Home > Causes of Inflation, Theory > High Prices Don’t Cure High Prices

High Prices Don’t Cure High Prices

This was an interesting week, in which it seemed that equity investors finally and abruptly got the message that high inflation is bad for the market; increasing interest rates are bad for the market; declining bid/offer liquidity is bad for the market; high energy prices are bad for the market; global geopolitical unrest is bad for the market; and a strong dollar is (eventually) bad for the market. The last two days in the stock market was a remarkably steady and orderly melting. Will it continue? Well, none of those trends I just mentioned look as if they are about to change significantly, so the only question is whether the extraordinary popular delusion returns.

The proximate cause for the selloff seems to have been the hawkish talk from Fed speakers, including the floating of the trial balloon early in the week about the possibility of a 75bp tightening. By the end of Friday, Cleveland Fed President Mester was actively pouring cold water on the notion that anything so aggressive was out of the question, while still talking in terms of 50bps increments.

I admit that as of only a few months ago, I didn’t think the Fed would hike rates more than about 75bps in total before they lost their nerve. On the other hand, they’re about 500bps behind the curve, so color me surprised…but not impressed.

To be sure, I also thought the stock market would have reacted before this point. And I do think that it is easier to talk about how much you’re going to work out this summer until it gets hot. So we will see.

But, on to my real topic today: the annoying canard that “high prices are the cure for high prices,” which is a phrase so absurd on its face that the discussion really shouldn’t go much further than that. The phrase implies that we can’t have inflation because if we have inflation, then prices will come down. It’s one reason that people are expecting used car prices to drop by as much as they previously rose – because “no one can afford a car at those prices!”

The idea is that as prices rise, the amount of money in your pocket can’t buy as many things. Therefore, real demand must suffer because higher prices mean that people can buy less stuff. Ergo, inflation causes recessions (which is weird, because we are always told how expansions cause inflation – which means that expansions must cause recessions. Are you feeling a ‘down the rabbit hole’ sensation yet?).

This is another example of a stock-flow fallacy. Or maybe it’s a fallacy of composition. It’s a micro/macro mistake. The point is that it doesn’t work that way.

The system can’t run out of money. If prices go up 25%, it doesn’t mean that you can buy 20% less stuff. Well, perhaps you can buy 20% less stuff, today, until you run out of money. But the person who sold you the car now has 25% more money than he would have previously, had he sold the same car before. Maybe you are out of money, but he has 25% more money. The money doesn’t leave the system when you buy something. It only leaves your wallet. (The stock market works exactly the same way, and no one ever questions why stock prices can’t keep going up because investors are using up all of their money, right?).

Now, if the total amount of money in the system is the same today as it was before the 25% increase in prices, and the velocity of exchange doesn’t change, then yes – that 25% price increase won’t stick because in aggregate we will be spending the same amount of money at higher prices, which means we take home fewer goods and services. If on the other hand the amount of money in the system went up by 25%, then total expenditures (if velocity is roughly constant) will be the same in unit terms as before. The system doesn’t grind to a halt and force prices lower. The system reaches equilibrium at prices that are 25% higher. By the same token, if there is 40% more money in the system, then those 25% price increases won’t be enough, there will be shortages, and prices will keep rising.

This seems like a good point to recall that M2 money since the end of 2019 has risen 42%. Tell me again why Used Car prices need to retrace so much?

The real question, to me, is why more prices haven’t gone up 42%. My answer is that we are still in the adjustment period. It takes time for that money to wash around the system, and it’s still on the rinse cycle.

  1. April 23, 2022 at 3:07 pm

    Money supply M2 doubled from the 2008 recession to the pandemic start. All that time the FED was saying 2% was the target, but largely unmet.
    Why does a slightly higher rate of M2 now suddenly cause “real” inflation.
    That tells me that the money supply is not the cause.
    I have no proof of any other cause, but M2 seems a poor excuse ?

