Credit portal




How does inflation occur

how does inflation occur

James A. Kostohryz

How Inflation Could Happen In The U.S.

Feb. 23, 2013 9:30 AM

Views are sharply divided amongst economic analysts regarding whether inflation poses any serious threat to the US economy.

One group argues that Fed "money printing" through QE is certain to cause inflation.

Another group argues that it is not possible for the US to experience inflation in the context of a "balance sheet recession," with tepid growth, high unemployment and low capacity utilization.

None of these analysts are correct, because they are looking at the wrong things.

In this essay, I am going to explain how the US could. under the right set of circumstances, experience a significant acceleration in inflation.

The Money Printing Myth

I have written extensively on why the Fed's QE policy, will not, in and of itself, cause significant inflation in the US. Therefore, I will not repeat myself at length. However, I will summarize two key points here:

1. Fed policy is not causing a massive increase in the money supply. The monetary base, which is the only monetary aggregate directly controlled by the Fed, represents only a relatively small fraction of the total US money supply. For example, the most recently announced QE3 program is currently only increasing the monetary base at a pace that, all things being equal, would cause a 3% annual increase the broad M2 money supply. This is not enough to cause significant inflation. Furthermore, the M2 money supply is currently growing at a rate that historically been associated with moderate rates of inflation in recent US history.

2. The money supply does not determine inflation. Even if Fed policy were causing a massive increase in the money supply, this would not, by itself, be expected to cause high levels of inflation. A great many other factors must be present in order for serious inflation to result.

Growth in the monetary base (controlled by the Fed) and broader measures of the money supply (not controlled by the Fed) can influence inflationary dynamics. However, these variables do not by themselves control inflation.

The Balance Sheet Recession, Philips Curve And Capacity Utilization Myths

It is frequently asserted by some economic commentators that under current conditions, the US cannot experience inflation due to high debt levels, high unemployment and low capacity utilization. The reasoning goes like this:

  • Balance sheet recession. Since money creation is mainly a function of credit creation, significant money, it is argued that growth will not occur in a highly indebted economy where consumers and businesses are attempting to deleverage.
  • Wage recession. Labor inputs are the most important cost embedded in all goods services transacted in the economy. Therefore, it is argued, due to high unemployment, it is unlikely that unit labor costs are likely to rise.
  • Excess capacity. It is claimed that there is significant excess capacity and that companies are unlikely to raise prices under such circumstances.

There is some truth to these various claims. However, the view is far too parochial. What is true in the US is not necessarily true abroad. For example, the money supply is growing quickly in relatively underleveraged developing nations where the concept of "balance sheet recession" is not relevant. Similarly, there is not as much excess labor and industrial capacity in the developing world meaning that those variables will behave differently in many key nations.

The Sources Of The Real Threat: Global Infl ation and Psycho logy

The US is not an island. The problem is that the pundits who are pushing the inflation thesis as well as the deflationary thesis are generally overlooking where the real threat to inflation lies.

There are five main factors that could trigger a troublesome rise in inflation in the US before the end of 2013. All of them are global in origin.

1. Global monetary conditions. Monetary conditions around the world are extraordinarily easy. Many key nations around the world, particularly in emerging markets, do not have balance sheet constraints. Therefore, easy monetary conditions can lead to rapid credit growth that can quickly cause overheated consumption and investment.

2. Global commodities. Capacity utilization in certain selected industries in the US may be slack. However, supply conditions for most major commodities internationally are tight. Therefore, overheated consumption and investment in developing countries such as China that tend to drive commodities consumption can lead to sharp rises in commodities prices.

3. Global wages. Unemployment may be high in the US and Europe. However, this is not the case in nations such as China and Brazil where strong economic growth tends to fuel wage inflation. Indeed, wages in China have been growing very considerably in the past two years despite relatively sluggish growth. This wage inflation will show up in the price of goods and services in the US.

4. Global inflation. In key nations such as China and Brazil, inflation tends to be very sensitive to rising commodities prices, easy monetary conditions and overheating domestic economies. Thus, conditions are ripe for a pickup in global inflation, spearheaded by rising inflation in developing nations.

