Photo by Mark Pilkenton from FreeImages

What is Inflation?

Four months ago, I wrote that we should not worry about food price inflation. How's that going?

This week, the Bureau of Labor Statistics released the latest inflation numbers. Food prices increased by 3.7% in the last year, which is the fourth time it has exceeded 3% in the last decade (2012, 2014, 2020). Overall, prices increased by 5.2% in the last year, which is the highest rate since 2008.

Source: BLS and R code at end of article


Compared to the last 35 years, inflation is high but not that high, yet I sense considerable angst about it. This angst stems partly from different uses of the word "inflation".

To an economist, inflation means prices and wages are increasing throughout the economy. If your wages are going up and prices are going up, then you can still afford to buy the same stuff (in theory). This is why many economists think moderate inflation isn't a big deal.

Price inflation was high in the 1970s, but so was income inflation. Price inflation has been low since 1984, and so has income inflation.  

US Income and Prices
Source: BLS and R code at end of article


Aside. It is hard to look at the figure above and not see the massive effect of the COVID-19 pandemic on incomes. Zooming in, we see big bumps in personal income in April 2020, when incomes were 14% above April 2019, and in March 2021, when incomes were 29% above March 2020. These bumps reflect the massive government policy response to the pandemic.

US Income and Prices
Source: BLS and R code at end of article


To most people, inflation is not an abstract concept in a mathematical model, but it is how you describe the things you buy getting more expensive.  You think it's a big deal, and you think economists are insensitive idiots for downplaying it.

The difference between the economist's view (inflation is when all wages and prices go up) and everyone else's view (inflation is when some things are expensive) was displayed starkly last week when the White House Council of Economic Advisors released a report on food prices. The CEA argued that meat prices are high in large part because powerful meat-processing conglomerates have been raising prices to jack up their profits. If you ignore meat prices, then food prices haven't gone up much at all.

US Food Prices
Source: BLS and R code at end of article


People who buy food responded with incredulity. "CEA says food prices haven't increased, as long as you don't count the things we buy," they said, dripping with sarcasm. 

Setting aside whether the CEA argument is correct (I don't know), they structured it in a way economists understand. The problem is not "inflation", which is a macroeconomic thing caused by too much money in the system. The problem is lack of competition in the meat supply chain, which is a microeconomic thing to be fixed through competition policy.

Perhaps if the CEA had said "the cause of food inflation is powerful meat processing companies," then most people would have nodded in agreement.  Except economists, who would have said "what are you talking about? Inflation is a macroeconomic thing ......"

So, next time you're involved in a debate about inflation, remember two things.

First, levels vs rates.  Are you talking about whether prices are high right now, like, "I can't believe that steak is $20 a pound"?  Or are you talking about how prices are increasing now and are expected to continue increasing? The latter is inflation. The former is high prices. 

Meat prices are high right now, about 16% higher than two years ago. Half that increase has come in the last year. But an economist would only describe this as inflation if they believed that meat prices will continue to increase, along with prices in other sectors. 

US Price Levels vs Rates
Source: BLS and R code at end of article


Second, raw commodity vs consumable. The prices of farm products such as corn and soybeans fluctuate wildly with market conditions, much more wildly than consumer prices. In June of this year, corn prices were up 100% from their value a year earlier, whereas consumer food prices were up only 2.4%.

People don't eat corn as it comes off the field. Most of the price of food is determined by the cost of processing, packaging and marketing. The USDA estimates that farm gate sales of food commodities made up 14% of the retail value of food in 2019.

If someone is talking about inflation and using a raw commodity rather than a consumable as their example, they are exaggerating.

US Prices: Raw Commodity vs Consumable
Source: Quandl, BLS and R code at end of article


The R code to generate the figures in this article is available here