Mainstream understanding of inflation may be all wrong

Editor
How much money a central bank creates may be less important to inflation than commodity prices

The Wall Street Journal recently published an article (March 6, 2017) by Jon Sindreu [1] which challenges the myths propagated by mainstream macroeconomists. Prof Bill Mitchell referred to this article and its implications in a recent blog” [2]. According to Mitchell: “Mainstream macroeconomics is largely fake knowledge. It has been categorically exposed by the deviations from usual behaviour in the lead up and following the GFC (Global Financial Crisis).

“There we have seen major policy shifts, new policy initiatives (building massive bank reserves), large fiscal deficits, and more – and, one by one, the main predictions of mainstream macroeconomics have come to nought.

“But we didn’t need the GFC to expose the fallacies of mainstream macro- economics. The Japanese economy has been doing a good, real world job of that for two and a half decades now “

In his article, Sindreu makes the following points:

“No number is more important for investors right now than inflation. The belief that it will continue to rise underpins the recent rally in financial stocks and the slump in government bonds. It is key to commodities, currencies and more. Yet investors are in a quandary: Theories used to forecast it just don’t seem to work.

“… For decades, the assumption has been that central banks have the ultimate handle on inflation. When inflation goes up, they raise interest rates to quell it; when it goes down, they lower the rates. Investors care a lot, because bond yields broadly track interest rates. They need to predict inflation levels as well as how central banks would react. ”

However, after many years of post-GFC experimentation, it is unclear whether the tools traditionally used by central banks can do much to influence inflation at all. A recent conference paper by Ceccetti et al [3] indicates that the main gauges used by policy- makers for understanding inflation (such as slack in the labour market) do not actually explain it.

It has been commonly believed within financial markets that inflation is ultimately a function of how much money a central bank creates. This was also Milton Friedman’s view. In the wake of the GFC, a number of major central banks slashed interest rates and created trillions of dollars, euros, pounds and yen. When this happened, many investors and policy makers assumed that inflation would quickly soar, accompanied by a sell-off of government bonds. However neither of these things happened.

The research reported by Ceccetti et al is consistent with the following:

1. The quantity of money created by central banks is a consequence of rising prices, not the cause.
2. There is little connection between people’s expectations of future inflation and what prices actually turn out to be.
3. Lower interest rates are not a key factor in the decisions of households and businesses to take on more debt and spend more.

What, then, causes an unacceptably high level of inflation? In order to fix our bearings, we will assume that the central government maintains levels of net spending that can be accommodated by the real economy without gener- ating inflationary pressures. According to Sindreu: “… historically, a better guide to inflation [than simple assumptions about demand-pull] has been prices of raw materials, largely commodities.

Swings in oil markets and market expectations of long-term inflation have moved in lockstep. Arend Kapteyn, chief economist of UBS’s investment bank, calculates that 84% of inflation variations since 2002 is explained by shifts in oil and food prices.

“Demand may play a small role indeed in fuelling inflation. Research finds that businesses rarely price their products based on how much they are able to sell. Rather, companies pass on to consumers as much of their costs as competition will allow. Throughout history, most sudden spikes in inflation were preceded by rising commodity prices pushing up costs.”

References:
1. Jon Sindreu, Everything the Market Thinks About Inflation Might Be Wrong, https://www.wsj.com/articles/everything-the-market-thinks-about-inflation-might-be-wrong-1488796206

2. Bill Mitchell blog, 15 Mar 2017, When fake knowledge peddled by macro- economics starts to fail the ‘investors’ http://bilbo.economicoutlook.net/blog/?p=35549

3. U.S. Monetary Policy Forum (Conference) March 2017, Deflating Inflation Expectations: the implications of inflation’s simple dynamics https://research.chicagobooth.edu/~/media/806FC2DED9644B5DA99518D2B07CC637.pdf