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

March 8, 2011 4 comments

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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Stagflation – the once and future King?

February 24, 2011 Comments off

With Oil spiking, and Libia blowing up pipelines, is stagflation for the U.S. the inevetible next step?  No, but it is very, very possible.  In the world of theories about what might happen over the next year, Stagflation is a decent one.

One of the causes of Stagflation is the relationship between Lebig’s Law and oil. When we have a supply shock in that limiting resource, there is a potential for Stagflation.  There usually isn’t any good way to substitute out of oil – that is why it is limiting.  So a shock in supply for this oil causes a spike in the price of oil relative to other prices.  This single good must by definition get much more expensive relative to other goods.

Many people think of this as a tax.  I do too – I published the math in another forum in July of last year, and have a detailed model on how much oil prices impact the economy.  I agree with DB on the magnitude of the impact of price changes in oil.

Oil is special in that it causes price increases in a host of related products.  Nearly everything has transportation costs.  Because most of the basic stuff that we buy has significant transportation costs, thats where the ‘flation’ part of stagflation comes in.

But the Stag part comes in from the parts of the economy that are facing price cuts, but the goods cannot be made for that cost.  I wrote about a very similar idea in a post a while back:

But in the $100 total world, if the car gets more valuable, then everything else gets less valuable. Should my food be worth less because my car is worth more? But what if that other good cannot be produced at for profit at $30? Then, the world stays the same and no innovation happens.  We do not get a better car.

The case of stagflation is very similar to this example.  When oil goes up in value, there is simply less money to be paid for other goods and services.  However, some of these goods cannot be made in a profitable manner at the new, lower price level.

So what happens? Some people get laid off and dont’ get their jobs back.  Other products can be made from cheaper stuff and sold at the same price. Many goods go up in price to cover the embedded cost of oil.  There is lots of uncertainty about future economic prospects, so few businesses expand.

Welcome to Stagflation!  All of this because of a supply shock in limiting good, oil.

Oops!  Just realized I didn’t give my reasons for not liking the Stagflation scenario.  Guess what – they don’t matter!  Stagflation in the U.S. and Europe is a reasonable possibility, and you should prepare a trading scenario for Stagflation.  I am!

If you’ve ever played the game StarCraft, you’ll be very aware of the practical implementation of Lebig’s Law.  The game is resource and economic management.  You need to mine 2 different types of minerals to be able to build your forces.  To construct these forces takes time, and they can only be built at specific buildings that can be constraints. Your forces are then up against other forces that have different strengths and weaknesses.   It’s managing a mini economy in real time!  Fun stuff.

 

 

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