Forget To Remember
There Are Prices And There Is Inflation
The coronavirus pandemic and the recent start of the war between Russia and Ukraine brought the inflation debate back in focus. After central banks in Frankfurt, London and Washington ignored signs of inflation throughout 2021, they are now taking it seriously.
It is true that price inflation, which is called inflation nowadays, has risen sharply since 2021, something that central banks have not expected a year ago. At the end of 2021, suddenly, central banks changed their tone by 180 degrees on inflation and at least agreed that price inflation would be around for long.
However, the million-dollar question is: Is the current rise in prices a sign of a structural shift from a 40-year deflationary regime to an inflationary one, or are recent price increases an expression of other factors that are not directly related to monetary policy?
I think that it is crucial to give a correct definition of inflation. Inflation is a term that comes around with some confusion these days. Alhambra Partners Jeffrey Snider once said that there is ‘inflation’, and then inflation. I agree with this statement. After all, inflation always leads to a rise in the general price level, but elevations in prices are not always caused by inflation. That is something we forget to remember.
Let us now talk about a speech that ECB executive board member Isabel Schnabel gave at the Monetary Policy and Climate Change Conference.
In her speech, Schnabel talked about several different kinds of ‘inflation’ that will discuss climate change and the economic environment during the green transition. According to Schnabel, the economy will experience climateflation, fossilflation, and greenflation.
Admittedly, Schnabel is describing ‘inflation’, not inflation, and in reality, she is simply telling the rise of some prices because of shifts in supply and demand. For example, climateflation means the lower supply of agricultural products because of natural phenomena like droughts.
Fossilflation means that fossil energy is getting more expensive. Let it be artificially because of laws (CO2-taxes, for example) or a supply shock (similar to drought and climateflation), as we can see because of the war in Ukraine.
Finally, greenflation describes the price changes for some commodities due to higher demand because those commodities are needed to build solar panels, wind engines, or other renewables.
I do not want to discuss the green transition here, and the reason why I discuss this speech here is precisely the difference between ‘inflation’ and inflation. My point is that Schnabel’s different scenarios describe price changes, not inflation, even if we use the modern definition of inflation, a rise in the general price level.
The general price level can rise occasionally, but it does not have to be caused by inflation. To discuss the topic, if we face a regime change from deflation to inflation, it is essential to differentiate between rising prices (price-inflation) and inflation.
In the classical sense, inflation is defined as a rise in the quantity of money. The result of an increase in the supply of monetary units leads to price inflation if one assumes that the rise in the quantity of money does not affect the total amount of goods and services produced in an economy. If the money supply in the real economy goes up, the general price level will go up over the medium term.
You already see that the production level influences price inflation apart from the money supply. Hence, a sudden fall in total production leads to a sudden rise in the general price level.
The consequence on the oil price due to western sanctions against Russia is an excellent example. Due to the sanctions, the cost of oil has increased by up 35 % because of self-sanctions. Nobody wants to have Russian crude.
Because of the self-sanctioning, the oil supply has gone down, and the price has risen. The price increase signals that market participants demand oil, whereas the higher price signals a lower supply.
As a result, one can expect that market participants will buy less of the good and buy other goods. Additionally, they may change their behavior. If prices at the gas station rise, people may drive more by bicycle or walk. If they lack alternatives (because they depend on the car to go to work, for example), they will reduce consumption of other goods. So, higher prices in one good will lead to lower prices of other goods.
Therefore, the general price level cannot rise if the supply of money remains constant. The money supply would have to be expanded to increase the general price level. Otherwise, general price increases would balance out over the medium or long term.
After all, an economy is not a supercomputer where everything in the economy adjusts in real-time, and new equilibria emerge. In the real world, the economy jumps from one disequilibrium to another (because parameters are constantly changing) but tends to move towards equilibrium.
However, over the short term, price inflation can indeed occur, although the quantity of money has not changed, because extraordinary events can lead to a distortion of market conditions and thus expectations which are probably not sustainable.
One example of such an event is the Korean War in the 1950s. When the war started, US businesses increased prices sharply because they expected that the US government would implement price controls as they did during WWII. Consumer price inflation spiked above 9 %, but 10y yields constantly remained between 2 to 3 %.
This stable long-term yield environment changed around 1956, and 10y Treasuries entered an upward trend that should last until 1980. Jeff Snider hypothesizes that that was the gaining importance of the international eurodollar system and rising demand for dollars outside of the United States. However, the US government also implemented extensive spending programs in the years after (Lyndon B. Johnson’s ‘Great Society’, financing the Vietnam War), and the Fed loosened its monetary policy. All this led to President Nixon’s closing of the gold window in August 1971, which boosted inflation even more.
To sum it up: In the short term (transitory), the general price level can rise despite no continuing (considerable) change in the quantity of money. This can be caused by increasing uncertainty and/or strong supply and demand structure imbalances.
A singular expansion in the quantity of money leads to an upward adjustment of prices until they have reached their new, higher level. That is what we could observe during the coronavirus pandemic. Excessive spending, credit guarantees, and central banks buying corporate bonds caused a big fiscal impulse. Price increases during 2021 were a logical consequence of expansionary monetary and fiscal policy.
