Where Is the Inflation?


Back in 2009, when the federal government began running trillion-dollar-plus annual deficits and the Federal Reserve started printing trillions of dollars to buy Treasury debt and sub­­­prime mortgages, economists debated whether much higher inflation was inevitable. Mainstream economists (who hold sway in government, the corporate world, and academia) argued that as long as the labor market remained slack, inflation would not catch fire. My fellow Austrian economists and I loudly voiced the minority viewpoint that money printing is always inflationary-in fact, that it is the very definition of inflation.

Today, with price inflation still not rampant, it's hard to ignore the victory chants coming from the White House press room, the minutes of the Federal Reserve's Open Markets Committee, the talking heads on financial television, and the editorial pages of The New York Times. They claim that the Fed's extraordinary monetary policy and the government's fiscal stimulus have succeeded in keeping the economy afloat through the Great Recession without sparking inflation in the slightest. Deflation, they argue, is still the bigger threat. Their claims of victory are premature and inaccurate. Inflation is easy to see in our current economy, if you make a genuine attempt to measure it.

The Consumer Price Index (CPI) doesn't qualify as a genuine attempt to measure inflation. The CPI report for July 2014 came in at 2.0 percent year-over-year. But because of consistent alterations in how the data is calculated, the CPI has hidden price increases under a blanket of subjective "adjustments." While the details are intricate, the results can be glaring.

For instance, between 1986 and 2003, the CPI rose by 68 percent (about 4 percent per year). Over that 17-year period, the "Big Mac Index," a data set compiled by The Economist that tracks the cost of the signature McDonald's burger, rose at a nearly identical pace. Since then, this correlation appears to have broken. Between 2003 and 2013, the Big Mac Index rose more than twice as fast as the CPI (61 percent vs. 25 percent). The sandwich, which reflects the average person's direct experience, may be a more accurate yardstick of inflation.

Meanwhile, the Fed is pushing up prices not reflected in the CPI. Through its zero-interest-rate policy and direct asset purchases via quantitative easing, the Fed has lowered the cost of capital and raised prices for stocks, bonds, and real estate. In doing so, it has argued that rising asset prices create a "wealth effect" and are thus a key goal of its monetary policy.

Over the past five years, the prices of these financial assets have risen dramatically. However, unlike past periods of bull asset markets, these increases have not been accompanied by robust economic growth. To the contrary, the last five years have seen the slowest non-recession economic growth since the Great Depression.

This Fed-driven dynamic explains the rich-get-richer economy we've seen since the alleged recovery of 2009 began. The wealth effect has allowed the elites to push up prices for high-end consumer goods such as luxury real estate, fine art, wine, and collectible cars. But that is cold comfort to rank-and-file Americans struggling to find work in an otherwise stagnant economy.

Broader consumer price inflation has been kept at bay because many of the newly printed dollars don't even hit our economy. Instead, foreign countries purchase them in an attempt to keep their own currencies from appreciating against the dollar. In the current environment, a weak currency is widely (and wrongly) seen as essential to economic growth. That's because a weak currency lowers the relative price of a particular country's manufactured goods on overseas markets. Nations hope those lower prices will lead to greater exports and more domestic jobs.

Thus we see "currency wars," in which the victors are those who most successfully debase their currencies. That policy perpetuates greater global imbalances (between those nations that borrow and those nations that lend) and the accumulation of dollar-based assets in the accounts of foreign central banks.

The more debt the U.S. government issues, the more purchases these foreign banks must make to keep their currencies from becoming more valuable relative to ours. It is no coincidence that many of the countries heavily buying U.S. dollars, such as China, the Philippines, and Indonesia, are experiencing high levels of domestic inflation. Inflation may now be America's leading export.

In recent years, U.S. federal deficits have declined from more than $1.2 trillion to less than $600 billion. This is not because the government has made hard choices to raise revenue or cut spending but because rising asset prices have resulted in greater tax receipts from the wealthy. Yet this windfall can only last until the next meaningful correction in asset prices. If tax revenues fall, growing federal deficits would compel the Fed to print the difference. In that case, foreign banks would need to buy even more dollars to maintain their currency valuations. If they lose the will to keep pace, the dollar would lose relative value. A weaker dollar could be the spark that finally ignites significant CPI inflation in the United States.

As foreign currencies gain strength, consumers in those countries will gain buying power and more finished products will gravitate toward foreign shelves. Given that a significant portion of the products we now buy are imported, the diminished domestic supply could push up prices for common products like apparel, electronics, and appliances.

The Fed used to be considered effective when it kept inflation low. Today, inflation is the goal. This is especially true for the Federal Reserve as led by Janet Yellen, who looks set to be the most dovish-on-inflation chairperson in the bank's history. The inflation created by the U.S. government has been delayed, not avoided. Already the costs of everyday goods are rising faster than incomes. This is why economic pessimism is so prevalent on Main Street. Sadly, that gap is likely to get much worse.

Mainstream economists would have us believe that inflation and a weak labor market can't exist simultaneously. Have they ever been to Argentina? Do none of them remember the stagflation of the 1970s?

The truth is that high levels of unemployment are historically correlated with higher inflation and low levels of unemployment with lower inflation. That is because an economy that more fully utilizes labor resources is more productive. More production brings down prices. In contrast, an economy that does not fully employ its citizens is less productive, and its government is more prone to pursue misguided inflationary policies to stimulate the economy.

Although America's policies may not differ dramatically from what has been disastrously tried by Argentina, the dollar is for now protected by the international reserve status that it has enjoyed for almost 70 years. But that privilege has its limits. The dollar may be bigger and more globally integrated than any other paper currency, but in the end, its value may be just as ephemeral.