Inflation Narratives

The standard narrative about inflation runs something like the following:

Modern inflation began in the Guns and Butter days under Lyndon Johnson, when the Vietnam War and the Great Society competed for labor and drove prices up. This was not entirely unintentional, as Keynesian advisers to Kennedy and Johnson, people like Arthur Okun and Paul Samuelson, convinced the presidents that by allowing a little bit of inflation, unemployment could be brought down. The standard narrative says that, with a modest assist from the oil shocks of 1973 and 1979, things just got out of control.

Riding to the rescue was Fed Chairman Paul Volcker, who with noble determination squeezed the quantity of money until the double dip recession of '80-'82 destroyed enough demand to bring down prices.

Since that time, the vigilant Fed has jacked up interest rates at the first sign of inflation and generated the so-called Great Moderation -- low inflation and steady growth.

The Great Moderation continued until the current crisis.

This trail of conventional wisdom then disappears into the tall grass of confusion over why prices rose between the onset of the recession late 2007 and the middle of 2008 and then collapsed. The confusion is minimized by ignoring the facts and emphasizing alarm over the financial collapse.

But it reappears in a general concern and even paranoia that immense monetary easing will sooner or later and probably sooner create a burst of inflation that will carry the country into the abyss. Meanwhile there is no real need to panic about deflation, since the Fed is doing so much, and after all it is mild and even more What's wrong with falling prices anyway?



So many points, so little time.

First of all, the Kennedy-Johnson inflation was the last demand-pull inflation. Johnson instituted a ten percent income tax surcharge to deal with it.

Separating that time from the present is the 1970's, first with Nixon's ill-conceived and disruptive wage-price freezes and cutting loose the currency from the Bretton-Woods scheme. Then by the two great oil shocks of 1973 and 1979.

The use of the interest rate, or in Volcker's case, the quantity of money, to dampen inflation runs into many practical problems, but it is well supported by academic and financial sector advocates. One problem is that inflation has more often accompanied recessions than booms since 1970, since the fact is that most inflations have been pushed by costs -- primarily oil costs -- not pulled by demand as in the 1960s. Another problem is that raising the cost of money, i.e., the interest rate, increases costs and hence puts upward pressure, not downward, in the short term. Another is the use of the CPI and so-called Core CPI to segregate prices. Some prices -- like those of assets -- housing and stocks -- escape inflation measures altogether.


A Tale of two impotences.

Paul Volcker in 1979 took Milton Friedman's theory of Monetarism and ran with it, constricting the money supply ruthlessly to wring inflation out of the economy. Interest rates climbed into double digits. Cocktail party chatter in the 1970s was not about houses, but about where to find the latest, best sixteen or twenty percent bonds. Savings and Loans -- the Thrifts -- were caught in the vise of low long and high short rates. Rather than deal with insolvencies, the response was to deregulate and hope the S&Ls could innovate a way out. The bailout of these institutions at the end of the 1980s showed the effectiveness of this strategy.

Earlier in the 1980s the Latin American debt crisis had brought the big banks as close to insolvency as they are today.

And while the determination of Volcker the general is praised by all to this day, it was the millions of unwilling draftees in unemployment lines around the country who actually won the war on inflation.

The second impotence is Ben Bernanke's. His response to the collapse of asset prices and incipient deflation has been historic monetary easing. Most observers suggest Bernanke was a bit slow out of the gate, but has been charging hard ever since. After twenty months, the big banks are zombies and a couple have gone under, even at the expense of unprecedented taxpayer bailouts. The economy is in negative growth territory.

This second impotence followed twenty years of speculation in stocks and then houses and by a general submersion of the society -- household, business and government -- into debt.

A collapse in asset prices destroyed trillions in paper wealth. We suggest the residential investment figures of the past six years be recalculated to reflect actual values. These trillions in paper wealth were the collateral for the debt balloon. The financial sector's fiasco has loaded onto this a credit crunch.