    • April 24, 2022 at 11:41 am

      Hi wheewiz,
      this graph shows the yearly US M2 growth.
      There was a large increase in M2 in 2020.
      The CPI is also shown in the graph.

      https://www.longtermtrends.net/m2-money-supply-vs-inflation/

    • April 25, 2022 at 8:57 am

      The Fed during that time lowered interest rates and kept them low – and velocity is correlated with interest rates. But the 2008 crisis was also a banking crisis – see my article “it was different last time”. BTW the “slightly higher rate” was almost 30%, more than twice as high as the highest rate recorded in the 1970s (which was the highest ever recorded). So it wasn’t just a small difference, but an order of magnitude.

  2. April 23, 2022 at 3:12 pm

    I take exception to your description of why the saying is the cure for high prices is high prices. Rather I always understood it to mean that when prices rise, that encourages suppliers to supply more goods to the market and therefore caps price increases and drives them back to marginal costs. In fact, I think the issue in, say the oil market, is that even though historically this has been the case, leading to the constant boom-bust cycle in oil prices, this time, it appears that the managements of oil companies have gotten religion and are listening to their shareholders, so they are not automatically ramping up production, but instead husbanding capital and repaying shareholders. But I always understood it to be a reflection of higher supply to come in the future driving prices back down.

    • April 24, 2022 at 12:22 pm

      Hi fxpoet,
      your comment got me thinking.
      Is the link from price to cost important?
      I guess if costs stayed the same, but price and profit goes up, then you may well get increased supply. Or costs decrease, price stays the same and profit increases.

      Mike did a very nice piece here, showing the likelihood of continuously increasing prices in an environment of consistently increasing inflating costs.
      I guess higher costs are linked with larger amounts of money, but similar supply.

      Supply may be induced by higher profits, not necessarily higher prices.

      https://mikeashton.wordpress.com/2021/06/01/how-expecting-inflation-un-anchors-manufacturers-pricing-strategy/

      • April 25, 2022 at 10:07 am

        Yes, I agree your idea of higher profits. I think the underlying assumption is higher prices for a commodity directly lead to higher profits. After all, this is a simplistic statement to begin with

    • April 25, 2022 at 8:59 am

      That’s not the way it is being used presently. Supply response is a multi-year effect, and this is being used to explain why inflation (and prices themselves) will quickly decline. But even your description requires an increase in REAL prices, not nominal prices.

      • April 25, 2022 at 10:05 am

        I guess I couldn’t even imagine that scenario, prices will fall because they are high? Thats just silly. I’ve only ever understood it to be the supply response

  3. Yelian Garcia
    April 25, 2022 at 7:34 am

    M2 and similar monetary aggregates have been empirically shown to be outdated and obsolete (since the at least the 70’s)

    Markets and macro-economies are not equilibrium systems, they are complex adaptive dynamic systems and thus your may want to familiarize yourself with the non-equilibrium dynamics and mathematics of said systems

    • April 25, 2022 at 9:04 am

      Thanks. I’m extremely familiar with those systems. And they don’t work, because non-equilibrium dynamical systems are typically over-complex and over-fitted to data. I’m not sure what you mean by “M2 and similar monetary aggregates have been empirically shown to be outdated and obsolete.” The forecasting record of M2 growth is dramatically better than the alternatives that have been put forward. I think perhaps you’re reading the bad research the Fed has been putting out ever since they got rid of the last monetarists.

      If their models worked so well, I’m not sure why they screwed up in such a monumental way when the “outdated and obsolete” models made extremely clear predictions of this outcome. Maybe rather than trying to adapt those super-cool models we need to go back to the ones that have worked so well, with no notable exceptions, since…well, forever. There is no example of a significant increase in money without inflation, and no example of a significant increase in inflation without money. I guess I don’t know what your standard of “good model” is but I would suggest that you look beyond the adjusted r2 for the period from 1993-2007.

  1. No trackbacks yet.

Leave a Reply

%d bloggers like this: