An Inflation Conspiracy?

Those of us who have been hawkish on inflation have been lonely for several months now. However, recent data has suggested that the Federal Reserve may soon start raising rates again. Nevertheless, there are a group of individuals who believe that the inflation numbers are actually worse. Our friend Barry Ritholtz has been leading the charge claiming that BLS data is understating inflation and unemployment (some have referred to these claims as conspiracy theories). I think that Barry is correct to assert that inflation is worse than the numbers indicate, however, I do not think that the numbers are the problem.

The real problem is that our focus is always on the overall price level rather than relative prices. Commodity prices are on the rise, and will continue to be, so long as the world remains awash in liquidity and real interest rates remain low. The former stokes the demand fire and the latter provides a disincentive for discovery and investment. Looking at the overall price level, it seems as though inflation is quite modest all things considered (albeit above most economists comfort level). The reason that inflation seems so much worse than the numbers indicate is because the prices of things that most consumers consider necessities, like gasoline and food, are experiencing the most rapid increases. In an economy where homeowners were (are?) more leveraged than they have ever been, they are now seeing their wealth decline due to falling home prices while simultaneously experiencing an increase in the costs of food and gasoline.

The world has largely been awash in liquidity for the better part of this decade. Despite this increase in liquidity, price indices have largely been held down by the rapid productivity growth beginning at the end of the 1990s and continuing through the first half of this decade. These low levels of inflation, however, were providing incorrect signals to central banks and fears of deflation reinforced the easy money policies. The proverbial chickens, however, are now coming home to roost. Productivity has begun to slow and can no longer be counted on to hold down prices.

What can the Fed do?

The best solution that the Fed can provide is to begin raising the Federal funds rate. Aggressively raising rates should start to reign in liquidity and lower inflation expectations. Higher real interest rates should provide the incentive for an increase in oil production and reigning in liquidity should reduce demand thereby putting downward pressure on oil prices and likely other commodities as well. Critics may charge that the economy cannot cope with higher interest rates. However, so long as the Fed stands ready to act as lender of last resort (a role they have performed well thus far), the U.S. economy should be able to weather the storm.

There may not be an inflation conspiracy, but inflation is a much bigger problem than the numbers indicate. It is time for the Fed to reverse course and start raising interest rates.