So the policy response from the Fed under Bernanke is precisely the opposite of that under Paul Volcker, but parenthetically the same as that under Alan Greenspan. Every effort is being made to expand the money supply in hopes this will bring down interest rates, create lending and borrowing, or just stimulate an inflation that will carry asset prices back upward. Simultaneously the Fed and Treasury are inventing new ways to float the banks off the rocks into which they steered themselves. Most of these involve swapping the bad decisions the banks made for taxpayer-backed bonds.

The housing asset has not stabilized, and continues to fall, although bailouts have specifically stabilized the housing-backed securities. Stocks appear to have stabilized, although money has to go somewhere, and the great infusion of liquidity will seek a rising asset.

The Fed's money creation continues apace.


Let's go over this territory one more time.

The inflation of the 1970s and 1980s began with the Guns and Butter demand pull inflation of the Johnson years, but erupted under Nixon and then Carter. Long after demand-pull was over, inflation continued because of the oil shocks of 1973 and 1979. The remedy for inflation did not change. Raise interest rates and the cost of money. The solution to inflation was income suppression under harsh monetary restrictions. The trend level of growth of the society as a whole came out of the 1970s at half the pace it went in. Real median income growth per capita stagnated. Income disparity began to rise. Borrowing and financial games replaced real economy production. It is also no accident and is a direct result of the high dollar that the U.S. was de-industrialized during the 1980s.

Let's leave for another day the arcane B.S. that has grown up over inflation, such as the Phillips curve, the Non-Accelerating Inflation Rate of Unemployment -- NAIRU -- sometimes referred to as the natural rate of unemployment, Core Inflation v. Headline Inflation and so on and so on.

Let's just take a direct look at the inflation experience on its own terms. What is inflation? It is a generalized rise in the price level. Energy costs or upward pressure on wages from tight labor markets can push a broad range of prices up. Nothing is so effective in being universal, of course, across goods and services as the price of money -- the interest rate.

Leaving aside its effectiveness in curbing demand or any other consideration, you have to admit that increasing interest rates increases the costs of doing business. If costs are translated into prices -- as we at Demand Side suggest they often are -- then the Fed's tool for fighting inflation only exacerbates it, at least in the short run.

Other than those for energy, labor and money, it is hard to think of other prices which cause generalized inflation. Health care? Perhaps. But the experience of inflations has often been the experience of a single price rising and dragging others up. Like energy.

And as we mentioned, some prices escape notice by the CPI entirely. The great price rises in assets of the stock and housing bubbles are not suppressed by the Fed, but encouraged. Stocks and Housing led to enormous financial suffering, but the rise in their prices was hailed as wealth, prior to the crashes.

If those assets were included in the CPI, you can bet the Fed would have jacked up interest rates long before anything go out of hand. And we suspect it would have been effective in forestalling economic problems. As it happened, however, easy money stayed in place right through the bubbles and fueled the expansions. Likewise, the Fed's cheap money policy was right at hand for the Commodities Bubble.

Perhaps we should suggest this to Bernanke and Greenspan as an early warning system for bubbles. Both have expressed their inability to sense them in real time.

Other prices, like those for health care, have risen strongly and consistently and are included in inflation measures. But they are not -- or have not been until recently -- taken on their own terms. Instead, so long as wages and other costs can be squashed enough to make room, they are accepted.

And what of the price of labor? Once upon a time wages rose at levels above inflation. Inflation was simply calculated as wage increases minus productivity increases. This led to, of course, prosperity and strong growth. As demand side economics direct it to.

Now wages lag inflation, and productivity increases are collected in profits or pay other costs. Growth suffers and prosperity is absent.

So at a minimum, when you see the word inflation or deflation, think of prices. Do not think of a phenomenon that is consistent. The post-war inflation was caused by pent-up demand and lagging capacity. The guns and butter inflation was caused by full employment. The stagflation was caused by energy shocks in the real economy, as was the short-lived inflation of Bush I. The inflation of 2007-08 was a broad-based commodity price rise generated in financial markets.

