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Monday, January 31, 2011

Quick Post- Krugman and Inflation

I've written about this before, but I thought Krugman's column today laid it out in fairly simple terms:

"What about commodity prices? The Fed normally focuses on “core” inflation, which excludes food and energy, rather than “headline” inflation, because experience shows that while some prices fluctuate widely from month to month, others have a lot of inertia — and it’s the ones with inertia you want to worry about, because once either inflation or deflation gets built into these prices, it’s hard to get rid of."

People often confuse these two types of inflation.  Sarah Palin does so frequently, my own grandma does so.  Headline inflation, his term I think, are generally commodities with wild volatility.  Think about it.  If the wheat crop dies, the price of wheat, corn, barley, etc. all rise.  It has nothing to do with inflation, it has to do with the increase in demand due to whatever calamity occurred.  Likewise with oil, when OPEC moves to control prices.  That changes prices for a whole slew of other commodities.  These are the prices that people note when they go to the grocery store and say, prices are rising, must be inflation.  It isn't.  It's usually an increase in demand due to a temporal fluctuation.   So for obvious reason, the Fed has to base its inflation calculation on the prices of items that don't fluctuate all that much.

Interstingly, the WSJ makes the same mistake.  Now, the wise heads at the WSJ are far more experienced than I, but note the quotes below from this article.  Look at the price chart, from November of 2010.  The price of cotton has effectively doubled.  Why?  Demand from China, says Bloomberg.  That's an increase in demand, buddy, not:

"There is a long-running debate among economists about what really causes inflation: higher costs (so-called "cost push") or just too much money. But right now you don't really have to choose: We have both."

There is no debate.  On a normal demand curve, on the "ideal" curve, prices are always rising, and production is rising commensurately.  But purchasing power has to decrease for the definition to be met.  Cotton crop farmers will have a bumper year if this trend is to be believed.  This is an excellent sign, not a harbinger of doom. A key component of the definition of inflation, is increased prices over time.  The amount of time is key.  The fed tracks inflation by the month, but doesn't bother to use volatile commodities for that metric.  A crop of anything takes months to grow, and the proper season.  That's at least a three or four month cycle.

Coffee.  There's a shortage.  Drives prices up.  Hence the rise in the graphic.  That simple.

Disclaimer: I couldn't find anything great on sugar and pecans, other than worldwide demand is up.  Some rumblings exist about increased costs, which would aid the inflation argument, but their again, I couldn't find any direct good cite.

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