The Great Inflation Debate: Back To Basics

The June number for the consumer price index in the United States showing a jump of 0.9% month-on-month (in seasonally-adjusted non-annualised terms) and 5.4% year-on-year has added even more fuel to the great inflation debate fire. Surely, the inflation genie is out of the bottle. Not so fast. Going back to inflation basics would suggest otherwise.

In much of the debate, inflation and relative price changes are being conflated. Inflation has to do with the purchasing power of money and movement in the overall price level, as measured by an index (weighted average) of the prices of a representative set of goods and services. Relative price changes, as the term suggests, are changes in the price of individual goods and services, or categories thereof, relative to one another. The two concepts, while linked, are very different.

In a decentralised market economy, the prices of individual goods and services, in absolute terms and therefore relative to one another, are in constant flux in response to changes in supply and demand. These price changes provide invaluable signals to firms about whether they should produce more or less of their output; they are the reason that products just happen to be on the shelf, or used cars in the lot, when consumers go shopping, without any central authority having to give instructions to that effect. We want unimpeded relative price changes so that resources can flow to where they are most needed and the market economy can function.

The inflation rate, on the other hand, has to do with preserving the purchasing power of money. We want that to be stable over time so that the amount of money it takes to purchase a representative basket of goods and services, the weighted average price of consumption, doesn’t increase too much or too fast. For a variety of technical and practical reasons, 2% is taken to be the right inflation rate in most developed economies, a little more in developing economies such as India (where it is 4% with a band of plus-or-minus 2 percentage points).

In principle, inflation and relative price changes are distinct matters. Inflation could be at target with all the necessary relative price changes taking place (the most desirable state of affairs). By the same token, it is possible for there to be no relative price changes but for inflation to deviate from target (imagine that all prices were rising by 10%, for instance).

In reality, relative price changes can and do impact the overall inflation rate. This is happening now. If something is a big enough component in the consumer (or other) price index basket and its (absolute and therefore relative) price moves enough, inflation will be pushed away from target. Case in point: there is a temporary shortage of new cars in the U.S., which is causing a surge in demand for used cars; the price of used cars and trucks in the U.S. in June rose by 10.5% month-on-month (non-annualised) or 45.2% year-on-year, which is one of the reasons headline inflation shot up.

Central bankers, sensibly, ‘look through’ such spikes in inflation because they can be expected to be self-correcting: the best cure for temporary high prices of individual goods and services is high prices. When supply and demand adjust and used car prices in the U.S. fall, as is sure to happen in the coming months, this will be a factor pushing inflation down.