Terms of the Times (2b): A self-inflicted blindness

They assert without evidence that continuing cost pressure cannot exist; they beckon the decline of prosperity.

 - Arthurian

Before the Volcker Fed, economists searched for the cost that was the source of cost-push inflation. That search was abandoned, unresolved, when Paul Volcker worked his magic. Marcus Nunes gives away the magician's secret:

On becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks ...

To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.

This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.

Or, as Robert Hetzel said,

The central bank is the cause of inflation. 

Or, as Mike Shedlock said, quoting a friend:

There actually is no such thing as 'cost push inflation'. Think about it - if the money supply were to remain stable (which isn't the case, but hypothetically), then a rise in price of some goods automatically would lead to a fall in prices of some other goods...

Economy-wide, a rise in general prices is only possible if the money supply increases.

Or, as Caroline Baum said:

This is one of those myths that never dies: cost-push inflation. Milton Friedman was adamant that both prices and costs rise in response to an increase in aggregate demand, which is a function of the Fed’s money creation.

Or, as Dallas S. Batten wrote in 1981, while Volcker was performing his magic:

The ultimate source of inflation is persistent excessive growth in aggregate demand resulting from persistent excessive growth in the supply of money.

Since Volcker's time, the search for underlying cost pressure has been cast aside, forgotten. Why bother to look for cost pressure? If the Fed can control inflation by controlling the money, who cares about underlying cost pressure? Who even cares?

 

I care, because cost pressure slows the economy.

Of course the monetary restriction we use to fight inflation slows the economy. This is Basil Fawlty's "bleeding obvious." But whether or not "the Fed can control inflation by controlling the money," it remains true that cost pressure not relieved by inflation finds relief by slowing the economy. It is obvious to me that if an increase in cost drives my profits down (and if profits were running low anyway because times are tough) then I'm going to have to raise my prices. The cost pressure forces my hand. 

And if policy prevents the increase in my prices, then maybe my business fails: The economy gets a little slower, because of cost not relieved by inflation. 

Note that "wage and price controls" could have the same effect as "tight money" in this regard, driving business out of business and slowing the economy.

Note also that if profits have been running low because times are tough, then cost pressure was probably reducing profits and slowing the economy already for some years before rising cost forced the closure of my (hypothetical) business.

Monetary restriction slows the economy. So does cost pressure that is not relieved by inflation. But here is something else, something I have trouble understanding: Cost pressure slows the economy even if inflation fully relieves the pressure. I can't make sense of it. But here it is, in the inflation diagrams:

This is a screen capture of slide 36 from a SlideShare presentation by videoaakash15.
You can click the image to visit the presentation.

Note the direction of the arrows below the horizontal axis. As the diagrams show,

Under demand-pull inflation, output and income tend to grow faster. Under cost-push inflation, they tend to grow slower.

The cost-push diagram does not show Aggregate Supply shifting to the left as an alternative to a price increase. It shows prices rising and Aggregate Supply shifting left. The diagram indicates that both of these changes happen.

Like me, not everyone gets this. But I am starting to find people who do.

Frederic S. Mishkin, in The Causes of Inflation:

... demand-pull inflation will be associated with periods when output is above the natural rate level, while cost-push inflation is associated with periods when output is below the natural rate level.

Demand-pull goes with rapid growth, Mishkin says, and cost-push goes with slow growth.

Siddha Raj Bhatta, the Deputy Director at the Central Bank of Nepal:

In a less than fully employed economy, demand side inflation raises price level but at the same time output as well as employment level also rises. On the other hand, in supply side inflation, price level rises but employment and output falls due to decrease in supply. Thus, supply side inflation has two costs: fall in purchasing power and rise in unemployment.

The Deputy Director says demand-side inflation helps grow jobs and the economy, while supply-side inflation is harmful to growth and employment.

According to Tejvan Pettinger at Economics Help, cost-push inflation causes

• "a shift to the left of short run aggregate supply."
• "rising prices and falling real GDP."
• "a fall in living standards."
• "a fall in real wages."

If I was the cleaner for the ECB, Pettinger says, I’d be tempted to barge into a meeting and say 

“It’s not the inflation you need to sort out, its the falling GDP!”

Taken out of context, of course, that last part. 

 

What happens if cost pressure is not relieved?

Let me say again that I do not understand how cost-push slows the economy if the cost pressure is fully relieved by inflation. On the other hand, it is easy to see that a policy of restraining inflation will leave the cost pressure less than fully relieved, and will result in some slowing of economic growth.

Restraint of inflation is standard practice, so my assumption is that cost pressure is always less than fully relieved, and therefore that cost-push inflation does always cause economic growth to slow.

Unfortunately, inflation is the lesser problem. Cost pressure is the greater problem.

It seems that no one who makes the "accommodation" argument -- no one who agrees with Hetzel, Shedlock, Baum, Batten, and Volcker, for example -- stops to wonder what happens when cost pressure is not relieved by inflation. By failing to accommodate the cost pressure, the monetary authority prevents inflation, and that's as far as the thinking goes. But this policy encourages the slowing of economic growth.

