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The Fed is all wrong about inflation
We all feel the effects of rising prices, but the Fed doesn't see them. It looks at short cycles, but it's the long inflation waves that change history.
By Jim Jubak
For the last year, I've been convinced that inflation is back and getting worse. I can feel it in my everyday life. My favorite pizza guy raised his price for a slice by 20% last month. My kids' tuitions climbed 8% this year. Heating oil and electricity are more expensive. Breakfast cereal. Books. You name it, it costs more.
Yet for the last year, Alan Greenspan and the other members of the Federal Reserve's interest-setting body, the Federal Open Market Committee, have been telling me not just that there isn't any inflation, but that there really isn't any danger of inflation.
Well, I've finally figured out why they're wrong. It's not because government statisticians have cooked the books to keep inflation numbers low (although they have), or that the Fed governors are part of a conspiracy to cut the inflation-indexed payments going to retirees (although they may be), or that these folks are so out of touch with the real economy that they can't see what the rest of us feel in our everyday lives (although that's quite probably true).
No, the real problem is that the Fed is worried about the wrong kind of inflation.
You see, the kind of inflation that the Fed cares about -- and tries to fight -- is the short-term, cyclical kind. Prices jumped by 13% in 1979, for example, after a 9% increase in 1978, as members of the Organization of Petroleum Exporting Countries (OPEC) ratcheted up the price of oil. So the Fed, under then-chairman Paul Volcker, drove U.S. interest rates up to 14.7% on 3-month Treasury bills in 1981, throwing the country into a recession that did indeed put an end to double-digit inflation. By 1982, inflation was down to 3.87%.
The long view of inflation
But the kind of inflation that you and I feel right now isn't cyclical but what is called secular. My belief is that prices tend to move up in long, long waves that last anywhere from 80 to 180 years and contain many short-term cycles -- like the one that peaked in 1979. It's the duration of these waves of rising prices, rather than the magnitude of year-to-year increases in inflation, that's important. Past price waves have been characterized by annual increases of as little as 0.6%. But applied over long periods, even that rate is enough to set economic expectations, to produce a strong sense that something has gone wrong, to create intolerable stress in the economy and to lead finally to a political and economic crisis.
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If the history of prices is an accurate guide, we're now about 100 years into a wave that hasn't yet peaked.
David Hackett Fischer, Pulitzer Prize-winning history professor at Brandeis University, lays out the case for long periods of steadily increasing prices interrupted by briefer periods of price equilibrium in his 1996 book, "The Great Wave."
What's fascinating to me about Fischer's price waves, which are very different and much more convincing in my opinion than the long-cycle theories of folks like Pretcher or Kondratieff, is how much they explain about our current economy.
Price waves boiled down
Hard to spot: In the early stages of a price wave, no one recognizes that a period of price equilibrium has ended and that a long wave of rising prices has begun. Partly, that's because the long-term upward trend in prices is obscured by short-term movements in prices like those that the Fed manages. For example, Fischer finds a great price wave began about 1729, with rising wheat prices in Paris, and by the early 1740s had spread to most of Europe. At the time, people thought this was simply cyclical fluctuation in prices. But prices would rise by nearly 2% on average for the next 100 years. It wasn't until the 1760s that writers began to comment on rising prices and scarcity.
Food and fuel: All of the price waves back to the first that Fischer examines -- the Medieval wave of inflation that started in 1180 -- began with increases in the price of food and fuel. Prices of manufactured goods actually fall during the initial phases of each price wave. The explanation seems straightforward: Through history it has been relatively difficult to increase supplies of food and fuel to meet rising demand. Expanding food production often meant farming new, less productive land. Fuel for much of human history has meant wood, and it's hard to get trees to grow faster.
In contrast, productivity improvements in the machines that make goods are relatively easy. The Middle Ages, for instance, had their own "Industrial Revolution" when water power was applied to jobs like washing and preparing cloth that had previously been done by hand. Makes you think twice about our current insistence on taking energy and food costs out of our most-watched measures of inflation.
Price waves begin as demand inflation increases the prices for food, fuel, land, and shelter. In all price waves until the 20th century, population growth led to that increase in demand. In the 20th century, rising consumer incomes and expectations produce the same effect.
Production costs: Cost-push forces add to inflation, especially in food production, as higher prices encourage farmers to bring marginal, less productive land into use. That produces more food, true, but at a higher cost, which leads to higher prices as the costs are pushed along to consumers.
Money supply: An increase in the money supply kicks in to drive inflation higher after the initial demand-based inflation has set prices in motion. Governments typically attempt to combat rising prices by increasing the amount of money in circulation. That, of course, just adds speed to price increases. This is true even in the 20th and 21st centuries, where central banks may try to fight cyclical inflation by raising interest rates or slowing growth in the money supply, but where the economy as a whole keeps creating new money in the form of looser credit requirements or no-down payment mortgages.
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