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Inflation and the price of oil
Dr Frank Shostak
According to many commentators the recent fall in the price of oil should soften the rate of increase in the core CPI, i.e. the consumer price index less food and energy. (On September 18 the price of oil fell to around $63 per barrel from $74.5 per barrel at the end of July — a fall of 15.4 per cent). For this way of thinking changes in the price of oil play an important role in driving underlying changes in the prices of non-energy goods and services. In a speech to the Emeryville Chamber of Commerce on September 12, 2006 the San Francisco Fed’s President Janet Yellen said that,
It seems likely that energy passthrough probably has played at least some role in recent core inflation movements. In this case, if energy prices level out, as expected by futures markets, this upward pressure on core inflation is likely to dissipate at some point, and this would help on the inflation front.
Similarly in his speech on June 15, 2006 before the Economic Club of Chicago the Chairman of the Fed Ben Bernanke argued,
In addition, higher energy costs may have indirect effects on the inflation rate if, for example, firms pass on their increased costs of production in the form of higher consumer prices for non-energy goods or services.
The yearly rate of growth of the CPI less food and energy edged up to 2.8 per cent in August from 2.7 per cent in July — the biggest 12-month gain in nearly five years. Note that this increase is well above the unofficial 1 per cent to 2 per cent accepted range. If we were to accept what various experts including Yellen and Bernanke are saying then this strong increase in the core CPI is unlikely to stay for too long and might be already history given the large fall in the price of oil.
BrookesNews.Com
Monday 25 September 2006
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It is true that producers of goods and services set asking prices. It is also true that producers whilst setting prices take into account various production costs including the cost of energy. However, whether the asking price set by producers is going to be realised in the market place hinges on the consumers acceptance of the price set. In short, consumers dictate whether the price set by producers is “right”. On this Mises wrote,
The consumers patronize those shops in which they can buy what they want at the cheapest price. Their buying and their abstention from buying decides who should own and run the plants and the farms. They determine precisely what should be produced, in what quality, and in what quantities. (Ludwig von Mises, Human Action, Contemporary Books third edition p 270.)
If consumers don’t have the money to support the prices asked by producers then the prices asked can not be realised. What is a price? It is the rate of exchange between goods established in a transaction. The price, or the rate of exchange of one good in terms of another, is the amount of the other good divided by the amount of the first good. In the money economy, price will be the amount of money divided by the first good. In short, a price is the sum of money paid for a unit of a good.
If the stock of money rises whilst all other things remain intact obviously this must lead to more money being spent on the unchanged stock of goods — an increase in the average price of goods. (The term average is used here in conceptual form. We are well aware that such average cannot be computed). If the price of oil goes up and if people continue to use the same amount of oil as before this means that people are now forced to allocate more money for oil. If peoples money stock remains unchanged then this means that less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come off.
Note that the overall money spent on goods doesn’t change — only the composition of spending has altered here, with more on oil and less on other goods. Hence the average price of goods or money per unit of good remains unchanged. Likewise, the rate of increase in the prices of goods and services in general is going to be constrained by the rate of growth of money supply, all other things being equal, and not by the rate of growth of the price of oil. In other words, it is not possible for rises in the price of oil to set in motion a general increase in the prices of goods and services without the corresponding support from money supply.
One could, however, argue that a rise in the price of oil may cause the Fed to lift its monetary pumping and this in turn should provide the support for a general rise in prices on account of the increase in the price of oil. Even if this were to be the case, as a result of a lengthy time lag from money to price inflation in the short run this would have almost no effect on the growth momentum of the CPI. In short, present price inflation is driven by past monetary injections. Now, for most commentators including Bernanke a rise in oil prices also runs the risk of igniting inflationary expectations that in turn could trigger higher price inflation, or so it is held. Again our response to this is that without corresponding support from rises in money supply no general increase in prices is likely to occur.
The lagged growth momentum of our monetary measure AMS* indicates that the yearly rate of growth of the CPI less food and energy could stay elevated during next year. According to our analysis the average rate of growth of the CPI less food and energy could be at around 2.4 per cent (well above the unofficial inflationary target). If our forecast is valid then we suspect that the Fed is unlikely to lower its fed funds rate target even if the pace of economic activity were to slow down quite visibly. Remember, according to the Fed’s officials their main priority is keeping the rate of price inflation in the acceptable range.
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Likewise our monetary analysis indicates that the growth momentum of the overall CPI is also likely to stay elevated throughout next year. (Year-on-year the rate of growth of the CPI eased to 3.8 per cent in August from 4.2 per cent in July). Seasonally adjusted the CPI increased by 0.2 per cent in August, just half of the 0.4 per cent rise seen in July.
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Now it must be appreciated that the Fed doesn’t directly control the quantity of money — it targets interest rates. So if on account of a weakening in economic activity the present target for the fed funds rate of 5.25 per cent turns out to be too high, then the US central bank will be forced to take money from the system to defend the target. In this framework the Fed seems to be passive, i.e., the Fed only reacts to various conditions that are posing a risk to the federal funds rate target. The Fed in this framework doesn’t initiate active monetary injections so to speak. This apparent passivity of the Fed doesn’t mean that the Fed doesn’t print money. The market pressure on the federal funds rate target dictates the pace of printing by the Fed. In the first week of September the pace of monetary pumping by the US central bank has eased visibly. The yearly rate of growth of the Fed’s balance sheet (Fed Credit) fell to 3.7 per cent from 4.3 per cent in August and 4.8 per cent in May.
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Conclusion
Despite popular thinking our analysis shows that it is changes in past money supply that drives price inflation and not changes in the price of oil. On account of likely elevated core price inflation next year we assign a low likelihood that the Fed will lower its interest rate target even if the pace of economic activity were to slow down quite visibly.
*1. Currency outside U.S. Treasury, Federal Reserve Banks and the vaults of depository institutions. (Cash)
3. Demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float.
4. NOW and ATS balances at commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations.
5. Consists of NOW (negotiable order of withdrawal) and ATS (automatic transfer service) balances at thrifts, credit union share draft balances, and demand deposits at thrifts.
Money supply: Cash + demand deposits with commercial banks and thrift institutions + saving deposits + government deposits with banks and the central bank. This definition shows clearly that any expansion in the money supply takes place solely as a result of central bank injections of cash and commercial banks practice of fractional reserve banking.
Dr Shostak is a former professor of economics who now works in the private sector