Inflation is here? Let’s take a look under the hood | Econ Matters

For anyone who has filled a gas tank during the past three months, there is no denying that the price is marching upward. Based on this observation, inflation is here.

After increasing by less than one percent between November 2009 and November 2010, the Consumer Price Index has recorded annualized rates of change equal to 4.8 percent in both December and January and 6 percent in February.
So the United States’ most recognized measure of inflation indicates an uptick in the inflation rate.
First, it is important to define what we mean by inflation. Economists see inflation as a sustained increase in the price index. Is three months a sustained increase? In my view, three months is not long enough to be a sustained increase. I do not want to rest my entire case on the number of months.
Let us take an encompassing approach to the current situation.
One factor that bears on the inflation conclusion is the circularity of it all. When one looks at the seven major components of the CPI, the main reason why the inflation rate has increased is because of the transportation component. In other words, the measured inflation rate is rising because energy prices have been increasing.
Three months with rising inflation rates, owing chiefly to one major category, especially one that is historically quite volatile, makes me more comfortable calling this a non-inflation. Energy price increases can last for several months. In addition, energy is a ubiquitous input in world production and can therefore account for higher costs and higher prices for other goods and services. Once the energy price increase is completed, there are no sustained cost-push forces to act on the price of the market basket of goods and services.
Another thing is the absence of protection sought by financial market participants. Sustained inflation is built into people’s forecasts. In other words, someone expecting prices to rise at a 10 percent rate during the next year will need more than a 10 percent return on even the safest assets held during the year. It’s a whole-time-value-of-money thing.
Despite the recent increase in oil prices, the returns on Treasury bills have been remarkably low and constant during the past year or so. Lest you believe that the Federal Reserve policies are keeping one-year Treasury bill rates low by creating lots of money, note that the return on one-year Treasury bills was 14.7 percent in August 1981. The return on one-year Treasury bills has not exceeded one-half percent since the end of 2008. My point is that people buying Treasury securities are not bidding up the return to insure themselves against the sustained inflation.
Perhaps, inflation has not worked its way past the threshold that marks the kind of sustained rates that are embedded in market interest rates.
Despite compelling evidence, we do observe Washington-dwellers citing inflation. Rhetoric aside, it would be folly to ignore the potential for inflation that exists. If inflation is always and everywhere a monetary phenomenon, the Federal Reserve has accumulated a lot of kindling to fan inflationary fires. Printing money was adopted when the financial crisis first began and the Federal Open Market Committee enacted quantitative easing II last fall.
Thus far, the absence of higher inflation likely means that demand for money matched the supply. Demand for money can be rather tricky though, and a nimble Federal Reserve must be prepared to undo the previous easing to keep inflation away. For us, the results come from an extremely complicated set of interactions among people operating in the economy. It might be worth watching those rates on United States’ Treasury securities.