Fisher Investments Editorial Staff
Inflation, US Economy

Taming of the Shrill

By, 10/20/2009
 

Story Highlights:

  • There are concerns the recent, aggressive, and global monetary stimulus will overheat the economy and cause rampant inflation.
  • Recent data and economic conditions simply do not build a case for imminent, high inflation.
  • The velocity of money is low, capacity utilization is low, and unemployment is high—all three factors keep prices in check.
  • The Fed's focus today is rightly on stimulating the economy rather than tightening policy.

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Inflation isn't necessarily an evil. (In fact, a small amount is normal and expected in a growing economy—and certainly more desirable than deflation.) But it seems we've somehow been programmed to regard inflation with fear—if not outright horror. So it's not surprising there are concerns the recent, aggressive, and global monetary stimulus will overheat the economy and push prices sharply upward. 

Recent data should somewhat temper inflation fears: The US consumer-price index rose 0.2% from August to September, following a 0.4% monthly gain in August. At the moment, certainly, inflation is exceedingly tame. However, today's economic conditions simply don't build a case for imminent, high inflation anytime soon either. 

In the early 1900s, noted economist Irving Fisher surmised the relationship between an economy's money supply (M), velocity of money (V), price level (P), and output (Q) can be generally mapped using the equation: MV=PQ. Money supply is the total amount of money available in an economy at any given time, while velocity refers to how many times a dollar is spent in any given year. (It's tempting to want to assign exact figures to this equation, but it's a bit more ethereal than that. Fisher's equation is intended to describe the general relationship among these factors, not calculate any precisely.) Nonetheless, you can see a rise in either M or V can translate to a rise in P—the much-dreaded inflation. 

But fears the Fed's expansionary monetary policy will cause inflation focus on M, largely ignoring V. While it's true new central bank lending facilities and low interest rates globally drive up M, today's prevailing low inflation rate suggests the increases in M have so far pretty successfully offset the precipitous declines in V caused by last year's financial panic and credit freeze. 

Moreover, industrial capacity utilization is at historic lows. Responding to the economic downturn, firms significantly reduced inventory, labor, and orders, leading to underutilized or idle factories and machines. When capacity utilization is high, firms can't easily increase output so they simply raise prices—they get less demand for their goods, but at higher prices. Spare capacity and waned demand means companies have less power over pricing—competing companies can easily increase output and undercut prices. Until firms start restocking inventory and plant capacity fills again, prices have little room to maneuver. 

A third factor limiting prices is high unemployment. An excess workforce (i.e., elevated unemployment) means employers can easily find someone who will do the labor at the wage they are willing to pay. Workers aren't in positions to demand higher wages—in fact, many stayed with their employers despite salary cuts—keeping a check on wage inflation. After all, most would agree a lower wage is better than no wage at all.  

These conditions show today's economy is barely simmering, let alone overheating. In turn, rampant inflation isn't likely soon—indeed, inflation has remained very low throughout this year. The Fed seems to be monitoring prices very closely and has plenty of time—and tools—to rein in monetary policy as needed, when the time arrives. Whether they do so successfully—well, that's a concern for down the road.

The Fed's focus today is rightly on stimulating the economy rather than tightening policy. Despite the fears, it's too soon to guess if and when high inflation will take hold. Pulling the rug out from under a recovering economy based on loose fears would undoubtedly lead to a more disastrous result.

 

 

 

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

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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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