On Sun, Mar 21, 2004 at 07:41:08PM -0800, Doug Pensinger wrote: > A few questions. In the late '70s oil prices spiked and the result > was double digit inflation (one of the things that killed Carter's > re-elction bid). This year oil prices are growing and predicted to > go higher by some. The news about reserves probably won't help. Is > it possible that we will see that kind of runaway inflation again?
Inflation is complicated. I doubt anyone unfamiliar with it would have been able to predict its behavior from first principles. For example, I've never been able to understand from first principles why a small positive inflation rate might be optimal for economic growth. Not that I don't have an idea (I would say that you would ideally like to sit at 0% inflation but deflation makes monetary policy harder so to reduce the risk of deflation you tolerate a little bit of inflation), but I can't see anyone coming up with that reasoning from first principles -- rather, it is concluded from observations of the working economy. Also, inflation has many, many forms. There are raw materials prices, energy prices, wages, food prices, health care prices, short-term interest rates, long-term interest rates, etc. The Fed has some control over short term interest rates, but long-term interest rates are largely market driven. Energy and health care prices may go up but not food prices or wages. There is the consumer price index and the producer price index. There is also the CPI minus energy and food. I think it is an oversimplification to just talk about "inflation" when you could have several of these components moving in different directions. In contrast, employment, capital, investment, and GDP are all rather simple and easy to imagine without having studied them. If you want to produce something, you need workers and capital, and the more workers and capital you have, the more you can produce. On inflation, I tend to think that there is a slower moving component, which is primarily determined by whether GDP is growing above or below potential GDP. You might also say that it is determined by capacity utilization. And then there are so-called "shocks" to the system, such as spikes in the price of oil when the cartel decides to hold-back supply, or spikes in the price of food one year when there are natural disasters affecting crop harvests. I tend to think of the latter as "noise" on top of the more steady and predictable "signal" of the former. While I doubt whether anyone can predict the latter, it also may not be all that useful to predict the shocks, since they will tend to come and go quickly. It is easier to predict the inertial level of inflation by looking at capacity utilization and comparing potential GDP to actual GDP. Right now capacity utilization is historically very low. Inertial inflation does not seem to be a significant risk. But there is one unusual component -- the huge current account deficit. First private foreign investors and recently the Chinese and Japanese governments have been heavily investing in the US, allowing the huge deficit to continue. That foreign investment is what allows the government to keep up the deficit spending while the private sector consumes like mad and saves very little. If that foreign investment were to stop, then either the dollar would fall a lot further, or interest rates would have to rise, or both. Traditionally, a falling dollar should be inflationary since imports become more expensive, but so far this has been muted since the foreign companies have absorbed a lot of the weak dollar by reducing their margins on their exports to America. But they can't keep doing that forever, so a falling dollar would eventually push up inflation. Alternatively, higher interest rates could reduce the dollar's fall, and they would also choke off investment, reducing aggregate demand and thus holding back inflation. But lower investment and lower demand would be devestating to GDP growth, probably causing a deep recession. I guess the Fed would rather let the dollar continue to fall than risk that. But you never know. > How would that [runaway inflation] effect your predictions? Heck if I know. My model is far too simple to include inflation, especially inflation shocks. I would point out, however, that energy inflation does not necessarily imply wage inflation. Since there are a lot of people looking for work, there is not much pressure on employers for rising wages. With productivity high, capacity utilization low, and no wage pressure, it doesn't seem likely that high energy prices would result in any economy-wide broad-based inflation. The Philips curve specifies a relation between unemployment and inflation, but it has been largely discredited and I think the correlation is very weak. I guess if there were an economy-wide inflation, then demand for workers would go up temporarily. But I just don't see such a broad-based inflation coming with capacity utilization so low. And even if it did happen, it would probably just be another cycle before a bust. The real trick is to increase the sustainable growth rate of employment, thus increasing the sustainable growth rate of GDP. I wish I knew how to do that! > Also, interest rates have been low for a long time. What's holding > them low and what would be the effect of a substantial increase? The Fed is holding short term rates low to stimulate the economy! You must have read that in the newspaper sometime in the past couple years? Also, Chinese and Japanese purchases of US bonds have been helping to keep longer term rates low. Usually higher interest rates result in less investment and less aggregate demand, thus a slowdown in GDP growth and low inflation. > And again, how would an increase influence your model? Now that I can answer. Higher interest rates would almost surely result in a recession in the current environment. That would mean lower employment. -- Erik Reuter http://www.erikreuter.net/ _______________________________________________ http://www.mccmedia.com/mailman/listinfo/brin-l
