listening to A Love Supreme and thinking about inflation.

a world of low inflation

Inflation has not been a significant problem for more then a decade. Often this is attributed to the Federal reserve, which has become proficient at adjusting interest rates to ward off potential rises in inflation.

But this alone does not fully explain the benign inflation we have experienced of late. Alan Greenspan, in one of his recent speeches, admitted as much, attributing the weak inflationary forces as being the result of a 'transitional period' for the economy where there has been historically high productivity. what does that mean? It means this. Productivity is the rate of output per unit labour cost. When productivity rises substantially, the economy is able to incur greater growth without there being significant upward pressure on wages. This is because goods and services are being produced more efficiently without the need for additional labour that would put upward pressure on wages.

The net result is that an economy experiencing high productivity can grow more strongly then one that is not before it begins to experience inflationary pressure.

The reason productivity has been so high can be partially attributed to technology and the efficiencies that it brings. It can also be attributed to the use of low wage labour, which has lowered the labour input needed to produce goods.

the effect of outsourcing

I want to focus on the latter for a moment. Let's seperate what has been happening to inflation in the services sector from what been happening to inflation in the manufacturing sector. Inflation in the service sector has been managable, but not ridiculously low, of late. Its been roughly in the 3-4% range on average. In comparison, inflation in the manufacturing sector has been negative. So there has been deflation in the manufacturing sector. This is because of the movement of manufacturing jobs to low wage labour locations. The low wages these companies incur give them the ability to lower the prices of their manufactured products. They lower the prices to outbid the competition and gain market share. This is why I can buy a toaster with my spare change.

The questions that this begs are: A. how long will it last, and B. What will happen when the exodus begins to slow and the efficiencies that these companies were able to incur begin to stabilize?

I don't know the answer to the first, though it seems that the manufacturing sector exodus is becoming mature. At some point there just aren't anymore jobs to outsource. The service sector exodus may be just beginning. I'm not sure. Its in the papers a lot, what with India supposedly taking over the IT industry and such, but just how significant this is I haven't gotten a handle on. You have to watch it. A lot of publicity is more due to politics then it is to actual economic impact. Bottom line, the service sector shouldn't be as vulnerable as the manufacturing sector to outsourcing. You can't outsource a lot of services jobs. Big Macs can't be shipped overseas.

The answer to the second, is more obvious. It makes sense that as this process matures, the productivity that it produced will slow, and with it will the deflationary pressure that it exerted.

the forgotten effect of raw materials

There is another factor that contributes to inflation that is often overlooked. Its overlooked because its been benign for so long that people assume that it will always be benign. This is material costs. Goods and to a lesser degree services require two inputs. Labour and raw materials. Labour I've discussed. Raw materials are overlooked because for so long labour was the primary driver of high prices. Raw material prices, particularly energy and base metals and even food, have been abundant enough that there hasn't been upward price pressure on them.

But this is beginning to change. For one, growth in China and India are raising demand for oil, for copper, for steel, for aluminum, and on and on, as these developing countries build the infrastructure they need. They are like the US or Canada at the beginning of the last century. For two, some of these resources, particularly oil and natural gas, are beginning to come into shorter supply. The result of these two effects is an increase in demand and in some cases a decrease in supply. The result is upward price pressure.

For two, as companies outsource, the wage input side of the equation decreases. This increases the effect of any changes to the raw material input. So suddenly raw material matter more.

so what does this all come together to mean?

I believe it means that inflation is going to make a comeback. The shift of manufacturing and service industries to low wage labour areas will mature and the deflationary effect that this shift has precipitated will begin to lessen. In addition, the low wage labour areas will begin to experience upward pressures on wages as they grow, which will cause inflationary pressure. Raw material costs will continue to creep up as demand from these developing nations increases and in some cases the supply of these resources decreases. This will also increase the input costs to produce goods and service. All of these factors will contribute to rising inflation.

The only thing that can prevent this is recession, probably a prolonged one, which of course would decrease demand and eliminate these upward pressures. But that's not good for anybody.

ok, we have higher inflation. that just means the fed raises rates to fight it right?

This is the intersting part. In a perfect world, yes, the Fed raises interest rates to ward off the inflationary pressures. But what does the Fed do in a country where debt is sky high? The US is so far in debt that the Fed has its hands tied. If they raise interest rates substantially to ward off inflationary pressures, as they did in the early 80s, there would be some serious pain among the people who suddenly couldn't pay off their credit cards, or more importantly, their mortgages. The Federal reserve has to be very careful, particularly when it comes to the housing market. A steep rise in interest rates would undoubtably cause some home owners with big mortgages to sell their homes, as they wouldn't be able to pay the additional interest. This could cause a decline in house prices, which would be chaos. So the Fed has to watch it. And they aren't stupid. Greenspan knows that higher inflation would not be good, but he also knows that killing the American consumer with high interest rates would be disaster.

Anyways, those are my thoughts. I think it will be pretty interesting to watch how this all unfolds in the coming decade. Its an interesting time to be alive.

- posted by Sigurd8/15/2004 11:47:00 AM