The surge of new money that flew into the real economy brought inflation to levels that we did not see in the United States since the 1980s. But credit impulse has contracted during last year while the prior created money units spread throughout the whole real economy, where it pushed prices upwards. Additionally, supply chain disruptions worldwide were another driver of price increases. If the correlation holds, then the slowing credit impulse would be a drag on inflation, ceteris paribus.
I expect that price changes caused by supply and demand imbalances due to supply-chain problems will stay here for a little longer, especially if China and other Asian countries continue to pursue a zero/low covid policy. I thought that consumer prices would peak somewhere in Q1 this year.
However, things happened. At first, geopolitical turmoil has led to higher uncertainty, and then Russia sent armed forces into Ukraine at the end of February, which caused even more uncertainty. Sanctions against Russia then put even more fuel to the fire.
Meanwhile, a food crisis is looming (I already wrote about the importance of Russian and Ukrainian exports of agricultural goods for the world two weeks ago), and France's president Emmanuel Macron mulls food stamps to help poor french households cope with Ukraine war fallout.
All this uncertainty and rising prices have another effect: more and more governments are planning to ramp up fiscal spending again or implement price ceilings for certain goods to support lower-income households. This could fuel inflation as one cannot solve a supply crisis by ensuring that demand remains high.
Recently, while inflation keeps rising, long-term yields have increased, not only in the United States but also in Europe. Producer prices rise significantly more than consumer prices, diminishing profit margins for businesses. High leverage of enterprises, governments, and households could lead to one final big economic bust.
However, central banks have made clear that they will fight inflation with everything they have. FOMC-members do not rule out rate hikes by 50 basis points and several of them. Even the ECB has announced to end PEPP sooner than expected.
Long story short, I am doubtful about that, and the Federal Reserve’s (and other central banks) track record does not support that. Remember Bernanke, when he argued that the Fed’s goal is to bring the balance sheet back below one trillion?
Or Janet Yellen, who bluffed about shrinking the balance sheet several times before she started it, claiming that it will be like watching paint dry?
It is a fact that the Fed had several chances to show that they are serious about fighting inflation. If it were severe, it would not have raised rates only by 25 basis points last week but by 50, and it would have begun tapering sooner and would reduce its balance sheet already. I leave it aside from that even if you hike interest rates to 2 % (which is unrealistic, in my opinion), one will not be able to fight inflation rates of 8 - 10 %.
Jay Powell is no Paul Volcker. Everything, from eurodollar futures, the yield curve, to downward revisals of growth numbers, points to a potential slowdown right around the corner. Suppose it has not already started. As I wrote last week: the best cure against high prices is high prices.
This brings me back to Isabel Schnabel and her speech about potential ‘inflation’ because of economic uncertainty and behavioral changes of economic actors. As I have shown here, all kinds of inflation that she mentions are mere price fluctuations because of transformational processes.
Several ECB officials also pointed out that the ECB will take action against inflation this year. However, I would be cautious about concluding that the ECB is serious, even though markets already anticipate potential tightening and rate hikes. If you read Schnabel’s speech, you will find out that the ECB (and the Fed will follow) found another field of activity.
You probably already suspected it when you first read about climateflation, fossilflation, and greenflation: The ECB wants to support the green transition with its monetary policy. If the ECB did not keep it, all these ‘inflations' would be price changes because of changes in the behavior of economic actors. Without an expansionary monetary policy, prices of other goods would fall over the medium-term if prices for goods increase because demand rises due to the green transition.
Not long ago, the ECB already changed its inflation target from below, but close to two percent to below, but close to two percent over the medium term. And despite several statements that the ECB is planning to normalize its monetary policy, two proposals of Schnabel’s speech do not support that.
Firstly, Schnabel suggests that the ECB should change its inflation target again. Here is what she said:
The first proposal is to raise the inflation target.
It suggests internalising the inflationary impact of the green transition by moving central banks’ goalposts. A higher target would automatically reduce the need for policy adjustments.
Another proposal is to exclude energy price changes from inflation calculation, although even Schnabel acknowledges that energy consumption makes up for a high proportion of spending of an average household.
However, Schnabel quickly dismisses the notion and continues.
As with raising the inflation target, ignoring persistent trend increases in the price of energy would ultimately serve to undermine trust and confidence in our determination to protect price stability.
This does not mean that the concept of underlying inflation will become less relevant for the conduct of monetary policy in the future. It just has to be defined differently.
This does not sound as if the ECB is strongly pushing for an end of its loose monetary policy. On the contrary, this sounds like it is ready to keep financial conditions eased for longer. Schnabel argues that despite high costs in the form of high inflation now, the reward would be damn cheap energy prices in the future.
Isabel Schnabel will not be at the ECB at this point in the future. She will enjoy her retirement then.
Have a great weekend!
Fabian Wintersberger
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(All posts are my personal opinion only and do not represent those of people, institutions, or organizations that the owner may or may not be associated with in a professional or personal capacity.)
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