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The Concept of Inflation as a Measure of Standard of Living


Inflation in the standard-of-living sense is a real problem. Statements from Geithner, Bernanke proclaiming inflation is "temporary" are not exactly false, but they're misleading.

There is a debate in financial circles as to whether or not we even have inflation, and, if we do, should we even worry about it. As expected, the chief monetary and fiscal officers of the federal government deny that inflation is a problem or that their policies have anything to do with it. This was reaffirmed by Chairman Bernanke in his talk to The International Monetary Conference on June 7. St. Louis Federal Reserve Bank economists, Chen and Wen, in a recent paper (Mingyu Chen and Yi Wen, Oil Price Shocks and Inflation Risk, Federal Reserve Bank of St. Louis, June, 2011) using data from prior oil shocks, conclude that while such oil price shocks had significant "inflationary" impacts in the 1970s and in the early 1980s, today, rapidly rising oil prices appear "to have only transitory effects on headline inflation and virtually no impact on measures of underlying inflation."

Statistical Proof

Much of the debate centers around semantics and the "meaning" of the word "inflation." If you adopt one meaning, as Chen and Wen do, then inflation is not an issue. If you happen to believe that inflation in the US is actually measured by the "core" CPI numbers reported by the Bureau of Labor Statistics (BLS), then you, like our government leaders, shouldn't be concerned. However, despite the fact that Chen and Wen conclude that inflation is not a problem (at least relative to the price of oil), in a footnote there is an admission that their conclusions are based upon their definition of inflation. "Although the effect on inflation [of oil price shocks] is transitory, the effect on the price level is not, because inflation is defined as the rate of change in the price level, not the price level itself" [emphasis added]. An appropriate interpretation of this is that we can have high inflation in the sense of high permanent prices, but we shouldn't worry about it because it will disappear as soon as the underlying cause disappears.

The Standard of Living Concept

On the other hand, if your definition of inflation is a concept that measures, not prices alone, but "standard of living," then the rest of this blog may be relevant to you. Under the "standard of living" definition, the general price level can actually be falling but "inflation" can be an issue if incomes are falling faster than prices, and, thus, the standard of living is declining.

In his 1937 book, Seven Kinds of Inflation – and What to do About Them, Richard Skinner identifies four kinds of "absolute" inflations and three kinds of "relative" ones. Absolute inflations include:

1. Rising prices of fixed income securities
2. Rising prices of land, equity securities and business values
3. Rising short-term interest rates
4. Rising general prices and living costs.

Today's definition of inflation as measured only by the CPI only captures item 4, but we all recognize items 1 and 2 and refer to these as "asset bubbles." Relative inflations include:

5. Growth in debt compared to wealth
6. Growth in interest charges compared to income
7. Growth in living costs compared with income.

Everybody now recognizes that item 5 describes the last two decades, and it appears that, with rising costs of vital food and energy commodities, item 7 would appear to apply today. As debt costs rise, like those in Greece, we know that item 6 is also real. So, of the seven kinds of inflation described by this 1937 work, we easily recognize six of them. Of those six, two are commonly referred to as "asset bubbles" (items 1 and 2), and three are recognized as economic problems, but not categorized as inflation (items 5, 6 and 7). Only one, rising general prices and living costs (item 4) is, today, actually called "inflation."

Who Is Right?

As could be expected and briefly described above, the government (Geithner, Bernanke) is in the camp that denies that inflation is a real issue. They will defend this position as long as they have an argument that is even mildly credible. And there are a whole set of well-respected economists who believe that inflation isn't an issue to worry about. David Rosenberg (Gluskin Sheff), for example, believes that deflation is a bigger threat because of stagnant real incomes, high debt levels, and significant balance sheet issues for America's consumers due to the real estate depression. On the other hand, there are those pro-inflationists who point to $4/gallon gasoline and rapidly rising food prices, which they blame on QE1 and QE2, as proof positive that inflation is rampant. So, who is right?

Actually, both are. Rosenberg's "deflation" is a "standard of living" concept. One might categorize it as close to Skinner's "relative" inflation concept (item 7 above – incomes not keeping up with prices), while the pro-inflationists are referring to one of Skinner's "absolute" inflation concepts (item 4 above – rising general prices and living costs).
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