bet my US $ to your Canadian $ on it. I'd win doubly.


On Aug 16 08:15 AM Schweizer wrote:


> There is a change underway though, and that is there is a new rising
> demand for dollars (making them more valuable) due to the expanding
> loan defaults. When loans default, they show as a loss on the banks
> books. This causes 2 things to happen:
>
> 1. Billions of Dollars literally disappearing from circulation<br/>2.
> Growing demand for dollars by banks who have to raise capital to
> maintain capital ratios, and they will get no more from the US Gov
> (public won't stand for it), and have about exhausted raising capital
> by equity sales (much of the basis for the recent rally).
>

Aug 17 06:48 PM

[JPDewy:]

In Europe they have limits on liability for Medical malpractice. The US doesn't.

On Aug 16 09:42 AM verdae wrote:


>why does health care in the US cost 16% of GDP while
> European Union nations average 9% and still manage to insure all
> their citizens?

Aug 17 09:49 PM

[437339:]

mlony

The Only fly in the " fed inflate away the debt " ointment is China .I have read ' where the Pentagon is concerned re Ciber war with China ". This IS their nuclear option . They literally can shut the US down without firing a shot . Bernanke is aware of this . His back is TRULY up against a wall !.

Aug 17 10:28 PM

[User 410955:]

What to do? What to do? Inflation or deflation??? So many brilliant ideas and opinions posted regarding each and I cannot decide which side is correct. I wish my crystal ball was not presently in the repair shop being polished. Me thinks I need to create two investment portfolios. Portfolio 1 will be comprised of long dated U.S. Treasuries, Portfolio 2 will be comprised of Emerging Market Equities, commodities, and U.S. Tips. In either event (deflation or inflation), should not my capital preservation be acoomplished at the very least? I would like to hear some suggestions about how to hedge my bets and come out a winner in either scenario?

Thanks

Aug 18 03:54 AM

[Donald Ingram:]

I think you can't see the forest for the trees because you're in the forest and lost! Don't forget - credit is money.
The CPI has not been this negative in the past 59 years!
Why would the CPI number only be down a little more than 2% when import prices are down 10 times as much and export prices are down 4 times as much?
Do you think maybe your government numbers are a little bit skewed?

Aug 18 04:07 AM

[E Nuff Sed:]

I think the best investment now of the face of the earth are equities of blue chip US based multinationals (esp. if you are non-US investor). You can buy best dividend paying companies like JNJ, MRK, P&G, BA etc. in cheap US$ - this is a once in a life time opportunity.

Aug 21 10:12 PM

[User 475673:]

if the government eliminates my debt, they effectively increase my money supply and therefore my ability to spend now and in the future. however i suspect someone else will have to cover this by paying more through government tax hikes and therefore reduce their money supply. is this a wash?

Aug 23 04:14 PM

[NYM Arts:]

Your Debt would be eliminated if you had received the Proper Raise Due you.
Rather, the CEO pilfered the Dough.
We must prevent CEO's from walking away with anything more.
They should be paid a Straight Salary. A few HUNDRED THOUSAND, Not MILLION.
No Stock Options, No Extras.
Give you a Raise to fund Better Days.
Elimination of the CEO position is what the Doctor Orders.
Those who will give me a Thumbs Down on this are a HUGE part of the problem, and should be Fired.

Aug 24 06:23 AM

[term2:]

All I have to offer is my anecdotal experience here in Las Vegas. Although housing and gas prices have busted from the craziness of a few years ago, gas prices are still high (gas at 2.73/gal). Electricity prices have just risen and risen, and are slated to go another 18% next month.

Restaurant prices have risen quite a bit over the last year. It seems businesses are preparing for the price inflation to come, and are dealing with the recession with a LOT of 2 for 1 coupons here. As soon as the economy improves, those coupons will DISAPPEAR OVERNIGHT and the higher prices will stick.

I really dont believe the government figures on inflation. Thats like asking the fox how many chickens are in the coop?
Since inflation is CAUSED by government to give them a hidden source of additional income, they would always minimize the results they report.

All I know is that a $3,000 car in 1966 now costs $30,000, a $20,000 house in 1970 costs $200k+ today. Gasoline was 24c a gallon, now its $2.79.

We should have thrown out the government people who chopped the value of our $$ by 90%, but we didn't. And now Obama is geared up to do it again, but this time businessis preparing for it by secretly raising prices NOW and hiding them through time sensitive coupons.

In short, I am saying the inflation is already started, but we are being lulled into thinking not because of deals and coupons currently on the table. We will all see and feel it when the coupons dry up.

Aug 30 12:29 PM

[Mark Anthony:]

I like this quote in the article and I think it is icing on the cake: "...in a recession it is of course quite normal for businesses to face great pressure to cut costs. Cutting prices helps them become more competitive, and that is the key to survival in an economic downturn. But is cutting prices at the company level equivalent to an economy-wide deflation? No. To argue that what occurs at the company level is also what occurs at the economy level is to fall for the fallacy of composition."

Completely agree. Businesses are sustainable only if they make a reasonable profit selling their product. Cutting throat prices that drive businesses out of business, are NOT normal prices, but bankruptcy sale prices. You can not make a inflation/deflation argument by looking at the bankruptcy sale prices. You have to look at prices which reflect some sort of normalcy: prices that allow businesses to be sustainable. Ultimately inflation/deflation is an issue of money supply/demand, not an issue of commodity supply/demand.

Aug 31 02:47 PM

[Mark Anthony:]

Right, debt is money and debt elimination destroys money. The US dollar itself is a debt based fiat currency. As foreign governments now refuse to extend further credit to the US government that destroys the credit that the US dollar is absed on and that destroys the US dollar itself. The destruction is on going and it is no longer reversible.

And you are saying the FED is simply wasting ink and paper printing the money? Don't worry, not a single drop of ink is wasted. The FED is printing money electronically, out of thin air. You think the amount of money the FED prints is a small quantity. Don't worry, before long, a trillion dollar will look like a pathetically and laughingly small quantity.

seekingalpha.com/autho...

On Aug 16 08:34 AM CLH wrote:

> How can people carry on such a meaningless discussion--inflation
> and deflation? Debt elimination always destroys money. The small
> amount the Fed prints has no effect because it is never used.
>
> Dollar up and gold and commodities down --big time.

Aug 31 03:00 PM