Janet Yellen adjusts her spectacles. Which are not magical inflation X-Ray Specs. Photo by Chip Somodevilla/Getty Images.
So, inflation is back. (Ish.) Too-low inflation? Soooooo three months ago. The Fed’s preferred inflation rate has more than doubled since then. Pundits say it’s making us “squirm.” Or it’ll make stocks more volatile. Or put America at risk of a destructive wage-price spiral, unless Fed Chair Janet Yellen gets her act together (or something) and hikes rates (which others say we’re all supposed to fear is just terrible, but no matter). Which all just seems a bit … bizarre. One, even after the supposedly astronomical increase, core inflation remains half a percentage point below the Fed’s 2% y/y target (that’s low). Two, none of those alleged inflation indicators mean anything—the market is your best indicator, and it isn’t exactly signaling runaway price increases. For investors, all this noise about inflation is just noise.
Inflation isn’t all that complicated to assess and predict. It’s a simple function of the quantity of money in the economy, how fast that money changes hands, and the amount of goods and services it’s chasing. If you have a growing money supply and steady bank lending, you get inflation. If you want to know where inflation is headed, you can just look at bond markets—like the spread between long-term Treasury yields and TIPS yields (bonds with coupon payments linked to inflation). The lower the spread, the less return market participants believe they’ll need to maintain purchasing power. Today, spreads are about 2.3 percentage points—they were higher in late 2012 and during much of the previous expansion. Inflation risk? Benign.
You won’t see this point of view in most outlets though. Pundits and economists have a remarkable tendency to overthink things, and they overthink the heck out of inflation. This, of course, is partly because they don’t understand it. Our dear Fed head is a prime example. Milton Friedman summed up inflation best: always and everywhere a monetary phenomenon of too much money chasing too few goods. Yellen, however, seems to think inflation is a function of the amount of slack in the labor market and people’s inflation expectations—as if it’s a self-fulfilling prophesy of a psychological phenomenon. If you don’t believe me, go read the FOMC’s last statement. She is also, shall we say, a decidedly not market-oriented bird—from her papers and Senate testimony to her Fed transcript entries, it’s clear she doesn’t trust it. As a result, we have a Fed head who ignores the simple indicators of inflation risk and looks instead to a smorgasbord of data that don’t have much to do with the quantity or velocity of money.
Yellen’s view of inflation is decidedly 1970s,[i] based on the belief prices are a function of wages, which are a function of “tightness” in the labor market. As the theory goes, when unemployment is low, workers have more clout, demand higher wages, firms pay them, then jack up prices to protect margins. Rising prices cause workers to demand even higher pay, which begets higher prices, which drives wages higher and presto! Inflation from a wage-price spiral. Now, this probably seems logical. Like, duh, of course competition for workers makes wages go up, and businesses have to raise prices to stay afloat, and of course workers would need a cost-of-living adjustment, and of course all the rest. But, there is a problem: It ignores the quantity of money. Regardless of what wages and the prices of a few items do, if the amount of money in the economy isn’t expanding, you won’t get a broad-based inflation increase. There won’t be enough cash to chase the majority of prices higher. Demand will be restricted. Some prices likely fall, offsetting those that rise.
That’s the slack element, anyway. As for the psychological element, well, I don’t know what to say. It’s fundamentally, theoretically, philosophically loony tunes. But it’s all the rage today. Not just with Yellen. The IMF, too, believes “well-anchored” inflation expectations mean inflation risk is low. So does the ECB. Like, if we all think inflation will rise, we’ll all run out, buy up whatever we need before it happens, drive prices higher and cause the very inflation we fear. Or if we don’t think inflation is in the cards, we’ll just act normal, and the world will be fine.[ii] We think, therefore we inflate? C’mon, if that were the case, I’m pretty sure we wouldn’t have a Fed. A Federal board of hypnotists to bewitch us into having the “right” inflation expectations, maybe, but not a board of “bankers”[iii] manipulating the yield curve in an effort to control growth in the money supply and encourage (or discourage) bank lending as needed. Fed practice is based on the notion of inflation as a function of the quantity of money, even if their bizarrely worded statements aren’t.
Perhaps if the FOMC woke up and realized this and started focusing on the yield curve again, we’d all be better off. You wouldn’t be reading this column, because no one would be freaking out about inflation. Ghosts of wage-price spirals wouldn’t be news. No one would fret falling unemployment was about to drive prices higher. But expecting the Fed to think clearly, simply and correctly about matters of policy and inflation is just too irrational. They’re economists. Overthinking is sort of a requirement. So we’ll have to live with the occasional burst of noise and bizarritude, just as Georgetown residents will have to live with Yellen’s disruptive, pizza-guzzling security detail. On the bright side, within the foreseeable future, investors likely won’t have to live with materially higher inflation.
[i] I say 1970s because she—like many others—believes a wage-price spiral drove that decade’s inflation. The irony here, of course, is both wages and prices were subject to Nixon’s controls. Inflation in the 1970s was a result of supply shortages caused by price meddling (too few goods) and double-digit growth in the quantity of money (too much money chasing).
[ii] The “psychological phenomenon” underpins most analysis of Japan’s deflation, too. Supposedly, with deflation entrenched, people don’t buy anything because they’re always waiting for a better deal, and that makes prices drop. And makes the economy super slow and weak. As if the anemic growth in money supply and crazy-weak lending environment have zippo to do with anything.
[iii] Most current central bankers never actually worked at a, you know, bank. They’re central bureaucrats.