What we keep getting wrong about inflation

What is inflation? The answer seems obvious: when things get more expensive, that’s inflation, and it’s bad. But an alternative view is that of Milton Friedman. In a speech in 1963, the hugely influential economist defined inflation as “a steady and sustained rise in prices” and added that “inflation is always and everywhere a monetary phenomenon.”

The distinction is important. Consider two scenarios that might illuminate this. In both, consumer prices rose 10 percent over the past year.

In the world of inflation, there is too much money. Everything is getting more expensive at the same rate, including labor. With your wages rising at the same rate as prices, the situation is disorienting and slightly uncomfortable, but not a crisis. The main danger is that inflation is self-perpetuating and the main responsibility for solving the problem lies with the central bank.

In Energy Crunch World, the cost of energy has doubled. About 10 percent of the expenditure was used for energy. that is now about 20 percent. In Energy Crunch World, the consumer price index is still up 10 percent, and the situation is described by all reputable journalists as “10 percent inflation,” just like in Inflation World.

But the price increase is not “fixed”. It is not widespread; and is unlikely to be “maintained”. The risk of a self-perpetuating energy shock is small. It is hard to imagine that we would spend 30 percent of income on energy next year, 40 percent the year after that, and 50 percent the year after that. But the damage is pretty bad. Rather than being slightly disorienting, this is a crisis. A basic need has become unbearable for many.

In Inflation World, things seem more expensive because prices are constantly changing. This is inflation. In Energy Crunch World, things really are more expensive. I would venture to suggest that it is not inflation – it is much worse.

The same distinction applies when things become cheaper thanks to technological progress. Music is much cheaper than it used to be, as are laptops and solar panels. And by “cheaper” I don’t mean in the almost meaningless sense that there are fewer digits on the price tag. I mean cheaper in the only way that really matters, which is that they require fewer resources to produce and are therefore affordable in larger quantities to more people.

Maybe I’m doomed to fail in my project to distinguish real price changes from inflation. The real world, of course, contains elements of both, so confusion is inevitable. We are dealing with a temporary but very painful rise in the real cost of energy and food, as in Energy Crunch World, but we have also seen loose money and broader price increases, as in Inflation World.

However, the two sources of higher prices require very different policy responses. In Inflation World, inflation is a monetary phenomenon and needs a monetary response, such as higher interest rates. In the Energy Crunch World, rising prices need a real response in the form of support for struggling households and every effort to reduce demand and find new sources of supply.

Look around and you will see a lot of confusion on this point. In the US, the recently signed Inflation Reduction Act is no such thing. It promises to squeeze the price of expensive pharmaceuticals, give tax credits for low-carbon energy sources and strengthen some tax loopholes. These are promising policies, but if they work they will work by improving the structure of the real economy, not by tightening monetary conditions.

The same logic applies to US proposals for tougher competition policy. If a monopoly is broken up and its markups are reduced, the result should be a fall in prices and an increase in incentives to improve quality and service. This should mean a one-off boost to real living standards, arguably far more significant than any impact on inflation. If it affects inflation at all, it will be a temporary blip — and “reduces inflation” was not and should never be the test of competition policy.

Or consider the idea of ​​a universal basic income. It is often attacked as inflationary, but there is nothing particularly inflationary about raising taxes and using the money to fund a basic income. The case against basic income isn’t about inflation: it’s that these higher taxes plus the availability of unconditional cash might create too great a disincentive to work for too many people.

Friedman was oversimplifying when he stated that inflation was always and everywhere a monetary phenomenon. But the statement is not very wrong and has a strong clarity. If you’re trying to evaluate clean energy subsidies, support for cutting-edge research, competition policy or tax reform through the lens of collapsing inflation, you’re missing the point. These policies are based or fall on their actual value.

Meanwhile, the best long-term forecast for inflation is that five years from now, the rate of inflation will be whatever independent central banks want. Even if elected governments could help, they have too many serious financial problems to keep them busy. Maybe they should start there.

Tim Harford’s new book is “How to get people to add

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