Relative Prices, Trade, and Inflation (oh my!)

I really like new econoblogger Dani Rodrik. He asks, “Does Free Trade Bring Lower Prices?“, and comes up with a good answer. (The right answer, in economics as in life, is always “it depends”. A good answer is one that offers its receiver some intuition just what “it depends” upon.) Rodrick writes:

Advocates of globalization love to argue that free trade lowers prices, and the argument seems sensible enough. Think of all the cheap goods from China that we can buy at Wal-Mart. But anyone who understands comparative advantage knows that free trade affects relative prices, not the price level (the latter being the province of macro and monetary factors). When a country opens up to trade (or liberalizes its trade), it is the relative price of imports that comes down; by necessity, the relative prices of its exports must go up! Consumers are better off to the extent that their consumption basket is weighted towards importables, but we cannot always rely on this to be the case.

Americans may forget this, since the price of the consumer items we export (movies, software) is more affected by economies of scale than resource and capacity constraints. But Mexicans who can’t afford corn for tortillas because of the United States’ bizarre corn-ethanol fetish may have noticed.

Does the fact that prices of Mexico’s staple food have skyrocketed count as inflation in Mexico?

Old fave econoblogger Mark Thoma recently suggested no, it shouldn’t. Mere changes in the relative prices of goods and services cannot constitute inflation:

I’ll use some hypothetical numbers for illustration. Suppose that when the price of oil is $28, the price level is 100, and also suppose that when the price of oil increases to $60, the price level increases to 120 all else equal (again, these are not intended to be realistic numbers).

Now, let the spike in oil prices happen quickly, but due to sluggish wage and price adjustment suppose the resulting 20% increase in the price level takes more time, say 2 years. During this two year period, as the price level rises from 100 to 120, inflation will be reported in the news.

But this is not what economists mean by inflation when they say, for example, that “inflation is always and everywhere a monetary phenomena.” To see this, suppose that the change in oil prices and the price level are both instantaneous rather than having the change in the price level drawn out over two years as before. That is, the price level jumps from 100 to 120 instantaneously and stays at the higher level from then on.

In this case, there is no inflation. Prices were stable before the instantaneous jump in the price level, and prices are stable afterward. From that day forward prices remain at 120 and do not increase any further. There is no inflation.

The question of whether changes in prices in and of themselves constitute inflation is a tiresome, and fundamentally definitional question. But I did find it a bit irksome when, after two posts arguing that changes in prices aren’t inflation, Mark excerpted without comment a long speech by San Francisco Fed President Janet Yellin which talked a great deal about price changes as a source of inflation, particularly the price of labor:

While the possibility of slower underlying productivity growth raises uncertainties about how to interpret the puzzle and the associated implications for inflation, it also has a more direct and distinctly pessimistic implication for inflation. In particular, a slowdown in the trend rate of productivity growth means that firms’ trend unit labor costs will rise more rapidly unless compensation growth declines in tandem. Absent such a moderation in compensation growth, firms may adjust to more rapid cost pressures by passing them into the prices consumers pay for their products, placing upward pressure on core inflation, at least for a time.

We cannot afford to go back to a world similar to the 1970s, where shocks that should have had only a transitory impact on inflation—whether due to oil prices, rents or movements in the dollar—shift longer-term inflation expectations and touch off a self-fulfilling wage-price spiral.

If inflation is “always and everywhere a monetary phenomenon”, than changes in the price of human work relative to other inputs should not be considered inflationary. Fed officials often view increases in the price of such minor inputs as food and energy with equanimity (in this era of “anchored expectations”), but are eternally vigilant to the danger that the cost of human care may be bid up. Sometimes it seems that the expectation the Fed wants “anchored” in workers’ psyches is not to expect to be paid very well.

If the “always and everywhere a monetary phenomenon” thing is for real, couldn’t the Fed just take care of the money stuff, and let a free market determine the cost of labor? Wage-price spirals and inflation expectations wouldn’t be a problem if the Fed, like, refused to accommodate unreasonable expectations.

I am aware of reasons why the Fed claims wage volatility is more worrisome than commodity price volatility. Commodity prices adjust rapidly, but overpriced wages are “sticky downward”, and may remain mispriced for a long time, harming economic efficiency and potentially requiring a costly inflation to adjust. (Makes you wonder why the Fed was so blasé about home-price inflation, as house prices are sticky downward as well.) I’m open to arguments that failing to accommodate expectations may be as damaging as inflation, and that the Fed would prefer not to be put in the bind of having to choose between the two. But, given a regime that in practice sees relative price increases as tolerable for anything other than wages, is it surprising that workers’ share of GDP has been relentlessly falling, while the share going to corporate profits has been rising? Are there no stable monetary regimes that wouldn’t bias the game against wage earners?

p.s. another reason i really like Dani Rodrik’s blog are two of his tags: Economist’s blindspots and (it only seems fair) Non-economist bloopers.

p.p.s. knzn has a nice post that reminds us that debt is money, and that a government that increases its debt over time indefinitely through fiscal policy ought produce monetary inflation (as opposed to relative price changes) as effectively as the Fed’s printing press. knzn might correct me, but I think increases in sufficiently liquid private sector debt would count as increases in money in his model, provoking inflation as well.