What is ahead. Alarmists are pointing to inflation expectations grown by the Fed's aggressive easing. That is, the number of dollars is being multiplied so the dollars per good will increase. We point to the destruction of money by deleveraging, to the absence of empirical evidence, and to the likelihood that the financial sector will take the liquidity as it has in the past and play games in the markets.

It is a good thing that the much-maligned politicians are giving the real economy a little love with stimulus spending.

That's the inflation narrative, or more than one.

Inflation targets are bad economics

When the Full Employment Act of 1946 passed into law it created the President's Council of Economic Advisers and the Joint Economic Committee, the two most influential economic policy offices in the federal government. The president was given broad authority to utilize fiscal and monetary policy to promote, in what is possibly the most famous phrase in economic legislation, "maximum employment production and purchasing power."

The Act ratified activist government, and the phrase set down the order of priority: (1) full employment, (2) maximum growth, and (3) stable prices. Five years after the passage of the Act, in the so-called Treasury Accords, the Fed (with complicity inside the Treasury) arrogated unilateral control of monetary policy for itself.

Sixty years later the order of priority has been reversed. Activist government is a memory. Markets are run without rules in a bad parody of a mob-run city. The Fed stands like a balding policemen on the sidewalk making sure nobody steals the apples, while the crooks in pin-striped suits run their toxic paper and mortgage scams on the shopkeeper inside. Always pleasant, the Fed holds the door for them on their exit.

Employment is viewed with suspicion, as a potential threat to prices. Production is assumed to be enabled by the hands-off enabling of cowboy corporations. Inflation is a bogeyman.

As we wrote yesterday, the claim that the falling dollar will not result in rising prices is absurd. Not only are the dollar prices of commodity imports like oil and metals raised by dollar weakening, but the prices of domestic goods that have export markets will be bid up. Sooner or later the Chinese currency will have to bend to rising energy prices and environmental degradation.

Typical among the patronizing Monetarists is the following exerpt from a blog (Economist's View, February 7, 2007):

To help with the discussion, let the rule for monetary policy be of the standard modified Taylor rule form: ff_t = a + bff_t-1 + c(y_t-y_t*) + d(π_t - π_t*) + u_twhere ff is the federal funds rate target, y is output, π is inflation, and u is the uncontrollable part of policy. A * indicates the target value of a variable and a, b, c, and d are choice parameters for the Fed. The parameters c and d determine how forcefully the Fed responds to deviations from its output and inflation targets.

(In more general models the deviations might be expected future deviations rather than the deviations today, there are issues about whether to use real-time or revised data, the rule can have additional terms, and there are other issues as well such as what target to adopt when market imperfections are present, but this will suffice.) Barney Frank says we must pay "equal attention to unemployment.” If he means that the Fed should respond as forcefully to deviations of output from target as it does deviations of inflation from target, that is at odds with current monetary theory which states that the best way to stabilize output and employment - Barney Franks' concern - is to respond more forcefully to inflation deviations than to output deviations. Thus, the value of d is around three times as large as c in standard formulations. If he means the Fed should take account of deviations of output from target (or employment deviations), they already do that. As to explicit inflation targeting, the issue is whether to announce the value of π_t*, the inflation target.

Barney Frank is worried this will elevate the importance of inflation deviations, but nothing I know of suggests that announcing π_t*changes the values of d or c. Targeting inflation is a means to an end - that of output and employment stability just as Barney Frank wants - and not an end in and of itself. Both theory and evidence tell us that the Fed can stabilize employment and output around their long-run trends, but it cannot change the long-run trends themselves with monetary policy.

Thus, the best the Fed can do is to stabilize the economy around these long-run trends and that, we believe, requires stable and low inflation and an aggressive response to deviations of inflation from target.

Here we have precision rather than accuracy. Two problems:

• Economics has no independent variables, so to try to force inflation to operate in dependence to other variables is simply bad math and bad economics.


• Economics is not a closed system. Leakage is the rule.

