Federal Reserve Chairman Jerome Powell may not be the hero we want, but he might be the hero we need. Confirmation for a second term in March thrust Jerome Powell into the early stages of a storyline of the mythical hero’s journey. The mission couldn’t be more perilous: Powell and the other 13 board members of the US Federal Reserve must slay the monster before it goes full Kraken on the US economy. Plot twist: there’s no reliable playbook1 for defeating this formidable beast that has already unleashed havoc on other developed economies around the world. Plot twist #2: if the heroes take down the monster too aggressively they will also harm the US economy with consequences for the overall world economy. This was “Tall” Paul Volcker’s fate: the last mighty gladiator to do battle with the infamous monster, and Fed Chair from 1979-1987. The cigar smoking chairman valiantly and methodically vanquished the monster, but at the cost of plunging the economy into a three year recession (1980-1982).
With intentions of having the best of both worlds, our band of heroes will try and accomplish something only achieved in dusty esoteric econ textbooks hidden in dusty library stacks: to obtain the soft landing AND beat the monster. Before our Fed friends can return home in the third act, they must overcome the most difficult of ordeals along their quest such as protracted economic uncertainty, intense media questioning and scrutiny, and lastly waining public confidence. Even after all that, they might not be fully able to defeat one of the most formidable boogie monsters in economics. Inflation.
What is inflation? Why is a basket involved?
Inflation is an increase in the overall price level of an economy. Deflation is when the opposite happens: the general level of prices start to trend downward. In the US changes in the price level are tracked by the Bureau of Labor Statistics (BLS). Through surveys, the BLS compiles a weighted basket of goods keeping track of approximately 80,000 items monthly2. Inflation is the consequence of increases in the overall price of that basket. Weights are assigned to give more importance (relative importance) to certain items in the basket. Not all products matter equally. The last step involves the selection of an arbitrary base year to create an index. Why? It lets us press the red easy button: indexation allows inflation to be expressed in percentages rather than dollar amounts.
COre inflation vs Headline inflation
As we have seen, not all categories in inflation receive the same weight in importance or media attention. Headline inflation is typically what is reported on in the news. In other words, headline inflation is the show-stopping A-list celebrity who holds our attention hostage and commands headlines. Another measure of inflation isolates the most volatile categories (items in food and energy sectors such as meat, fuel are prone to price swings) to get a closer gauge on overall inflation in the broader economy. This measure is called core inflation.
| Relative importance | ||
| Category | Relative Weight (%) | |
| Housing | 42.363 | |
| Transportation | 18.182 | |
| Food and beverages | 14.259 | |
| Medical Care | 8.487 | |
| Recreation | 5.108 | |
| Communication | 3.728 | |
| Other | 2.737 | |
| Education | 2.677 |
Is inflation inherently bad?
To understand why inflation can be bad requires an understanding of real and nominal variables. Nominal variables are those which we quote in current prices, like your hourly wage or salary at your job, the price for a gallon (or liter) of gas (or petrol), a movie ticket to the latest summer blockbuster, etc. Real variables are adjusted for inflation or are unaffected by inflation. As an example, regardless of inflation or prices you might have a pet (or two) in your household like adorable Pembroke Welsh Corgi “Cheddar” in the TV series Brooklyn 99. Another way to think about real variables are as volumes or amounts. So regardless of inflation your have the same number of fingers and toes, as well as the same height in centimeters, meters, or inches. Likewise, your home, apartment, or studio apartment has so many bedrooms and bathrooms that don’t fluctuate based on the current level of prices.
Inflation silently nibbles (or chomps) away at a real variable consumers care about intensely. Purchasing power. Purchasing power is a real variable represented by the amount of goods and services you can get with a dollar. As prices climb from inflation consumers have just as much money as they did before. For example 100 pounds sterling (£100) stays the same before and after inflation. Consumers nominal money holdings will remain unchanged by inflation. However each individual dollar (or pound) now gets fewer goods and services than before. This is the fall in purchasing power that affects all consumers. Because each individual unit of currency purchases fewer goods, more units of currency will have to be applied to each purchase.
Now here’s the part where we can exact some answers. Inflation that people expect is not bad. When consumers business (and markets) forecast an expected inflation level they will make necessary adjustments and adaptations, mainly through searching for alternatives. Unexpected inflation is the point where an entire economy will feel the pain because adequate adjustments to consumption might not be possible, sufficient, or timely. See below for Zimbabwe’s experience with hyperinflation.
Zimbabwe’s Hyperinflation of 2007
Essentially, hyperinflation is a rapid increase in an economy’s price level. Phillip Cagan’s 1956 definition4 was adopted as the gold standard: in excess of 50% per month for at least 30 days. Zimbabwe’s misery under hyperinflation: peaking in 2008-2009 it rippled throughout the Zimbabwean economy. Prices changed hourly. Some estimates recorded prices doubling every 25 hours 5. The force of this devastating economic tsunami spread across the country quickly. The severe and unexpected rate of inflation rendered cash holdings worthless. In the aftermath the Zimbabwean government was forced to adopt the US dollar as official currency. Lesson learned? Nope. Cue the Curb Your Enthusiasm intro theme. Zimbabwe had another hyperinflation episode in late 2017.
What is shrinkflation?
Shrinkflation occurs when a seller/vendor/producer tries to retain customers by keeping the price point relatively unchanged, or slightly higher, while offering less of the product or service. This is possible because some consumers are hyper-focused on the nominal price and not the real price of the product or service. Oftentimes, the seller has only trimmed a couple ounces from the bottle, cinched in what was once a more voluptuous bottle (I’m looking at you Mrs Butterworth), or alter the dimensions slightly in different proportions. Shrinkflation also goes by ‘desheeting’, a term taken from toilet and paper towel rolls.
What is Stagflation?
Stagflation sounds painful..and it is. Discovering stagflation is two scoops of bad news, delivering a slowdown in economic activity (recession) accompanied by a rising price level (inflation). Combine these two measurements and you have all the ingredients for economist Arthur Okun’s “Misery Index” created in the 1960’s. This index was created during this era because as a result of embargoes, monetary policy, and fiscal policy, the US experienced stagflation frequently.
References:
- Fleming, Sam. “Fed Has No Reliable Theory of Inflation, Says Tarullo.” Subscribe to Read | Financial Times, Financial Times, 4 Oct. 2017, https://www.ft.com/content/a5438cce-a933-11e7-ab55-27219df83c97.
- “Consumer Price Index Frequently Asked Questions.” U.S. Bureau of Labor Statistics, U.S. Bureau of Labor Statistics, https://www.bls.gov/cpi/questions-and-answers.htm#:~:text=BLS%20has%20classified%20all%20expenditure,and%20other%20goods%20and%20services).
- Cagan, Phillip. The Monetary Dynamics of Hyperinflation. 1956, https://www.bu.edu/econ/files/2011/01/Cagan1.pdf.
- Hanke, Steve, and Erik Bostrom. Studies in Applied Economics – Krieger Web Services. Oct. 2017, https://sites.krieger.jhu.edu/iae/files/2018/07/Zimbabwe-Hyperinflates-Again-Hanke-Bostrom-.pdf.
- Koech, Janet. Hyperinflation in Zimbabwe – Dallas Fed. https://www.dallasfed.org/~/media/documents/institute/annual/2011/annual11b.pdf.