Inflation debate goes round in circles

In: Uncategorized

28 Jun 2011

This is my latest comment from Fund Strategy magazine.

There can be few discussions as dissatisfying as that of inflation. The vast bulk of it can be reduced to a simple tautology: rising prices cause rising prices.

From learned experts to junior journalists it is common to hear such arguments. Rising energy prices are causing inflation, they say. Rising food prices are causing inflation. Rising wages – that is, an increasing price of labour – are causing inflation. Such supposed insights reveal next to nothing.

They start by making the elementary error of confusing correlation and causation. For example, it is mathematically true that a rise in energy prices will result in an increase in the overall inflation rate (except for measures that exclude energy). But this simply begs the question of what is causing energy prices to rise in the first place.

The phrase “rising energy prices are causing inflation” really means that prices in the energy sector are increasing faster than the average.

It is a statement about a sector that is proving particularly prone to inflation rather than an identification of an underlying cause of rising prices.

To explain why energy prices are increasing it would be necessary to look at the sector itself. In particular, to explain why it is that demand is apparently increasing faster than supply. Are there particular factors pushing up demand? And if so why is it not being met by increased supply?

The same would be true of price rises in any other area. For instance, if wages were rising particularly fast that would need to be explained too.

Commentary on inflation is so often superficial because it is widely and wrongly assumed that it is a straightforward topic.

The ability to generally quantify it as a two digit number (with a decimal point in the middle) adds weight to this view.

This assumption is reinforced further by the way investors typically see the world. Since inflation often erodes asset values a lot of attention is paid to rising prices.

What this approach misses is that prices, whether rising or falling, are the convoluted result of a combination of many factors. It is wrong to treat inflation as if it has a life of its own.

It would be far better to acknowledge these complexities, and try to understand the underlying economy, than present tautologies as if they were great insights.