I’m going to write about this topic in two posts. Today will cover background; tomorrow will ask/answer where we stand now. In a way, these posts are a follow-on to writing about the employment situation in the US.
inflation…
What is it?
Inflation is a general rise in the level of prices–in other words, in the cost of stuff–that continues over a period of time.
…in a service economy
In a service economy like the US, the largest element in the cost of most things–from financial advice to medical care to computer hardware/software to restaurant meals, and on and on–is the wages paid to the people providing the public with services. Goods, too. Because of this, inflation in the US is all about continual rises in wages.
Increases in industrial raw material prices can end up creating inflation here, but only under a number of conditions:
–the price increases for materials can’t be just one-off. They have to keep on coming.
–manufacturers/ distributors have to pass these cost increases on to consumers by raising their prices, not just absorb them themselves, and
–consumers have to pass the extra costs on to their employers by demanding–and receiving–steady wage hikes.
don’t get inflation started!
Like a lot of things in economics, inflation is partly a state of mind. A Fed study done when I was just starting out in the stock market demonstrated that at that time consumers’ expectations about future inflation corresponded almost exactly to what actual inflation had been over the prior five years. It’s not all that surprising that people should extrapolate from recent past experience (what else would you do?), but a problem nonetheless. If everyone gets it into his head that prices are rising at, say, a 5% annual rate and demands a wage increase that keeps him whole. So inflation can get institutionalised, as it did in the late 1970s, and become very hard to eradicate.
Multi-year labor contracts may stipulate that wages are automatically increased for inflation–and the define inflation through an index like the Consumer Price Index, which systematically overstates the effect of price rises on the cost of living. Not a huge issue for today’s US, though.
In addition, inflation tends to feed on itself and starts to accelerate. In the late 1970s, when an extra-loose money policy sparked inflation, which went from 3% in 1972 to well over 10%–with widespread conviction that inflation would continue to rise–before Paul Volcker stepped in in the early 1980s.
money spigots now wide open again around the world
It’s certainly true in the US and in Japan, and increasingly so in the EU.
The idea is to make the cost of money very low so entrepreneurs will invest and, at the same time, to make the returns low enough on “safe” investments that savers will feel compelled to provide capital. Why do this? …to counter the huge economic contraction set off by the near-collapse of the world banking system five years ago.
The risk to this strategy is that, at some point, more productive capacity will be added than there are workers to man it. If so, labor-short companies will start to poach workers from other firms by offering very large salary increases. Voilà! Inflation–always about wages in the developed world–is kindled.
More tomorrow.