Elisabeth Dellinger
Inflation, Monetary Policy

Fun With Uncle Milty

By, 09/14/2017
Ratings964.317708

Will the Phillips Curve’s fecklessness ever dawn on the Fed? Photo by Elisabeth Dellinger, who asks you to pardon the lens flair.

Dude, where’s my inflation? Fed people are perplexed, unable to fathom how inflation could stay low even though the economy is at what many deem full employment. According to Fed Logic, because companies must compete for a limited pool of workers when unemployment is low, they have to raise wages—and raise prices to offset the extra expense—and thus inflation happens. The central bank’s dual mandate is based on this model. Yet, this isn’t how inflation works. It isn’t a labor market phenomenon. Nor is it a psychological phenomenon, which guts a frequent explanation for The Case of the Missing Inflation. As Nobel-laureate Milton Friedman and many others have shown over the last century-plus, it is a monetary phenomenon: too much money chasing too few goods and services. The budding Nancy Drews and Hardy Boys at 20th and Constitution don’t need fancy models, complex theory or cipher keys to crack the case. Brushing up on Uncle Milty’s greatest hits would do it. But even if they never see the light, investors can learn from their confusion.

The Fed’s logic and dual mandate of maximizing employment while keeping inflation low and stable are based on a mid-20th century model called the Phillips Curve. In 1958, a gent named William Phillips noticed an apparent link between unemployment and wages in Britain. Economists took it and ran, presuming that since firms link wages and prices in order to preserve profit margins, wage inflation must cause price inflation—hence the widespread belief low unemployment creates inflation as wages and prices spiral together.

At face value, this might seem logical. Yet as Friedman observed in a 1968 keynote, it overlooks a crucial factor: When employers set wages, they account for inflation. They compete based on real (inflation-adjusted) wages, not nominal. I’ll let him take it the rest of the way:

Implicitly, Phillips wrote his article for a world in which everyone anticipated that nominal prices would be stable and in which that anticipation remained unshaken and immutable whatever happened to actual prices and wages. Suppose, by contrast, that everyone anticipates that prices will rise at a rate of more than 75 per cent a year—as, for example, Brazilians did a few years ago. Then wages must rise at that rate simply to keep real wages unchanged. An excess supply of labor will be reflected in a less rapid rise in nominal wages than in anticipated prices, not in an absolute decline in wages. When Brazil embarked on a policy to bring down the rate of price rise, and succeeded in bringing the price rise down to about 45 per cent a year, there was a sharp initial rise in unemployment because under the influence of earlier anticipations, wages kept rising at a pace that was higher than the new rate of price rise, though lower than earlier. This is the result experienced, and to be expected, of all attempts to reduce the rate of inflation below that widely anticipated.

Translated: If you say rising wages create inflation, you are essentially saying inflation creates inflation. Sorry, not how it works.

The above passage’s reference to the anticipated inflation rate might seem to support some Fed people’s hypothesis about inflation expectations: The long-running trend of slower inflation has caused people to expect low inflation, which in turn reduces actual inflation. All because when people expect a given level of inflation, “they set prices and wages in a way that makes actual inflation hit [it].” Consider that fairy tale logic. Did inflation reach double digits in Britain and America in the 1970s because people suddenly expected it? Did mass psychology cause hyperinflation in the Weimar Republic? Zimbabwe? Venezuela? All had massive dislocations in either the quantity of money or supply of goods and services. Sometimes both. “I think, therefore I inflate” is not mankind’s driving existential force.

Here, too, our pal Milty offers a more nuanced explanation of inflation expectations’ role:

It takes time for people to adjust to a new state of demand. Producers will tend to react to the initial expansion in aggregate demand by increasing output, employees by working longer hours, and the unemployed, by taking jobs now offered at former nominal wages. This much is pretty standard doctrine.

But it describes only the initial effects. Because selling prices of products typically respond faster than prices of factors of production, real wages received have gone down—though real wages anticipated by employees went up, since employees implicitly evaluated the wages offered at the earlier price level. Indeed, the simultaneous fall ex post in real wages to employers and rise ex ante in real wages to employees is what enabled employment to increase. But the decline ex post in real wages will soon come to affect anticipations. Employees will start to reckon on rising prices of the things they buy and to demand higher nominal wages for the future.

In other words, prices rise before wages and salaries, and as employees realize this and reckon it isn’t a one-off, they demand higher compensation to keep up, and employers grant it since they need workers. It is an after-effect of inflation, not a contributor. In wages as well as hiring, labor markets trail the economy at a late lag. (This might offer comfort to those worried about UK wages not keeping up with higher inflation in recent months—it just takes time for all this to work out.)

As a result, all the fancy labor market-based models in the world won’t explain where inflation went or how to restore it. Devising them would be a futile exercise in overthinking. So of course, you can bet that is what the Fed staff is doing, and recent comments from some of them confirm as much. But while they spin their wheels, the rest of us can go back to basics: The Quantity Theory of Money, championed by Friedman and so many others throughout the 20th century. According to this classic tenet, inflation stems from one or all of the following: faster broad money supply growth, money changing hands more quickly (known as the velocity of money) or supply shortages. It is basic supply and demand: More money creates more demand, which creates bidding wars for a limited supply of goods. Bidding wars drive prices higher, and higher prices eventually drive more goods to market.

This is fairly easy to test with history. When the US suffered through stagflation in the 1970s, all the evidence suggests it stemmed from the after-effect of price controls (which create shortages), capped interest rates (which boosted the broad money supply) and the oil shock (another supply shortage). In both 1972 and 1977, the broad money supply (M4) was growing north of 10% year over year. Both times, inflation eventually climbed into double digits. Similarly, the few times we have had deflation, it stemmed from frozen money markets during recessions, which tightened money supply. You can see this most clearly in the early 1930s and late 2008.

Understanding this is key for investors trying to put the Fed’s inflation handwringing in context. Fed chatter would have you believe low inflation is a problem that must be solved, which can lead to investors fearing lowflation is an economic risk and by extension a danger to stocks. View it through Friedman’s coke bottle glasses,[i] however, and it becomes more benign. If inflation is a monetary phenomenon, we can simply ask, what is broad money supply doing—growing fast enough to drive growth, not fast enough, or too fast (to put us at risk of overheating)? This year, M4’s year-over-year growth rate has bobbled between 3.7% and 4.8%.[ii] Faster than this expansion’s first few years, though slower than 2016. Meanwhile, economic growth has picked up a bit. In the heady 1990s, people called this a Goldilocks Economy—not too hot, not too cold, just right. When so many fear something that is actually quite nice, it is generally a sign people don’t appreciate how good the economy is—the perfect backdrop for a bull market.

Yet the takeaways aren’t all rosy. Wacky monetary tricks to “fix” lowflation, in addition to being a solution in search of a problem, could provoke unintended consequences. Expansions don’t just end on their own. They often end when central banks mess up and invert the yield curve. If a creative Fed employing fishy models decided to totally juice the economy in order to get inflation up—and over shot—they’d probably be tempted to overreact by jacking up short rates and inverting the yield curve. This is sort of what Alan Greenspan and his buddies did at the end of the Tech Boom: They kept short rates ultra-low to placate Y2K fears, then overcompensated with rate hikes in early 2000 and inverted the yield curve. A bear market began that March, and recession followed a year later. We don’t appear to be in imminent danger of anything like that now, but keep a wary eye out for Fed monkey business.

 


[i] A term of endearment, I assure you (as I type this with my own nerdy specs on). No one wore big glasses better than dear Milty.

[ii] Center for Financial Stability, as of 9/14/2017. Year-over-year change in Divisia M4.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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