The importing of thermodynamic thinking into economics around the turn of the last century was a conceptual error then and has continued to this day as a primary fallacy of the latest Neoclassical economics.

To say that anything is "at odds with current monetary theory" is similar to saying, "We waved at the moon and it went from this side of the sky to the other, so why are you not listening to us?" You will remember the Reagan-Volcker recession of the early 1980s, when "current monetary theory" suggested a simple, painless way of reducing inflation was to reduce the quantity of money, because inflation was simply too much money chasing too few goods. Reducing the quantity of money would bring prices into the comfort zone without pain.

Result, lots of pain. Prices came down after Volcker blinked and oil prices backed off, but not until after millions of unemployed, unwitting inflation fighters, had their lives sometimes permanently damaged.

The idea that price stability in the context of these discussions is intimately associated with anything other than low volatility in prices is not borne out by any evidence, in spite of the neat phrase. The absence of volatility is no indication of stability. Witness the recent financial market collapse after years of non-volatility. In fact, in the case of prices, keeping the lid on will only create pressure that will hurt people and businesses. The falling dollar must be reflected in prices, and translated in an orderly way. Order is stability. Suppression is only building pressure.

We have had hundreds of billions of dollars in trade deficits for decades. Standard economic theory has no explanation for this. The currency is supposed to adjust to keep the trade in real goods and services relatively balanced. The currency is now adjusting. To make the adjustment orderly, we do not ignore it or pretend it is bad. Instead, we should create the conditions for a strong economy which can support its currency by something other than reputation.

All of this would not be so important except for the fact that the Fed has only one tool, or perceives that it has only one tool -- the interest rate. The interest rate is used to hammer down inflation, provide bail-out liquidity for financial sector mistakes, and open demand in the broad economy to counteract downturn.

• As a tool against inflation, it is bad when it is applied to cost-push inflation, because it does not reduce costs, but increases them.


• As bail-out to the financial sector it is bad because the financial sector is not in a liquidity crisis, it is in an information crisis. It is not that there is no liquidity to buy the toxic product, it is that nobody knows what they are worth. (Though it is likely the information is being kept in the closet because the purveyors don't want people to know how badly they've been duped.)


• As a way of opening demand to counteract a downturn, interest rates work after a lag. But of course, the direction is the opposite from that utilized in the inflation fight.
  

One possible silver lining to the financial sector fiasco is that it will prevent the Fed from doing what it wants to do when falling dollar inflation hits their spreadsheets. Of course, the best thing it could do would be to back away from the button and get to work putting some reins on the renegade market.

Is Bernanke's inflation target futile?

Ben Bernanke's end run around Congress and the Humphrey-Hawkins bill last week in setting de facto inflation targets cannot make Barney Frank very happy. Frank is head of the House Financial Committee and a dogged critic of inflation targeting.

Frank sees the determination of the Fed under Bernanke to target inflation as misplaced, and feels the Fed is worrying too much about inflation and not enough about inecome inequality. "We are at the situation where distribution of wealth has become a significant economic issue," he said in July.

In February Frank told the Financial Times that Bernanke "has a statutory mandate for stable prices and low unemployment. If you target one of them and not the other, it seems to me that will be inevitably be favored." Transparency may be a smokescreen. "When you make it more transparent, you enhance its importance.... But when you make it public, you lose flexibility."

The Fed is mandated by statute to pursue two objectives for monetary policy -- low inflation and maximum employment. These two goals have become known as the "dual mandate." Absent an official or implicit employment target, an implicit target for inflation -- such as that issued November 19 by Bernanke -- seems to contradict the Fed's responsibility.

In a July 17 hearing, Frank's House committee heard economists weigh in on the subject.

Harvard University's Bejamin Friedman told the committee:

"The idea that economic policy should pursue price stability as a means of promoting more fundamental economic well-being, either currently or in the future, is not ground for pursuing price stability at the expense, much less the exclusion, of ... more fundamental economic well-being.

