Some Serious Stuff on Inflation . . .

The Specter of Inflation is haunting economic discussions.  One side are policy analysts who insist that the aggressive monetary policy of the Federal Reserve System will lead to high inflation very soon.  They want to Fed to pull back and see no problem with cutting government spending in order to reduce upward pressure on the economy.  These folks are the descendents of the Monetarists who believed that overall economic activity was under the total control of the money supply.  For them, Milton Friedman still lives.

The other side of the argument is the traditional macro-economic argument that inflation cannot take place where Aggregate Demand is at a level so far below full employment that the unemployment rate is historically high.  They point to lack of increased wage growth, both on a nominal and real basis, and argue that there is just not demand to push up prices.  These are the current day Keynesians.  For them Econ 101, Macro Economics is the right idea.

Who is right?  It looks like the Monetarists are right for the wrong reasons, and the Keynesians are wrong for the right reasons.  What both side fail to recognize is that the U. S. economy has moved into a much greater subservient role with respect to the world economy.  It used to be that the U. S. economic engine was so powerful that it dominated world economics.  Inflation in the U. S. drove world wide inflation, and the U. S. was not greatly affected by economic conditions outside its borders.

This has changed.  Emerging economies like China, India and Brazil, along with growth in developing nations in Asia, Africa and South America are now starting to dominate the world economy, particularly with the failure of the U. S. and much of Europe to fully recover from the recession.  As a result, rising inflation rates in those countries are very likely to spill over into the U. S. economy. 

Even if wage pressure remains low, pressure on the U. S. price level can be expected to be high for these four reasons.

1. Commodity Prices:  Demand for raw materials in China and other high growth countries are pushing up raw materials and food prices.
2. Health Care Costs:  The failure of the Obama health care bill to contain any type of cost control provisions means health care costs in the U. S. will continue to rise.
3. The Weak Dollar:  The decline of the U. S. dollar will push up import prices, particularly of non-durable goods.
4. Education, Training and Productivity:  As state and federal support for schools and job training declines, the cost of educational services may rise faster than the average rate of price increases and productivity of the U. S. workforce may fall.

Since the rate of inflation is an average, if these sectors are rising above the target level of 2-4%, other items must be falling in order to keep inflation low.  The largest sector for falling prices is housing, but this may be over soon, and rising housing prices will mean they do not offset other rising costs.

In short, those who say inflation is not a threat because of lack of Aggregate Demand are right to that extent, but lack of Aggregate Demand is only one part of the equation.