What we keep getting wrong about inflation

6th October, 2022

What is inflation? The answer seems obvious: when things get more expensive, that’s inflation, and it’s bad. But an alternative view is Milton Friedman’s. In a talk 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 matters. Consider two scenarios that might illuminate it. In both of them, consumer prices have increased by 10 per cent over the past year.

In Inflation World, there’s too much money around. Everything is getting more expensive at much the same rate, including labour. With your wages rising at the same rate as prices, the situation is disorienting and slightly inconvenient, but it’s not a crisis. The main risk is that inflation becomes 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 per cent of spending used to go into energy; that’s now about 20 per cent. In Energy Crunch World, the consumer price index has still risen by 10 per cent, and the situation is described by all reputable reporters as “inflation of 10 per cent”, just as in Inflation World. But the increase in prices is not “steady”; it’s not widespread; and it is unlikely to be “sustained”.

The risk of a self-perpetuating energy shock is small. It is hard to imagine that we would be spending 30 per cent of income on energy next year, 40 per cent the year after and 50 per cent the year after that. But the damage is bad enough; rather than being mildly disorienting, this is a crisis. A basic necessity has become unaffordable for many.

In Inflation World, stuff only seems more expensive because the price tags keep changing. That’s inflation. In Energy Crunch World, stuff really is more expensive. I’d venture to suggest that’s not inflation — it’s much worse.

The same distinction applies when things get 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 greater quantities to more people.

Perhaps I am doomed to fail in my project to disentangle 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 increase in the real cost of energy and food, as in Energy Crunch World, but we have also seen loose money and broader increases in prices, as in Inflation World.

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

Look around and you’ll see plenty 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 tighten 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 to toughen competition policy. If a monopoly is broken up and its fat mark-ups reduced, the result should be that prices fall and incentives to improve quality and service increase. That should mean a one-off boost in real living standards, arguably far more important than any impact on inflation. If it affects inflation at all, it will be a temporary blip — and “reduces inflation” never was, and never should be, the test of competition policy.

Or consider the idea of a universal basic income. It’s often attacked on the grounds that it is inflationary, but there is nothing particularly inflationary about raising taxes and using the money to fund a basic income. The case against a basic income is nothing to do with inflation: it’s that those higher taxes plus the availability of unconditional cash might produce too much of a disincentive to work for too many people.

Friedman was oversimplifying when he declared that inflation was always and everywhere a monetary phenomenon. But the statement is not far wrong and has a bracing clarity. If you try to evaluate clean energy subsidies, support for cutting edge research, competition policy or tax reform through the lens of inflation-busting, you’re missing the point. These policies stand or fall on their real-world merits.

Meanwhile, the best long-run prediction of inflation is that five years out, the inflation rate will be whatever independent central banks want it to be. Even if elected governments could help, they have plenty of serious economic problems to keep them busy. Perhaps they should start there.

Written for and first published in the Financial Times on 16 September 2022.

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