"It would be a mistake for the Federal Reserve to organize its monetary policy within an inflation-targeting rubric."

According to a Market Watch report by Greg Robb, "Friedman disputed the Fed's suggestion that an inflation target would improve transparency. He added that many of the world's central banks that have inflation targets "avoid any reference to the possibility of tension, even in the short run, between their inflation objective and any real outcome."

In the same July hearing, according to MarketWatch:

Prof. James Galbraith of the University of Texas said that inflation was killed by globalization in the early 1980s and would only come back if there was a collapse in the value of the dollar.

He said Bernanke should assure Congress "that interest rates will not be raised solely on the evidence of low or falling unemployment."

In fact, Bernanke's de facto inflation target is not only usurping Congressional power, but is inevitably flawed. As we will blog tomorrow, any effort to keep the falling dollar from appearing in higher inflation can only suppress the economy. The prices of imported manufactures from countries with flexible exchange rates must rise with the falling dollar, but more importantly, so will commodity imports like oil and metals. The strengthening of exports is good news for manufacturing companies and their employees, but it is no respite from higher prices. The prices of those goods with export markets will be bid up, and will rise for domestic consumers.

Keeping the lid on prices can be done only by suppressing wage rates. We've written the past two days that this is the Fed's preferred method, but its effect in the upcoming climate will only be to exacerbate the downturn.

Inflation: Cost push, demand pull, Fed pratfall

Yesterday we looked at what is in the inflation basket, both in core inflation and headline inflation. We saw that the depression of wages over the past 30 years has been the chief inflation-fighting strategy by the Fed.

Today we follow that up with a look at the two dynamics of inflation, cost-push and demand-pull. We’ll give you our conclusion and forecast up front. The Fed will apply the interest rate brakes in error because it does not distinguish between the two dynamics, or if it does, it finds no problem in continuing to call on the middle class to shoulder the inflation-fighting burden for everyone.

First let’s listen to some of the conceptual context. Here’s Fed Chair Ben Bernanke responding to a question from Joint Economic Committee vice-chair Carolyn Maloney on November 8.

“... In all but the shortest of terms the Federal Reserve’s policy determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”

Chairman Bernanke is adamant that the Fed not only can control, but can determine inflation in all but the shortest of terms.

Bernanke is not encumbered by concern for the real world. A practicing economist who spoke to the point was Carl Weinberg, chief economist at High Frequency Economics (November 20, Bloomberg’s “On the Economy with Tom Keene).

“... The Fed is out to control the things it can control. When it comes to goods and services, things that are controlled by labor costs, the Fed is in there keeping an eye on it. It doesn’t mean headline inflation isn’t important, but it means that in terms of the Fed monitoring things in terms of what it can do, I think core inflation is probably the place to look.

“Something else to think about is when you see food prices go up, or you see energy prices go up, that’s not inflation. That’s a relative price change. And in fact, the analysis is very different when you see the price of food go up relative to the price of everything else, because it squeezes out consumption of other things and is actually a depressing impact on the economy as long as we don’t have wage increases to offset those food price increases. So generally speaking a rise in food prices brakes the economy by itself. A rise in energy prices brakes the economy as long as other prices are under control.”

To round it off, here is Marvin Goodfriend, former Fed staffer, now a professor at Carnegie Mellon University and a Bernanke disciple (November 15, Bloomberg):

“...Insofar as inflation forecasts go, as you lengthen the horizon the Fed ought to be able to manage inflation. That is, you can target inflation over the long run. That’s the nature of what Monetary Economics teaches us, that Central Banks determine the rate of inflation over the longer run. So the longer the horizons are, the more these forecasts turn into targets for the Federal Reserve to aim at.

“On the other hand, the longer the forecast horizons are, the more difficult it is to forecast the real GDP numbers and the unemployment, over which the Federal Reserve has less control over the longer run.”

So the clear message is that the Fed under Bernanke feels it has an iron lock on inflation in all but the shortest of terms, and the only part it can really affect is wage growth by sponsoring ongoing slack in the labor economy. (Parenthetically, this is a big reason for the support of free trade in many financial quartes – it ships out wage growth).

