Why price inflation will take off
By Alasdair Macleod
Monday, 4 February 2013
There are key aspects of economics that neo-classical monetarists do not apparently comprehend; the most important, given their job-description, being the relationship between money and prices. They are like motorists who drive on the basis of the chaos and destruction viewed in the rear-view mirror. This is what happens when you use historic prices to guide monetary policy.
We are all aware, through application of logic if nothing else, that if you increase the quantity of money, prices will increase as that extra money is spent. What is less appreciated is that prices can change dramatically due to shifts in preference for money over goods. An illustration of this was the fall in prices during the financial crisis five years ago, when over-extended consumers responded to the global banking crisis. Government interventions in capital goods markets, such as for residential property and automobiles, were urgently implemented to stop prices collapsing. Shifts in money-preference can be very dramatic, as that episode showed.
Since that time, preferences for money have not changed much. Despite the massive expansion of money-quantities in the major economies, prices for goods have been generally stable, though government CPI statistics tend to be self-serving rather than reliable price inflation indicators. Instead of fuelling price increases, money has instead been applied to reducing indebtedness, or to speculation in the capital markets.
What is important to understand is five years ago there was a large one-off shift in favour of money, which suggests that the next large shift will be away from money; not because suddenly we are all going to like spending again, but because we will like money even less. This is not to say that some of us won’t become more cautious, rather the reverse. If the economic outlook deteriorates it will be because we are cutting back spending on inessential goods. It is just that the price effect of this reduced spending is unlikely to be anything like as dramatic as what we saw at the time of the banking crisis.