What Is Inflation and Why Do We Care?

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Includes: DIA, QQQ, SPY, UDN, UUP
by: The Hedonic Calculus

I'm writing this post because when I have conversations about inflation/deflation with people on Wall Street, many times it seems like we're talking about two different phenomena. They seem to talk about consumer prices increases while I talk about inflation in the classical sense: a devaluation of the currency. The difference in views leads to much different interpretations of policy action.

Some believe that it is insane to worry about inflation when "velocity" has fallen. I believe that we are already witnessing the first phase of a three phase inflation in which:

  1. The weakening of the currency leads to higher securities prices and depress yields.
  2. Depressed yields incentivize debt accumulation.
  3. Debt accumulation is spent on physical goods and inputs to production.

If you agree that we're in the first phase of inflation and not real wealth creation, then it would follow that something should be done about it.

Here's my view of what inflation is and why we should care about it:

What is inflation?

The answer to this question seems pretty obvious, but asking different people may yield different answers. Three answers would probably be given: a general increase in prices; 2) the erosion of the purchasing power of currency; or 3) an increase in CPI. At face value it would seem that the definitions are one and the same, but that’s not the case; the difference is a matter of cause and effect. The root of true inflation is the weakening of a currency. This leads to the price increases, which are measured by CPI, not the other way around.

This is an important distinction because price increases by themselves are not necessarily bad. Prices are the most important source of information in a capitalist system. For instance, when the price of wheat rises because of increased demand, it incentivizes farmers to plant more wheat, increasing the supply of wheat. If the price has risen because there has been an increase in demand for wheat then this increased supply will be favorably met. The increase in price caused the farmers to more efficiently satisfy people’s demands.

There are however two main components of price. The first component is supply and demand or natural market forces. The second component is the value of the currency in which the price is denominated. Without currency, the price of any good can be measured in terms of its relative value to other goods. For instance, the price of an apple may be viewed as being two bananas.

However, in a multiple good economy it would be cumbersome to think of one item in terms of the price of every other. If a person needs bananas, apples, wheat and milk to survive and he produces oil, how does the person trade for the goods he needs?

Currency is the solution because it is a unit of account, which allows for uniform comparison; the dollar is like a meter or a gram. The difference between a meter and a dollar though is that the value of a meter is constant. Imagine having to measure the distance between two points but the value of the meter is constantly changing. Today the distance may be one meter, but tomorrow the same empirical distance may be 2, 3, 4 or more meters. How do you compare that distance to other distances especially those measured at different times? If today I am 6 feet tall, but tomorrow we decide that one foot is 6 inches instead of 12, then tomorrow I am 12 feet tall. Have I grown? Clearly I have not. This is the problem that we run into every day when we price goods and securities, and the problem posed by inflation. The value of the dollar itself changes based on forces of supply and demand for the currency.

Because the value of the currency changes, the price of a good can rise for purely monetary reasons. If the quantity demanded for wheat remains flat, but the amount of cash in every person’s bank account were to magically double, then the value of the dollar relative to the bushel falls. The price of the bushel therefore rises from $1 to $2. Recall however that the demand for wheat has not changed. This second scenario is true inflation.

Why do we care about inflation?

When the value of the currency changes, price changes can be difficult to interpret, and thus lead to an inefficient allocation of resources. How is the farmer supposed to discern between an increase in demand and an increase in inflation? If prices are rising he is liable to think that his product is more highly desired, but if he is wrong, then there is an oversupply of wheat. The oversupply of wheat makes society poorer because the farmer could have allocated his land to producing something more desirable than an extra bushel of wheat.

Unexpected inflation really causes problems in contracts, which are formed at one point in time where the dollar is worth one thing, and in the next it's worth another. In a debt contract for instance, if a person borrows $100 today and agrees to pay $100 back tomorrow, then the lender stands to lose if $100 isn't worth tomorrow what it was worth today. The borrower of course stands to gain from this transaction.

In my conversations with typical "Wall Streeters" in 2008, people would always fear deflation and say that we have no way to control it. This always confused me for two reasons.

  1. Why would you be afraid of deflation when it is the normal course of events for prices to fall and send market signals?
  2. There is an easy solution to deflation too: print money (why would you want to do that though).

Well that's what we've done, but when the value of currency changes it leads to a misallocation of resources and destruction of wealth. That doesn't seem like too great a prize.

Disclosure: None