The Obama Administration and Inflation

Classical economic theory says that when an economy heats up, employment is up. Demand is also up which creates shortages of raw materials and labor. This leads to price increases and feeds into a cycle that causes inflation.

When the economy is in a downturn then unemployment is up and demand is down. Retailers try to hold onto customers by keeping prices level. This reduces inflation.

At some point, some economists looked at the relationship between inflation and unemployment and decided that they directly influenced each other. For some reason, the underlying economic health was ignored. As a result, they came up with a theory that unemployment could be fought by increasing inflation. Keep in mind that prosperity might fuel inflation but inflation does not fuel prosperity.

The nation found this out in the late 1970s under the Carter administration. Inflation was a problem during the entire 1970s but by the end of the decade it was out of control. Carter's people had tried to fight a recession by causing inflation. On top of that the economy had to absorb the shock of an Arab oil embargo and a jump in gas prices. The result was such a mess that they had to invent a new word for it: stagflation - a stagnant economy with high inflation. The way out was a very painful double-dip recession, one that was comparable to the current Great Recession.

We are at a different place now. Inflation has been low for a decade. The last two years it was rated at zero. Inflation was probably too low for too long, especially interest rates. The Fed kept rates low as an economic stimulus which led to a bubble fed by loans at record low rates. The bubble burst when the fed raised rates a small amount in order to try to offset the inflationary pressures of rising prices for oil and metals caused by growth in China. Too many people with mortgages had taken out variable rate loans with the expectation of ever-lowering rates. They could not afford even a moderate increase in interest rates.

Normally the Fed could try to stimulate the economy by lowering rates. It did that but this failed for several reasons. The rate were already so low that there was little additional stimulus possible. The way that lowering rates works is that it leads to lower mortgage rates which are supposed to encourage a new round of real estate transaction. The housing market was already saturated with houses being sold at a loss so there was no stimulus effect.

The Fed's newest move is something called "quantitative easing." It will buy up some long-term treasury bonds which is supposed to lower the interest rate for long-term bonds and may encourage some expansion. It will also reduce the value of the dollar overseas in the hope that a weak dollar will make exports cheaper and more attractive while making imports more expensive.

There is a very real danger that this will start a new round of inflation and lead to a modern version of stagflation. We are no longer the manufacturing giant that we used to be. A lot of our consumer goods come from China (even American good like the IPhone and IPad). A weak dollar means that either Apple will lose some of its profit margin or they will have to raise the price. Apple has such a fat profit margin built-in that they can probably absorb it but most other companies will be at a disadvantage.

To make matters worse, a weak dollar means that the cost of raw materials will go up on good manufactured here. This will be on top of a rise caused by a resurgent China.

Prices for other things will go up because of government policies, either in the form of tax hikes or mandates (like replacing cheap incandescent light bulbs with expensive CFLs made-in in China).

Prices in general are staying even but some items have jumped - things like cotton and wheat. The perception of inflation is enough to trigger a new round. That's the last thing that the economy needs.

No one under the age of 50 really understands how pernicious inflation is. It cuts away at everyone's income. Unemployment is a hardship for those without a job but inflation males the entire nation poorer. It feeds into a cycle of wage and price hikes in which no one is ever ahead long enough to get ahead.

The Obama has been courting inflation since its first couple of months. The fact that inflation has not started up, yet, has more to do with how far the economy fell than anything else.

Between, a modest recovery, action from the Fed, and pressure from overseas, the long-expected inflation may start up fast in the near future.