Imagine a case where mild, long-term cost pressure exists. It is mild, so neither the inflation nor the slowing of growth is troubling. But the Consumer Price Index rises from 102.1 in January 1984 to 262.231 after 37 years. Is that mild inflation, or are we just accustomed to it?

If any of that inflation was cost-push inflation, then economic growth was slowed by the cost pressure. If it continues for 37 years, the cumulative impact on growth must surely be troubling.

People say cost-push inflation is rare. That's wishful thinking.

People have many explanations for the slowing of economic growth. All of these probably have some merit. But no one seems to consider that a mild, long-term cost pressure could be the driving force behind the gradual, long-term decline of economic growth. It just doesn't fit with evolved thought.

The proper solution to cost-push inflation

The proper solution to cost-push inflation is not to raise interest rates and slow the economy further. The proper solution is to discover and eliminate the source of the cost pressure. 

According to fully-evolved inflation theory, there's no such thing as cost-push. There is demand-pull demand side inflation, and there are "supply shocks". According to this theory, no solution is required because there cannot be a cost-push problem. That's like saying There is no God. 

We cannot know. We can only assume. That's okay for religion, but not for economics.

My idea of the proper solution to cost-push inflation is, first, to admit that it might exist.

Keep your "simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit". And keep the view that without monetary accommodation, there can be no inflation. I do. I maintain that view.

But consider the possibility that, should cost pressure arise, it would slow economic growth. As the inflation diagram shows, it might slow economic growth even if the Fed creates enough inflation to fully accommodate the cost pressure. It would certainly slow economic growth in any other case.

What is the proper solution to cost pressure and cost-push inflation? The proper solution is to discover and eliminate the source of cost pressure.

 

The Temporary Nature of Supply Shocks

Peter Cooper lays this out in a recent post at heteconomist:

A supply shock can cause one-off price hikes, independently of demand conditions, but for the one-off effect to act as a catalyst for cost-push inflation there needs to be a socioeconomic process capable of reinforcing the initial effect ...

Inflation is defined as a sustained increase in the level of prices. You don't get a sustained increase from a supply shock, because supply shocks by definition are "one-off" events, as Cooper says. Or

• "one-time" events, as Robert Hetzel says. And Allan H. Meltzer. Or
  
• "temporary" as Tejvan Pettinger says. And Randal K. Quarles. And Milton Friedman, as paraphrased by Johannes A. Schwarzer.

Supply shocks don't create inflation, because supply shocks are temporary and inflation is sustained. That's the "evolved" view.

Five Key Points

You see where we end up:

1. We have defined "inflation" as a sustained increase in the price level.
   
2. We have replaced the term "cost-push" with "supply side" and we attribute supply side inflation to "supply shocks" and to nothing else.
3. We have defined "shocks" as temporary, one-time, one-off events that are incapable of creating sustained inflation and therefore, by definition, incapable of creating inflation.
4. We end up with demand-pull (or demand-side) inflation -- the "too much money chasing too few goods" inflation -- and supply-side (formerly cost-push) inflation, which is by definition temporary (and therefore not even inflation, by definition), and not something for the Federal Reserve to muck around with. And
   
5. We end up exactly as Scott Sumner said:

   "There's supply side inflation, which is created by shocks like sudden increases in oil prices, and then demand side inflation caused by overspending in the economy. It's really demand side inflation that the Fed is concerned about. There's not much they can do about supply side inflation."

Sumner's view is the dominant, fully evolved view, far as I can tell. Supply-side non-flation is caused only by economic "shocks". Therefore, there is no such thing as "cost pressure" and, in particular, no such thing as "sustained cost pressure."

I said earlier that I cannot lay out the chronology precisely. I am conscious of this as a weak point in this essay, and in my economics in general. So let me take a moment to strengthen the story a bit.

Frederic S. Mishkin's The Causes of Inflation is from September 1984. Mishkin wrote:

The conclusion reached in this paper is that in the last ten years there has been a convergence of views in the economics profession on the causes of inflation. As long as inflation is appropriately defined to be a sustained inflation, macroeconomic analysis, whether of the monetarist or Keynesian persuasion, leads to agreement with Milton Friedman's famous dictum, "Inflation is always and everywhere a monetary phenomenon."

To my ear Mishkin is saying that inflation was "appropriately" redefined some time between 1973 or '74 and 1983 or '84. Essentially, he is saying that inflation was redefined to work with other redefined or replaced terminology, in order to be able to reach a consensus that inflation is always demand-pull, always "a monetary phenomenon".

This validated the work of Paul Volcker (which, good grief, was still ongoing in 1984). The redefined terms validated the "simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit". At the same time, the changes invalidated the concept of cost-push inflation, cost pressure as an economic phenomenon, and three decades or more of work on cost-push inflation.

 

If you define "supply shocks" as temporary, and "cost-push" as a temporary phenomenon induced by supply shocks, you are closing the door on the possibility of long-term consequences arising from continuing cost pressure. You are asserting, without evidence, that there is no such thing as long-term cost pressure.

In the process, you deny the possibility that an initially small cost problem could be responsible for the onset of a long-term economic decline. Your denial does not prevent this decline. But it will surely prevent you from understanding it.