What is Inflation: Five Types of Inflation Defined

Over on RealMoney, Barry Ritholtz argues that the U.S. government is probably underestimating inflation because it is focusing on the wrong type of inflation. I would agree with that, having identified no less than five different types of inflation: commodity inflation, wage inflation, monetary inflation, fiscal inflation, and foreign exchange inflation. Before discussing “inflation,” it helps to define, “What is inflation” and identify which form of inflation is being talked about. Failure to do so may have caused some of the confusion that often surrounds this topic.

The inflation that most American economists remember best (from the 1960s and later) is wage inflation, otherwise known as demand-pull inflation. Workers observe rising prices and demand compensation in the form of higher wages, which creates a vicious cycle of more inflation and more wage demands. This has not been happening until recently in the United States, due to the absence of labor unions, and to what Karl Marx called the “reserve army of the unemployed” in “offshore” markets. This appears to be the form of inflation that the Fed and other U.S. government authorities are focusing on, and it has indeed been benign up to now.

A less common, but more volatile form of inflation is commodity inflation, better known as cost-push inflation. We can see it today in commodity prices such as energy and metals. Energy and food price changes are excluded from “core” inflation because of their period-to-period volatility. But over time, oil price rises have averaged 6% a year, higher than other forms of inflation, and assuming that they don’t cause inflation is really assuming away the problem. Other commodities such as timber rise at 3% a year “real” (above the rate of calculated inflation).

That’s largely because such rises are (wrongly) excluded from the calculation. Another form of commodity inflation that is excluded from the official statistics has been the parabolic rise in housing prices. (The government instead uses a calculation of “owner equivalent rents,” which are basically tied to the benign wage numbers.) Commodity inflation is the most obvious form of inflation today (after having been quiescent in the 1990s), as reflected in higher food, gasoline and gas bills, but is severely understated.

Monetary inflation was most famously seen in Weimar Germany during the 1920s, when the German government went crazy with the printing presses to the point where it took billions of marks to equal one dollar. This wiped out the savings of the middle class, most members of which were compensated with (worthless) “million mark” notes, and eventually led to the rise of Hitler. Nothing of this sort has happened in the western world since, but it is a worry when the United States has a chairman of the Federal Reserve who has talked (hopefully facetiously) of dropping money out of helicopters.

Fiscal inflation is due to excess government spending, for which the budget deficit is a reasonably good proxy. It originated in the “guns and butter” spending of President Lyndon Baines Johnson in the 1960s, and similar spending of today’s President George W. Bush. We have war spending without a “war economy” e.g. rationing or wage and price controls, and if the 1960s are any guide, we will be paying the price later this decade and in the 2010s.

The last type of inflation, foreign exchange inflation, is particularly scary to me, someone who lived in Mexico before and during the peso crisis in 1994. This happens when the local currency (pesos in this case) falls dramatically against other world currencies, thereby sharply raising the price of imported goods, and hence the overall price level.

This is a real worry for the United States when the latest annual trade deficit is somewhere over $760 billion. I’m not looking for anything like the two-thirds fall of the Mexican peso in 1994-95 as a result, but even a 20% across the board drop of the U.S. dollar against the Euro, yen and yuan (the Chinese currency was unpegged from the dollar only in 2005) would be a severe shock stateside.


Tom Au
for Markets and Money

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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