5. Inflationary expectations. In inflation models, the most important predictive variable is typically inflationary expectations. If people believe inflation will happen, it is more likely to actually occur. In this regard, worldwide news of rising commodity prices and

rising wages in key nations such as C hina coul d cause inflationary expectations in the US to rise. In this regard, it should be considered to be very troubling that despite very subdued economic activity, virtually all measures of inflationary expectations in the US reflected in various surveys and TIPS market indicators appear to be on the rise significantly. If inflation picks up globally and makes headlines, inflationary expectations in the US could rise significantly.

I would like to emphasize that none of the first four factors above, nor even in combination, will be sufficient to ignite significant inflation in the US. The US economy is remarkably autarkic. Imported inputs represent a mere 12% of total US GDP. Internationally priced inputs and/or domestic inputs influenced by international pricing are probably responsible for another 10%-15% of US input costs. This implies that international factors by themselves can only determine about 22%-27% of total pricing based on cost. Therefore, it would take very large accelerations of inflation abroad to significantly affect inflation in the US on a cost-push basis. For example it would take an acceleration of inflation of about 4% amongst the US key import partners to directly accelerate US inflation measure in the US in the neighborhood of 1.0%.

Only an important shift in inflationary expectations in the US could turn such relatively modest cost pressures deriving from international sources into a serious problem.

I would like to add a final a final inflationary threat that investors should monitor - but this time on the domestic front: Housing prices are heating up, and so are rents. Given that housing costs (measured by the BLS in a category called owner's equivalent rent) represent about 40% of core CPI, this development should be tracked closely by investors.

Would A Little Inflation Be A Bad Thing?

A little inflation would not be a bad thing if it were caused endogenously by rising demand and greater resource utilization, including declining unemployment.

However, rising inflation caused by internationally sourced cost-push pressures, in the context of high unemployment and stagnant wages, would represent a serious problem, as it would mean contracting real incomes and declining consumption.

Furthermore, rising inflation in a context of still-high unemployment would place the US Fed in an untenable predicament. On the one hand, the Fed could choose to affirm the integrity of its inflation-fighting credentials by tightening monetary policy and possibly triggering a recession. On the other hand, it could prioritize its full-employment mandate and choose to stand by as inflation accelerated. The later course would risk exacerbating inflationary expectations and concomitant inflationary momentum, as faith was lost in the Fed's commitment to price stability. The former course of action would risk hurling the US back into a recession, with dangerous potential consequences for the US's already worrisome fiscal position as well as the still fragile US credit system.

In sum, a little bit of the wrong kind of inflat ion coul d be a very bad thing for the US economy and for broad stock market indices represented by (NYSEARCA:SPY ), (NYSEARCA:DIA ) and (NASDAQ:QQQ ). It could also destabilize bond markets represented in such index products as (NYSEARCA:TLT ) and (NYSEARCA:JNK ). Furthermore while higher commodities prices might temporarily produce price gains in commodity producers such as Exon (NYSE:XOM ), Freeport-McMoran (NYSE:FCX ), gold miners (NYSEARCA:GDX ), the medium term impact would be unclear as the future of QE would be called into question and the Fed might even have to tighten monetary policy.


Significant inflation is not a certainty in the US, and I am not actually predicting such an outcome at the present time. By the same token, damaging inflation in the US is far from a remote possibility, and many US analysts have become far too complacent in that regard.

If US growth accelerates in the US and other global economies in the second and third quarter of 2013, I believe a global inflation scare could emerge by the fourth quarter of 2013. Furthermore, although I am mainly concerned about internationally sourced price pressures at this time, developments in US residential housing markets should be monitored closely due to their preponderance in core CPI.

Americans live in a global economy, and inflation abroad and/or inflation in internationally priced commodities will affect the US economy. And under the right set of circumstances, such cost-push inflationary forces could provide the spark that alters inflationary psychology in the US. Such a shift would tend to decrease liquidity preferences amongst producers and consumers thereby leading to increased transactional velocity, pricing power and ultimately, inflationary momentum.

Readers should note that the most recent reading in core CPI increased by a much-higher-than-expected 0.3% in the month of January. This should be of concern to US Fed officials given how remarkably weak US economic growth is at the present time. With core inflation currently running at 1.9% and accelerating, it would not take all that much for the core CPI to start pushing up against the Fed's announced 3.0% threshold, thereby triggering the dangerous dilemma described earlier.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Category: Bank

Similar articles: