Wednesday, March 16, 2011

Three eras of Inflation

- by New Deal democrat

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This week we will get February's producer and consumer inflation readings. While a lot of attention will be paid to food and energy prices, the overall allocation of commodity price increases between producers and consumers has received little attention. While the variation in any one month appears trivial, the long-term trajectories of producer vs. consumer prices tell an important story about how much of the burden has been borne by consumers vs. how much has been retained by producers. Since World War 2, there have in fact been three eras of inflation.

In the post WW2 "Great Compression" of incomes, where the middle and working class fully shared in America's prosperity, producer and consumer prices moved generally in lockstep. With the exception of the Vietnam war inflation of the late 1960's, producer inflation (red) - and only that inflation - was passed on to consumers (blue):

The came the Reagan era of the "great moderation" and of the 18 year bull market in stocks, in which declining interest rates, automation and offshoring meant that producer price increases were kept to a minimum, and consumer prices increased far beyond those paid by producers. Put another way, in inflation terms the middle and working classes were gouged:

By about 2000, consumers had reached the end of their rope. Only easy credit fueled a temporary binge during the Bush years. Producers have been unable to pass on price increases to consumers, for the simple reason that consumers can no longer afford them:

This is why I do not see a general inflation (as opposed to Oil price inflation) as a threat to the economy. Producers who increase prices due to commodity price increases will be met with a downturn in consumer demand (just as happened in 2008). They won't recoup their losses, instead some of them will go out of business. Those who are able will increase the hours and obligations of salaried employees, or hire new workers at lower wages than before. Inflationary spikes will be temporary and will be quickly offset with a deflationary response. In milder cases this will lead to a slowdown as during last summer. In severe cases there will be another deflationary bust.