But back to cost push vs. demand pull.

There are two reasons prices might go up. One is the price of inputs goes up – commodities like oil, metal, grain, etc. The second is that the supply of the product is insufficient for the demand, and the price is bid up. This second is the market’s very effective means of rationing scarce products.

The last event of demand-pull inflation in the US economy was in the 1960s under Lyndon Johnson, with the Great Society competing with the Vietnam War for labor and capital. It was called “Guns and Butter” inflation. American consumers, flush with cash, pulled prices up. Johnson responded with an income tax surcharge of 10 percent to cool off demand. He was the last president to make a tax increase the central point of economic policy. Since that time taxes have been equated with the vilest of sins, the US has run immense budget deficits, and the economy has generally performed at one-third the Johnson era level.

Also since that time – even in the “New Economy” Dot.Com boom of the 1990s, we have not had demand pull inflation (noting that inflation is a generalized rise in prices).

But we have had cost-push inflation. Beginning under Nixon with the first OPEC oil crisis: Oil supplies were reduced by the OPEC oil cartel for the precise purpose of pushing up the price. The market began to ration the supplies by way of the price mechanism. “Stagflation” began, and plagued the 1970s.

Yes, I said “ration.” Here, too, the supplies are insufficient for the demand, but because the supply is constrained. One is too many dollars chasing goods. The other is too few goods being chased. It’s all the same, you say? Upon reflection, you will see there is the possibility of balance without inflation that lies between the two extremes. But more importantly the events on the ground look different.

In demand-pull inflation, there is a boom. Producers are motivated to generate product in the earlier, lower cost years, further stimulating demand. In cost-push inflation, there is not a boom, because the costs of the commodities are already, as Weinberg says, braking the economy.

In terms of economic policy, stagflation was an important turning point. It was here that the country, under Richard Nixon and Ronald Reagan, took a hard right away from the Keynesian Demand Side policies that had accompanied the great growth of America after the Second World War. The proposition that supposedly refuted the Keynesian conceptual framework was the supposed contention by Keynesians that unemployment and inflation could not co-exist. This connection between inflation and employment began with the so-called Phillips curve, an invention outside Keynesian theory. But that made little difference to ideologues looking for a return to Supply Side dominance.

The inflation-employment connection continues today at the Fed (hardly a Keynesian institution) in the form of NAIRU – the non-accelerating inflation rate of unemployment. NAIRU as a proposition was blown up by Nobelist Robert Eisner, but adhered to anyway by the Fed, who may have realized that tighter employment markets might not accelerate inflation, but slack markets certainly dampened it.

And since the 1960s, in spite of the confusion of pundits, all recessions have been accompanied by inflation.

The Why of this is not difficult to see. Weinberg put his finger on it. If the product of an economy is composed of labor and commodity inputs, and the price of commodities goes up, in order to keep the overall price level constant, the price of labor must go down.

Now as we approach an inflation fueled by higher oil prices, higher commodity prices of all kinds – including food, metals and energy, and higher input prices from a falling dollar, we basically have two options. We can allow inflation; that is allow these pressures to be reflected in the overall price level. Or we can attempt to reduce demand further, put a lid on prices, by raising the interest rate. No matter that demand, as Weinberg says, is already dampened.

The risk is that the Fed will choose the low volatility in the short run, by increasing the downward pressure on the middle class, rather than allow the short-term price volatility that will release the pressure. Complicating the problem is that the asset investor bubble that moved from the Dot.Com boom to Housing has now migrated into commodities. This source of inflation pressure ought to be addressed by an increase in margin requirements.

The Fed has already released its inflation targets, although it refers to them as “forecasts.” And as you heard, the Fed considers itself duty bound to address only inflation, never mind regulating the Wild West of mortgage originators or the Wild West of unregulated securities and investment trusts. Never mind the collapsing dollar or incipient recession. The Fed will raise rates when prices begin to rise. Why raise rates instead of, say, increasing reserve requirements or some other demand-dampening tactic? Because as we’ve seen the Fed knows only one tool – the easy button of interest rates.

