Mises Daily Articles
Macro Confusion: Inflation, Commodities, and the Fed
A recent discussion regarding commodity prices on CNBC consisted virtually of sentence-by-sentence errors with respect to macroeconomic theory. Most of the misstatements involve either accidentally or intentionally — I don't know which — attributing economic and financial market events to various incorrect or misleading cause-and-effect scenarios, when the real explanation is simply the government's creation of money and credit.
Regrettably, these errors are not restricted to the CNBC commentators and guests in the segment in question, but in fact are characteristic of economic misunderstanding generally. Therefore, I offer the following as a step-by-step clarification of these issues, so that readers can gain a clearer understanding of both the truth and the misconceptions.
Will the Fed Raise Rates?
The discussion began with CNBC's in-house economist Steve Liesman discussing whether the Fed should raise rates in response to reports of soaring wholesale inflation numbers. He explains that the Fed "has so far concluded that it would be the wrong medicine right now for the problem."
That alone brings us the first concern: It is difficult to imagine that the Fed has actively decided not to raise rates, when the fact is that — as things stand — it could not raise rates even if it wanted to (and it might want to). It can raise treasury rates by ceasing to buy treasuries, but it can't raise the federal-funds rate.
The Fed raises the federal-funds rate via open-market operations that withdraw money from the federal-funds market, making money more expensive. But given the massive amount of excess reserves that the banks hold at the Fed, it is virtually impossible for the Fed to withdraw all the reserves it has created without causing massive economic damage. Therefore, it is the excess money on the market that is keeping rates near zero. Thus, the banks — not the Fed — are in charge of interest rates. As the Economist stated:
The Fed could announce a federal funds target of 3% but the tsunami of excess reserves now out there swamps any conceivable demand, so the Fed funds rate would be guaranteed to remain stuck at zero. The target would be meaningless.
It is because the Fed can't raise rates due to the excess reserves (along with the much-discussed concern that all those excess reserves will lead to inflation) that the notion of the Fed having "painted itself into a corner" in terms of trying to "unwind" all of the positions it took from failed Wall Street firms is so widespread.
Now, it would be possible for the Fed to raise the federal-funds rate by way of paying the banks significantly higher rates on their reserves than the current 0.25 percent. But such an action would cause banks to cease lending to the public, which would create a recession. Therefore, the Fed cannot raise rates without causing a recession.
Why the Fed Is Leaving Rates Alone
Nonetheless, Liesman explained the reasons the Fed has decided to leave rates unchanged. He first noted that the argument some put forth is that the Fed should raise interest rates in order to cool rapidly rising commodities prices that are leading to wholesale price inflation. But he then said that the Fed has stated it is not going to react to commodity prices, because those price increases are coming from economic growth in emerging markets, not from the Fed. (And, of course, the Fed is not going to publicly admit that due to its recent attempts to address the problems of its own prior actions, it can do nothing about rising prices now.)
What's wrong with this argument is the idea that commodities prices or inflation can arise from strong economic growth. What the Fed is referring to regarding emerging markets growth is the Keynesian notion that after a period of strong economic growth, inflation can arise from too much demand chasing too few goods. This "too much demand" is usually said to be caused by workers/consumers via increased spending resulting from increased employment. In this way, more employment would cause inflation. This increased employment and spending that leads to prices rising faster than goods is what Keynesians call demand-pull inflation. They admit that inflation causes prices to rise — though they claim that many, many other factors do as well — but only when the economy is operating at full capacity.
The main problem with this theory is that Keynesians claim that additional demand comes from additional production and employment instead of from the central bank. "Demand" consists of the desire plus the ability to purchase something. People can only demand and purchase something by paying for it. They pay for it by exchanging other goods that have been produced; money is simply the medium of exchange. Thus, production is the source of true demand. But when the medium of exchange — money — is increased, the price of the product being purchased will rise. Such a rise is not an increase in real demand; it is an increase in the prices of products being produced. Real demand can increase only by way of an increase in production, which in fact lowers prices. In reality, the increased demand that the Keynesians refer to (but do not name) is increased monetary demand, not real demand. Increased monetary demand comes only from an increase in the quantity of money pushing up prices.
