You Decide: Is inflation ready to take a leap?

Dr. Mike Walden
North Carolina Cooperative Extension

Two of the key concerns in our economy are unemployment and inflation. We want both to be low. When unemployment is low, more people have jobs and earn income. When inflation is low, the dollars we earn don’t lose purchasing power as fast. That is, our dollars buy more with low inflation than with high inflation. The bottom line is low unemployment and low inflation make for higher living standards.

During the last four years, jobs have been created and the unemployment rate has fallen. Certainly we’d like the improvements to occur faster and be more widespread, but we do see improvement in the labor market. But while these gains are happening, a new worry is emerging: higher inflation!

When I began my training in economics in the 1960s, it was commonly accepted that unemployment and inflation moved in opposite directions. A country could have low unemployment and high inflation or high unemployment and low inflation, but not both low unemployment and low inflation.

The reasoning was that more jobs would lead to more spending, thereby giving businesses the ability to increase prices at a faster rate – which is the definition of higher inflation.

But in the 1970s the accepted unemployment/inflation tradeoff fell apart. The country experienced both high unemployment and high inflation together, something the conventional economic wisdom said couldn’t happen. In fact, a new term, “stagflation,” was coined to describe the situation, and a new measure, the “misery index,” a combination of the unemployment rate and inflation rate, was developed to calibrate the phenomenon.

Current economic thinking says there may be a temporary opposite relationship between unemployment and inflation – meaning if the unemployment rate falls, the inflation rate rises – but the relationship is not permanent. Instead, economists now believe any inflation rate can exist with any given unemployment rate. Societies don’t have to accept a high inflation rate in order to obtain a low unemployment rate.

So, if job growth and a lower jobless rate don’t cause higher inflation, then what does? One possibility was summarized by the late economist Milton Friedman when he said inflation results from “too much money chasing too few goods.” Those worrying about jumps in future inflation rates point to the double-digit annual growth rates in the monetary base engineered by the Federal Reserve in recent years.

While much of this monetary base effectively remains in the vaults of banks, inflation-pessimists say it could just be a matter of time before those reserves are deployed in the form of loans. Once this occurs, according to these economists, inflation could explode.

Yet not all economists are on board with this ominous forecast. A major reason is something called the “velocity of money.” In Friedman’s description of inflation resulting from “too much money chasing too few goods,” think of velocity as indicating how fast the money is running. For a given quantity of money, the lower velocity is, the lower inflation is.

Today money velocity is low – very low. Some measures put it at a 50-year low. Low interest rates typically cause low money velocity, since the foregone interest earnings from holding money is very low. And interest rates are also very low today. So inflation-optimists say as long as money velocity and interest rates remain low, there is little likelihood of inflation igniting.

Do the recent data on inflation support either the inflation-pessimists or inflation-optimists?

During the past year (June 2013-June 2014), the “all-item” retail level inflation rate was 2.1 percent. This is exactly at the average of the previous four years, but is a little higher than the 2012-2013 year.

Of course, the prices of individual products can rise at faster or slower rates than the “all-item” average. For example, last year meat prices were up more than 7 percent and dairy prices rose 4 percent, largely due to the drought in key farming regions. In contrast, new car prices remained flat and clothing prices edged up only 1 percent.

So should we worry about faster inflation coming? In the near-term the answer is probably “yes.” If the jobless rate continues to drop, experience shows the inflation rate may bump higher — at least for a temporary period.

In the longer-term, if banks begin to bump up their loans, thereby putting significantly more money in circulation, then we could also have a longer lasting inflation problem — unless there is a counterbalancing action. The Federal Reserve could take action to curtail the loans. Or, if the nation’s production also jumps into a higher gear to make more products and services for consumers to buy, then inflation could remain tame.

Economists, just like everyone else, are still trying to decide what will occur and where inflation is headed!

Dr. Mike Walden is a William Neal Reynolds Distinguished Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of North Carolina State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks.

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