Two additional points.

One: Attempts to keep oil prices out of even core inflation are hopeless. Oil leads all energy prices – including coal, electricity and natural gas – as a component or as a substitute. These energy prices must contribute to transportation, power and heating components of other goods and services. A simple example, air travel.

Two: Raising interest rates to fight cost push inflation is similar to the medical practice of bleeding the patient practiced in the pre-scientific era. Higher interest rates contribute to higher costs, not what you want to do with cost-push inflation.

In the end, I suppose, the patient either recovers in spite of the treatment or dies. In either case, the disease is resolved and the Fed can point with pride at its interest rate remedy.

Fed target on inflation is painted on the backs of the middle class

Ben Bernanke told the Senator Chuck Schumer and the Joint Economic Committee on November 8, quote.

“... In all but the shortest of terms the Federal Reserve’s policy determines how much inflation there is, and we’re going to make sure that the inflationary impact that may come from the weakening dollar is not passed into broader prices and become part of the underlying inflation rate.”

The hubris is chilling.

What is inflation? It is a generalized rise in prices. A basket of consumer goods is priced from one period to the next and the rise in the sum of its prices is the rise in inflation.

Sometimes food and fuel are taken out of the basket purportedly to remove volatility, because their prices bounce around. The slightly emptier basket is called core inflation.

Bernanke is not encumbered by concern for the real world. A practicing economist who spoke to the point was Carl Weinberg, chief economist at High Frequency Economics (November 20, Bloomberg’s “On the Economy with Tom Keene).

“... The Fed is out to control the things it can control. When it comes to goods and services, things that are controlled by labor costs, the Fed is in there keeping an eye on it. It doesn’t mean headline inflation isn’t important, but it means that in terms of the Fed monitoring things in terms of what it can do, I think core inflation is probably the place to look.

“Something else to think about is when you see food prices go up, or you see energy prices go up, that’s not inflation. That’s a relative price change. And in fact, the analysis is very different when you see the price of food go up relative to the price of everything else, because it squeezes out consumption of other things and is actually a depressing impact on the economy as long as we don’t have wage increases to offset those food price increases. So generally speaking a rise in food prices brakes the economy by itself. A rise in energy prices brakes the economy as long as other prices are under control.”

We'll take up food and energy below, but the key point here is a primary component of prices -- up, down, or sideways -- is the wage rate, or remuneration to workers. Not, of course, as a separate item in the basket, but as an element of all the items, all the goods and services. This is particularly true of the core inflation basket. And this is the secret the Fed has found to keeping inflation down, keeping enough slack in the labor market.

Real wage rates have stagnated since the 1970s. “Real” means adjusted for inflation. Productivity has gone up by 50 percent. Wage rates could have adjusted upward by 50 percent. Imagine the economic dynamo. This is particularly true since the turn of the century (see chart). Productivity gains have not been realized by workers, but have been transferred to the upper classes (the rentiers, as Keynes called them) and to the producers of commodities and services, notably health care.

If we look at “core” inflation as a proxy for the price of labor, we begin to get a different take on inflation. The evil of rising labor prices is not so easy to fathom. If labor prices rise, demand rises, and presuming there is capacity in business, all boats rise. Labor prices can rise at the rate of productivity improvement without increasing inflation. Instead, labor prices have risen only at the lethargic rate of core inflation, thus real incomes have stagnated, as mentioned.

Combine this with the fact that food and fuel consume a great deal of the American budget, so removing them removes much of what is important to lower and middle class Americans. This "headline" inflation affects different economic levels differently. Food, fuel and health care make up a larger portion of the costs at the lower end. The rate of inflation has been greater for the bottom ranks of the population than for the top. In fact, the inflation rate goes up as you go down the income scale. This means the balance is made up at the upper end with lower inflation.

