Home > Main > The Real Reason to Ignore Energy Inflation when core inflation is low

The Real Reason to Ignore Energy Inflation when core inflation is low

March 8, 2011

The usual reason given to ignore Energy and Food costs in inflation discussions is that these prices are volatile and therefore can distort the “true picture” of inflation.  It’s true – these prices are volatile, and vary far more than most prices.

But some people say  ignoring food – and particularly energy – is foolish.  A common phrase is “You’re ignoring everything that people actually need to buy.”   It makes sense – you cannot live without food and energy.

But that little word – “need” – put me on the path to enlightenment.  Smart people should almost completely ignore energy costs in the short run when considering inflation responses.

Why is this the case?  Even by the wrong headed ideas of conventional monetary policy, very little we do with monetary policy will have any impact on either the demand or the price of energy.  And if the monetary policy used is large enough to impact energy demand even just a bit, this means the rest of the economy is feeling a tremendous impact.

Both the demand for energy and supply of energy are notoriously inelastic. Energy demand does not change much in response to price or supply changes.

Place this simple fact into thinking about the goals of monetary policy.  Our goal of monetary policy is to keep prices stable. The current mechanism of keeping prices stable involves changing the supply of money. This change impacts the demand for money, which then theoretically spills over to the demand for real world goods, which then impacts the prices for these goods.

The thinking is that changing this demand for real world goods will change as the demand for money changes, thus changing the level of prices for these real world goods.  But we know from decades of evidence, the demand for oil and energy just doesn’t change much in response to anything.

Here is the story for conventional monetary policy thinking:

  1. There is price instability
  2. Change the supply of money
  3. This shifts the demand for money to a different point on the demand curve.
  4. This change in demand for money impacts the demand for real world goods
  5. This changes the price level of real world goods

I highlighted step #4, because the energy markets break step #3 nearly completely.  We know demand for energy is extremely inelastic. There will be very little change in the demand for energy no matter what happens. Demand for energy just doesn’t change much in the short run – it takes huge economic downswings to impact it at all. A minor change in economic outlook won’t change energy usage – read demand – a whit.

If  the lever we’re using to impact the price of something doesn’t change the quantity demanded of the good for which we want to alter the price, why bother using the lever in the first place?

So, the only way to impact the demand for energy is to destroy or create vast amounts of economic growth that alter the prices of other goods, besides energy, enough to impact the demand for energy.  And if the policy is large enough to alter the demand for energy, the other prices in the economy probably won’t be that stable.

Additionally, if core prices are stable, then by definition there is something fishy about the entire inflation idea anyway.  Inflation is when all prices in an economy go up, not just some sectors.

I am not saying that rampant speculation in energy shouldn’t be discouraged, or that there should be no official reaction to energy price movement.  But if core inflation is low, the steps taken to change energy costs will most likely result in far worse economic outcomes than just letting the energy prices go up and have high energy costs destroy economic growth all on their own.

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  1. George H
    April 23, 2011 at 12:33 pm

    If you agree there is “rampant speculation in energy”, do you also agree there is “excessive liquidity” as the common people would understand it? If so, do you think or do you no think “rampant speculation in energy” is somehow linked to “excessive liquidity”? In other words, without the presence of “excessive liquidity”, which is monetary policy related, “rampant speculation in energy” may have been subdued?

    If all these are possible, does monetary policy have an impact on energy price, though in an illicit way, that is, without being channeled through the economy and the supply and demand chains, most ironically?

  1. April 11, 2011 at 12:10 pm
  2. April 22, 2011 at 9:39 am
  3. April 26, 2011 at 8:14 pm
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