Article 3 - Inflation: the Hide & Seek Game

Following the two previous articles that I posted about monetary policy and its effect on innovation and the economy, the purpose of this article is to showcase one of the foundations of Monetary Policy: inflation.

Let us go back in history to examine what happened in the past, when and why did the use of monetary policy start.

The deployment of monetary policy does not go very far back in time, in fact, it goes back to the 70s when the UK faced a high inflation of more than 20%, when price-income policies didn’t work (basically freezing salaries and prices). This also affected the US, and this is when the 1976 Nobel Prize winner, the famous monetarist, Milton Friedman came into the picture by introducing a new economic theory that states that reducing the money supply (how much money is circulating in an economy) would put downward pressure on inflation, hence reducing it. Paul Volcker, the US Federal Reserve Chair implemented this strategy successfully, and then it was also implemented in the UK successfully, whereby increasing interest rates, people would borrow less money, hence the multiplier effect that I explained in Article 2, would create less money in the economy, so less usage of money leads to a drop in prices.

Since then, monetary policy came to the forefront of policy making, whereby it seemed to be a very useful policy to implement, controlling inflation, by simply increasing interest rates. The usefulness of this policy was manifested in its ease of use, quick implementation, and its lack of adverse effects on consumers (voters), on the contrary, consumers were happy about it because they were able to borrow money at lower rates. 

The above graph shows US household debt. It has hit an all time high of 14.3 Trillion USD recently! As discussed in Article 1, this graph shows the importance of recessions. It pushes households to deleverage. 

Then came the bright idea of using monetary policy, not only to control inflation, but also to stimulate economic growth when it goes into recession. Previously, policy makers would use economic/fiscal policies to fix an economy in recession, and monetary policy to control inflation when an economy “overheats” due to favorable economic/fiscal policies, so it was a balanced approach to controlling economic growth. So, slowly but surely, politicians started sensing the added value of monetary policy of not having an affect on consumers (voters), contrary to economic/fiscal policies. Also, another bright idea came up, which is pushing monetary policy usage to a new high, which is using it to stimulate economic growth rather than just to fight inflation, and this is when we started seeing negative interest rates, despite this being totally counter-intuitive (having to pay a banking institution for keeping your money with it)!

Then came another counter-intuitive and very dangerous practice that helped overcome the limitation policy makers faced when they dropped interest rates to 0: printing money! To make it sound good, policy makers called it Quantitative Easing (QE) rather than printing money. It is actually a very simple mechanism, whereby the central bank would “create” new money out of thin air (yes this is possible, it is like turning a money printing machine) and use it to buy financial assets from financial institutions who are not able to sell these assets against cash. So instead, the central bank buys these securities leading to an increase in the money supply in the system, and inflates the balance sheet of the central bank.

How did this new style of policies have an effect on inflation, where is it hiding and why are we not seeing it anymore?