It is quite incorrect to argue that producing more goods will result in prices rising instead of falling. It is also incorrect to say that an economy can overheat as a consequence of (real) demand exceeding supply, since increased real demand comes from increased production, which itself results in a greater supply. An increase in demand — which is in fact an increase in supply — cannot cause prices to rise. Prices can rise only if the monetary unit is being devalued as more money is being added to the economy. Thus, the only thing "overheating" is the government's printing presses.
A Closer Look at Emerging-Markets Growth and Commodities
Therefore, by definition, if emerging markets are truly growing quickly, they are creating new goods and services at a very fast rate; they are producing more commodities and other goods. Their demand for purchasing commodities is being enabled (i.e., paid for) by those other recently produced goods that are given in exchange for commodities, and whose creation lowers both domestic and international prices. And if the United States (and other Western economies) were truly growing as well, it, too, would be producing more goods, causing prices to decline. All of this increased production would cause all goods — including commodities — to fall in price, not to rise.
Indeed, unlikely as it is, there could — theoretically — just happen to occur simultaneously a slower supply growth rate of all of the hundreds of commodities produced in the world relative to the hundreds of thousands of other goods produced in the world, causing all of the various commodities to rise in value relative to other goods. But in the absence of more money being created, an increasing monetary demand for and an increasing price of commodities would be offset by a corresponding decrease in the monetary demand for and prices of other goods. Additionally, as the price of commodities rose, demand would fall.
But the demand for commodities and the prices of other goods have not been falling. Why? Because what is driving up commodity prices — while the prices of all other goods are rising at the same time — is simply an increase in the quantity of money. Market participants are bidding up the price of commodities, along with consumer goods and stock and bond prices (and, formerly, real-estate prices) with the additional money they are receiving from the central bank.
Rising asset prices are the manifestation of inflation. The prices of financial instruments and commodities are rising more rapidly than consumer prices because they are traded on exchanges, where banks, insurance companies, hedge funds, and the like insert funds newly borrowed at cheap rates from the world's central banks. Further, foreign central banks themselves redirect reserves earned from the US trade deficit into the financial markets. Therefore, new money flows disproportionately into the asset markets relative to the real economy.
For Federal Reserve officials to claim that the large amount of new money they have created in the last few years is not contributing to pushing up the price of commodities markets, and to (implicitly) assume that all of that money has instead flowed everywhere else in the economy except to commodities markets is indefensible. (And even if they were correct, the fact that other prices besides commodities are rising shows that the Fed must be responsible for those price rises).
But let's even say that they're right. In that scenario, because neither the money the Fed is creating nor emerging markets growth is responsible for pushing up commodity prices, then it must be new money being created in emerging markets or developed markets outside of the US that is responsible for rising commodity prices (but not for aggregate American prices).
But even in this case, the Fed still plays an indirect role. This is so because many countries in the world create new money only as a means to keep their currency in line with, or lower than, the US dollar, in order to support their mercantilist trade policies; when the Fed expands the money supply, lowering the value of the dollar, foreign central banks create money to respond to this event (by way of creating new local currency to match the excess dollars they receive through trade surpluses they have with the US). But what's certain is that either some or all of the central banks are the only entities responsible for rising commodity prices (but only the Federal Reserve can be responsible for aggregate American prices).
It is important to point out that the mechanism of transmission of monetary policy to the economy or financial markets discussed by mainstream economists concerns the interest-rate effect, not the money-supply effect. Most economists hold that lower interest rates spur economic activity by way of lower borrowing costs, which bring about additional investment spending and in turn consumer spending.
This additional production and consumer spending causes increased "demand" that stimulates the economy — sometimes to the point of inflation, as we saw above. But also as noted above, "demand" is usually implicitly seen to be some amorphous type of "strong economic activity"; the money-supply component of this monetary policy is rarely made explicit.
While lower interest rates indeed cause businesses to borrow and invest more, what is usually being borrowed, invested, and spent is new money, not previously existing money. Interest rates are lowered by increasing the money supply. It is this new and additional money that causes increased corporate revenues and profits, GDP, and asset prices. It is the new and additional money that is the sole cause of rising prices of any kind, anywhere (given that most other prices are rising simultaneously).