So when the Fed chairman insists he has the answer to the inflation problem, that the Fed controls inflation, the middle class of America should watch out. The interest rate button, the Fed’s tool of choice, is connected to a trap door under their jobs.

A direct look at inflation

Even the Wall Street Journal says, "Get Used to It: Inflation Is Here to Stay." That part is right. The mumbo-jumbo that follows about "core inflation" could be flushed.

Let us take another direct look at the phenomenon of inflation.

Inflation is a general rise in prices. There are two kinds: demand-pull and cost-push.

Demand-pull inflation occurs when an overheated economy creates demand for goods that supply cannot handle. This occurs after wars, for example, when pent-up demand meets supply crimped by industries that have been destroyed or are not yet geared to consumer goods. The last time it occurred in the US was during the Johnson years, when the Vietnam War and the Great Society bid up the price of wages and products. But that was a mild case. After World War II, the whole world went shopping in America. Demand was over the top. That was a severe case.

Two attributes of demand-pull bear noting:

One, Wages can keep pace with rising prices, so it is those on fixed incomes who are hurt, not the working person. Eventually, and sooner rather than later (as in a year or two), production capacity will expand enough to moderate prices. This is particularly true now with global sources of supply. The "spiraling inflation" or "accelerating inflation" that preoccupies the Fed has never really happened with overheating. Currency collapse? Yes. Not from too much demand.

Two, There is a business boom associated with this type of inflation. That may seem to follow obviously from excess demand, but it is furthered by the fact that consistently upward prices mean that it is profitable to produce in the earlier, lower-cost times and sell into the later, higher-priced times. A corollary is that it may pay manipulators just to hold onto commodities and watch their price increase. This mandates a strong anti-monopoly regime, because a competitive market will defeat this strategy.

If demand-pull sounds familiar, it shouldn't. We haven't seen this in several decades.

Cost-push inflation is that associated with increases in producer costs which must be passed on as a matter of business solvency. This is what we see in energy price inflation, where the cost of production and transport goes up, so the price to the consumer goes up, the "surcharge" era. Health care costs are built into prices in a similar way. As are credit costs. Devaluation of currency adds more. This is the era of stagflation, such as we are entering again.

What!? Credit costs? Did I get that one by?

Yes. The cost of business operations is increased by the cost of capital.

But then doesn't the Fed increase interest rates to try to STOP inflation?

That they do. Does it work? No. In cost-push, it just increases costs. Of course, pretty soon there is a recession and people lose their jobs and demand IS so constricted that prices can't go up. But this is like amputation as a remedy for a hangnail.

Case History: In 1999 and 2000 Fed Chairman Alan "Maestro Magoo" Greenspan read "inflation" in his tea leaves. Unemployment was low, but it had been low for years without triggering an inflation. Ah ... but oil prices had begun to rise.

Greenspan hiked interest rates and learned quickly that it is easier to stop an economy with high interest rates than it is to restart one with low rates. In three years, Fed-controlled interest rates hit historical highs, then dropped to historical lows as the economy tanked. Those low interest rates are with us today, but precious little economic health.

We are seeing the same behavior in Ben Bernanke, Greenspan's replacement at the Fed. Energy cost-push inflation has begun to show itself, so he is raising interest rates. Long-term rates are beginning to follow.

What is the logic? If we are hoping to cut demand by raising rates, Why not just let energy prices do it themselves. Nothing bleeds effective demand better than siphoning it off into oil cartels and mega-corporations.

There is no logic. There IS a kind of funny sequence of reactions in the Market (capital M), however. When inflation begins to rise, stocks fall. Not because buyers are afraid business will begin producing more in anticipation of selling later into a higher-price, higher-wage environment.

No. It is entirely because they know from experience that the Fed will raise rates. And they know interest rate action will depress the economy. This is in spite of the fact that long-term rates have become separated from short-term rates. Too bad Fed action doesn't do anything to the inflation -- except add fuel to the fire.