(1) Why Isn't Inflation Higher?

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I.

The Coyote is wondering about the low level of inflation:

1. Is it possible that inflation exists but it shows up mainly in financial assets (stocks, bonds, perhaps real estate) that don't really factor into standard inflation metrics? Every step the Fed has taken, as well as other western central banks, appears to me to be crafted to pump money into securities markets rather than into main street. Certainly we have seen a huge inflation in the value of financial assets and real estate over the past several years. 

2. Expansion of the economy above the rate of productivity improvement should drive inflation, unless there was a lot of excess capacity to soak up. That may have been partly the case in the US since 2008, but surely that is gone. Does the still greatly underutilized Chinese and Indian labor force act as excess capacity that prevents inflation from heating up here? If so, might Trump's trade restrictions interfere with this going forward?

ad 1) I would tend to think the answer is yes. But I would have to look into that more carefully, perhaps following up with a post on financialisation at some time.

ad 2) I am confused. In my last post, I have offered a link to a Fed paper according to which production capacity in the US has fallen dramatically since the GFC and appears not to catch up with the much higher pre-GFC level. Does that mean that an "expansion of the economy" is more likely to create inflation, the production capacity being liable to be soon stretched to its limit? Or does it mean that because production capacity is so low there is more scope to increase it without triggering inflation? In the short run, I suspect, the former might be the case, in the long run the latter — until in the long run the short run will prevail again.

With a large part of production capacity being exported to China and other countries since the late 1980s, what would happen if domestic production capacity got revived?

II.

Here is a helpful outline of inflationary and non-inflationary conditions: what would happen if the central bank were to pump massive amounts of money into the economy either by dropping money from helicopeters or trasferring large sums into the bank accounts of every citizen?

First, the two examples – the helicopter drop and electronically crediting peoples’ private bank accounts with new deposits are not equivalent events. But that is a small issue. 

Second, neither will necessarily cause the price level to accelerate more quickly (that is, increase inflation). 

Why not? What if all the cash from the helicopters fell into the fields and stayed there? 

What if the bank customers, fearing future unemployment and the income uncertainty that accompanies that fear, decided to build saving deposits up further and considered the electronic crediting of their accounts to be a boost to that effort. 

In either case, there will be no price level effects of the central bank operation. 

If, the bank customers took all the increased deposits provided by this central bank operation and used the funds to purchase TVs, food, cars, holidays etc – that is, real goods and services then there is the possibility of accelerating inflation. 

If there is idle capacity in the economy and firms who supply TVs, food, cars, etc have the capacity to supply those goods and services then they will defend their market share by increasing output and sales at the current price levels on offer. Firms typically ‘quantity-adjust’ rather than ‘price-adjust’ when there is excess (idle) capacity. Otherwise, they risk losing market share. 

So in that case there will be no acceleration in inflation. The increased spending will generate a positive output and employment response and the nation will enjoy higher real incomes. 

The possibility of inflation will only become a reality, if the bank customers start liquidating the increased deposits through increased expenditure and the economy is incapable of meeting that increased growth in nominal spending through increased output. 

When firms can no longer ‘quantity-adjust’ they ‘price-adjust’. 

So it is not a self-evident truism that central banks can always increase the inflation rate.

The source. 

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