Similarly, it is usually said that the lower dollar causes commodities prices to rise because, since commodities are priced in dollars, as the dollar falls, commodities become cheaper in foreign-currency terms. Thus, demand, and therefore, prices, increase. This much is true. But rarely mentioned is the other side of this effect, which is the "money effect." The value of the dollar (of each dollar existing) falls because more dollars are created. It is those additional dollars that bid up commodity prices (new dollars flow disproportionately into commodities markets).
To the extent that the demand for dollar-priced commodities is from overseas (such as the commonly referred to "demand from China"), though the demand usually originates as real demand — i.e., production and real economic growth — the only "demand" that actually pushes up prices is additional monetary demand in the form of additional foreign currency being created overseas (which can be used to buy dollars with which to purchase commodities).
Wall Street Chimes In
Another discussant on the CNBC show was Milton Ezrati, senior economist and market strategist for Lord Abbett mutual funds. He agreed that the Fed has no control over commodity prices, and he said that raising rates might not be in accordance with the Fed's "long-term goals." Though he didn't say what those goals were, they are pretty clear: to keep an abundance of money flowing into the economy so that "demand" does not fall off and so that (artificial and contrived) employment does not fall; and to keep money flowing as well into the financial markets, so that there is the appearance of a "strong economy," because most people (falsely) believe that the financial markets rise because the economy is growing. Most importantly, the Fed's primary goal is to keep the money-supply growth positive, so that a monetary contraction will not take place and cause banks to become insolvent.
Ezrati is therefore correct in saying that changing monetary policy now could harm the Fed's "goals"; if the Fed slowed or reversed the rate of money pumping, both GDP and the financial markets would fall. Though it's not clear whether all economists understand the specific cause-and-effect relationships, the result would be a recession, unemployment, and bank and business losses. It would then be even harder to pump the economy back up again with artificial credit.
But, of course, Ezrati was incorrect in agreeing that the Fed has no control over commodities prices. Not only that, he went on to make another incorrect claim: he also mentioned that a major factor causing the dollar to fall is America's fiscal situation, which, he says, the Fed can't control. But this is completely sophistic. Without the Fed buying the government's bonds, the government could not have much of a fiscal deficit, since it would have to rely solely on taxes and real savings from individuals. But when the Fed purchases these bonds, it does so by creating money, which lowers the value of the dollar. The Fed is therefore the sole entity responsible for lowering the dollar.
Jim O'Sullivan, chief economist at MF Global, appeared on the program too. He said outright that it is too risky to raise rates because the bond and stock market might fall; he is thereby acknowledging that the Fed affects asset prices. Granted, he was likely thinking in terms of higher rates causing slower economic growth, resulting in less economic activity and thus lower asset prices (which supposedly reflect that activity). Still, even if he was not recognizing the more realistic transmission effect of more Fed-created money directly pushing up prices, his comments show that the Fed's policies affect asset prices — even if they don't (as I would argue) wholly drive them — in one way or another.
Curtailing the Rise in Commodities Prices
Liesman then states that "some Fed officials suggest they could lower commodities prices only by tightening policy and reducing economic growth." For Fed officials to say that they can lower commodities prices by tightening policy is tantamount to contradicting their previous statement claiming that they are not driving commodities prices (unless it was different specific officials making each statement). The Fed officials are saying that if they raise interest rates and/or reduce money supply growth, the economy will slow. They are therefore saying that the economy is being driven — or at least pushed along — by low rates and by money and credit "being available" (as they would say). Therefore, the growing economy, in their view, causes a "demand" for commodities. They don't say that it is a monetary demand — just a general "demand."But they also acknowledge that if this demand were reduced with "monetary policy tools," demand for commodities would fall. Thus, they are simultaneously saying that their policies are not driving commodities prices higher, but that if they undo their policies, commodities prices will fall. The fact is that it is their money pumping that is driving both GDP growth and commodities prices — but not the real economy.
Falling Prices and Wages
Interestingly, Liesman said that if the Fed did in fact tighten monetary policy and slow economic growth, that wages and prices would fall. In this case, he asserted, inflation-adjusted prices would not be changed at all. He said that "prices [would be] coming down, even though … wages are coming down too, and the actual affordability of the thing that's coming down hasn't changed … at all … so there's an asymmetry out there."
Now, if Liesman is referring to a sudden monetary-contraction-induced deflation that would come about from shutting off the money valves, he is right that prices and wages would both fall. But the way to prevent such a deflation is to not print money in the first place, as deflation of the money supply can come about only from having previously expanded the money supply. Additionally, falling prices and wages resulting from a contractionary deflation would be a temporary, not ongoing, occurrence.
But if Liesman is — as appears to be the case — referring to falling prices that would come about from not expanding the money supply to begin with, he is dead wrong. Absent money printing, when prices fall, they fall due to an increase in the supply of goods. Wages, however, do not fall, because the supply of workers does not increase as the supply of goods increases.
Even if the number of workers did increase, the supply of goods would increase in proportion to the increased supply of workers (i.e., each new worker will produce additional goods). No matter how many workers are working, as their productivity increases, the supply of goods per worker increases. Thus, the prices of goods fall faster than the prices of labor. And if the labor supply does not increase, wages will never fall at all. In fact, this phenomenon of the prices of goods falling relative to the price of wages happens even when there is inflation of the money supply, because new money pushes up wages much faster than it pushes up the prices of goods, because goods are expanding faster than are people. That is how real wages rise whether prices are rising or falling.
So Liesman's idea that prices and wages would fall at the same pace fails to understand what an economy really is and how standards of living really improve. Further, it is insulting to say that people will be in the same shape in real terms, even if prices and wages do move together. This is because the mere act of printing money in order to make prices rise destroys savings, destroys capital, and therefore causes economic and financial crises. All of these things lower standards of living and make people worse off.
Consider just the savings effect of printing money. People have to save for their retirement because they have to have money to live on when they're no longer working. Their current savings will not support them in the future, so they must save more, especially because prices will be higher. Suppose that today it costs a 40-year-old $45,000 a year to live. With inflation of 3 percent per year, it will cost her over $94,000 a year to live when she retires at age 65. Thus, she must save heavily in order to have an amount of savings large enough to live off each year, and still have it grow for future years of retirement (say, into her 90s, given current life expectancies) at a rate faster than she is drawing down on it. A very high growth rate is needed, especially considering that she will be taxed on all her gains.
But consider an alternative scenario in which no money was printed, and that the rate of production increased at 3 percent per year. In this case, upon retirement, the living that used to cost the woman $45,000 would now cost just over $21,000. And by age 95, it would cost less than $8,500 per year — in real terms, and with nothing taxed! In that case, not only would workers not have to race against the inflation clock before and during retirement, but whatever savings they had would buy more each year.
So indeed, in today's world, because of the government's printing of money, even if wages keep up with inflation, people have to save more and consume less than they would otherwise, and once wages aren't earned anymore, most people usually begin falling behind immediately. Clearly, society would be in better shape with greater savings, a stronger economy, and with prices falling in both nominal and real terms on a monthly basis, as would be the case absent money creation and rising prices.
Nevertheless, Liesman goes on to express his outright surprise at Bank of Japan surveys that consistently show that people like falling prices more than rising prices (seriously, he was actually surprised). Even though this expert economist doesn't understand how people are any better off without credit expansion and inflation, actual people who face the consequences in their everyday lives do understand quite clearly.
Another problem with the statement regarding falling wages and prices is that, even if prices and wages did fall at the same rate, and even under monetary deflation, if there were no printing of money, commodities prices would fall at a much faster rate (because they have been rising at a much faster rate), causing people to more easily afford commodity-based products such as gasoline, food, and airline trips. In other words, in the absence of printing money, some prices would not, as now, rise so disproportionately faster than others; a better balance would be maintained.
For circumstantial proof that commodities prices would fall significantly if the Fed quit creating inflation, consider Figure 1, which shows the 2008 collapse in commodities prices — as measured by the Powershares DB Commodities Index — that resulted from the reduction in the rate of money-supply growth during 2005–07, and the subsequent reduction in credit growth and velocity of circulation (particularly in the financial markets) in 2007-08. As we all know, derivative prices, such as food and oil prices, also fell dramatically in 2008.
The Wage-Price-Spiral Fallacy
Liesman then states that one of the Fed's "tests" for inflation involves looking for a "wage-price spiral." The idea of the wage-price spiral — another construct of Keynesianism accepted by most economists and taught in virtually every economics program — is that workers demand higher prices in order to keep up with inflation, and that the higher wages in turn cause more inflation, prompting workers to once again push wages higher. Once this vicious circle process gets started, inflation can explode uncontrolled.
The fallaciousness of this argument once again brings us back to the quantity of money. Without additional money added to the economy, neither workers nor businesses could ever raise aggregate wages or prices for the reason that, given a fixed quantity of money, it is mathematically impossible for aggregate prices to rise. For a detailed proof of this, please refer to my last article (middle section).
As far as whether workers could raise individual prices, let's do a mental experiment. Consider an economy with $100 of demand, or, money and spending ("demand" and "spending" both consider velocity as well) with 100 workers that produce 100 units of goods. In this scenario, each worker is paid $1 and each good sells for $1.
Now suppose that workers somehow forced up wages by 33 percent, to the level of $1.33 per worker. With the same $100 of money and spending with which to pay salaries, only 75 people could be employed ($100 in spending for labor divided by $1.33 per worker = 75 people). Then, 75 people would receive $1.33 each. Every time workers forced wages higher, more workers would become unemployed.
Similarly, suppose prices were somehow driven up 11 percent from $1.00 per unit to $1.11. The number of units sold would fall by 10 percent to 90 units sold ($100 in spending for goods divided by $1.11 per good = 90 goods sold). With production falling 10 percent, approximately 10 percent fewer workers would be needed, and unemployment would rise by 10 percent. Every time prices rose, the number of goods in the economy would decline, and more workers would be unemployed. Thus, workers would not keep driving up prices.
But in today's world, as wages and prices rise by the year at even a "slow" rate, unemployment levels do not rise, and the number of goods produced and sold does not fall. This is because the central bank is continually providing the economy with more money, so that wages can be bid higher without causing unemployment. When the increased dollar amount of wages is spent in the economy, resulting in increasing demand for goods, prices increase. Thus, if there is any semblance of a wage-price spiral, it is an artificial one caused by the Fed itself. So when the Fed says it is looking for a wage-price spiral, it is really looking for the results of its own money pumping in the form of price inflation. (And while it wants to restrain price inflation, it actively seeks and promotes asset-price inflation in the form of stocks and bonds.)
Another indicator that Liesman said the Federal Reserve uses to test for inflation is that of rising "inflation expectations." It is widely believed that the mere expectations of inflation can actually bring on inflation. For example, in a 2007 speech, Fed Chairman Ben Bernanke relayed that it's possible for "people [to] set prices and wages with reference to the rate of inflation they expect in the long run."
Supposedly, according to this argument, workers expect inflation and, therefore, start demanding higher wages, or consumers begin paying higher prices for goods, even in the absence of businesses and consumers having received additional monetary purchasing power with which to bid up wages and prices. Thus, this unrealistic argument does not take into consideration that there would be no additional money in the economy with which to pay higher wages or higher consumer prices.
Indeed, there could be expectations of inflation, but expectations of future inflation are brought about only by the existence of previous inflation, or by observing that more money is being added to the economy, and knowing that the additional money will eventually raise prices. But the actual existence of inflation can come only from an increase in the quantity of money (and velocity, or the amount of times each dollar is spent, is driven mostly by the supply of money.)
The CNBC program is an example of typical misunderstandings about macroeconomics. In order to understand the global economy correctly, one must have the correct economic lens through which to view it. While mainstream economists without a doubt are very bright people, they have learned — and they stick with — theories that cannot possibly be correct when thoroughly scrutinized.
Why do they not consider alternative explanations that explain and forecast their world better than their own theories? Depending on the case in question, they might not consider other theories due to one or more of the following reasons: they refuse to believe that they have incorrect theories, even if theirs don't often pan out; they truly haven't been exposed to other theories that could be plausible; they would have to make a large investment to learn a new theory; they would betray the ideology that they want to stick with no matter what; they prefer to speak the most common economic "language"; or, they benefit in various ways in their careers by supporting theories that even they know do not fully add up. Whatever the reason, we must remember that just because they say something doesn't mean it's true.
 And not by a supposed multiplier effect from monetary spending.
 This example is based on the example George Reisman uses.
 Since a lot of people ask me about this, I will refer anyone interested in learning more about the relationship of velocity to the money supply to George Reisman's Capitalism, p. 517 section 3, and p. 915 section 7, and to doing a text search on Mises.org for discussions on velocity by Henry Hazlitt, and by Frank Shostak.