1. Supply support: This new paradigm of using monetary policy to the extreme rather than balance it out with economic/fiscal policy, as well as using it as a preventive measure rather than a corrective one, has led to the supply side of goods and services being strongly supported. In fact, during economic expansions, when traditionally interest rates are high, suppliers of goods and services access to cash (borrowing) is more expensive than during economic slowdowns or recessions. The more expensive funding is reflected in the prices of goods and services they sell (more inflation). During economic slowdowns and recessions, borrowing costs for these suppliers are lower, therefore, there is less pressure on the prices of goods and services (less inflation). So when interest rates are kept at very low levels, as we have seen over the past 10 years, the prices of goods and services remain in check
2. Financial asset inflation: When monetary policy is expansionary, while interest rates are very low, and quantitative easing is being used extensively, the economic system is flushed with abundant cash, and it is cheap to borrow money. Most of this abundant cash is used to invest into financial markets and into real estate. Indeed, with cheap credit, consumers are incentivized to buy more goods and services, but there is a limit to that. These consumers would buy cars, refrigerators, gaming consoles to a certain extent, hence they will not buy an additional good or service they do not need, so they switch to investing rather than consuming, and this is where this excess cash flows into financial markets and real estate rather than into goods and services to create inflation. That is why currently, we call the increase in financial market prices, and sustained real estate prices as financial asset inflation
3. Price adjustment mechanism: The transmission or the creation of inflation comes from a gap between supply and demand. Sometimes demand increases due to better purchasing power like an increase in salaries, or population growth, and suppliers do not have enough products to sustain this increased demand, so they increase the prices of these goods and services. Demand triggered inflation is called demand-pull inflation. From the supply side, when the economy is at full employment, companies have to offer salary increases to hire a needed employee who is already working, rather than hiring an unemployed person. This leads to increased prices of goods and services due to the increase in labor costs. This is what we call supply side inflation or cost-push inflation. However, this mechanism has been quite muted lately due to online retailers. We are all using online retailers to buy goods and services, especially from mega large online retailers. These online sellers of goods and services have a very efficient and optimized supply chain system, whereby their inventories of goods can adjust very quickly to changes in demand. Therefore, the effect on prices is quite limited when demand changes upwards or downwards. This helped mute inflation as well

Obviously, there are several additional reasons that can be stated for the muted goods and services inflation we have been witnessing in the past decade, but it is not the purpose of this article to create a full economic and financial analysis of inflation.

Monetary policy is a very effective tool as long as inflation is under control at low levels. Should inflation rise, then policy makers will have to increase interest rates to control inflation, and avoid the loss of value that the economy faces with high inflation levels.

Clearly inflation is key in all this, but how is inflation measured? Hmmmm, let us have a laugh.

In the US, there are two main types of inflation measures: The PCE (personal consumption expenditure) and the CPI (consumer price index). Both indicators are closely correlated and follow similar trends. However, the measures are not identical. The two indicators measure the price changes of a basket of goods and services, and both measures exclude food and energy items because their prices are deemed “too volatile”, hence difficult to measure and incorporate in neither the PCE or the CPI. Both indicators measure average inflation over a past period of time, and if the monetary policy makers detect an increase above a certain target, they increase interest rates to push inflation down because inflation destroys value. You surely noticed that I used the word “past” in the previous phrase. These indicators measure what happened in the past to determine what the policy makers will do in the future. Need I say more? I will just stop there, and let your imagination explore how our monetary policy makers are determining our future and the future of our children, knowing that inflation is one of the pillars of monetary policy determination.

So let us imagine the case where oil prices go up, and there is a serious drought affecting farmland, hence both energy and food prices go up, however, core inflation that central banks use through CPI and mainly PCE wouldn’t show such a spike. In this case, central banks would not increase interest rates, and consumers’ disposable income would be hit hard for a period of time until inflation creeps into the core, which triggers central banks to take action to lower it, which restores consumers’ disposable incomes levels.

What is the incentive for any political system to resort to unpopular economic/fiscal policies when they have the perfect tool to push forward economic slowdowns, while inflation is kept low due to the reasons above? It is the perfect setup for a political system that wants to kick the can down the road and postpone any structural reform needed. It is a scam.

Continuously using monetary policy is like a doctor who gives a cancer patient strong painkillers. The patient feels ok and carries on with his life while cancer is eating him up. The alternative is treating this cancer with chemotherapy and surgery which are both hugely painful and unpleasant but would cure the patient at the end. Surely during this harsh medical treatment the patient would be cursing the doctor to the moon and back. Using economic/fiscal policies in the face of sustained economic problems are the solution, and not painkillers, but consumers (voters) will hate the pain of economic/fiscal reform and would not vote for the leader who decided them.

The money printing that is happening at the moment across the world will only exacerbate the financial asset inflation and keep everyone high on this drug, not feeling the structural issues facing the world, namely the anemic lack of economic growth because we are not innovating and creating value anymore.

The next article will deal with innovation and patents, and their effect in creating sustainable economic growth.