Those of us who have been hawkish on inflation have been lonely for several months now. However, recent data has suggested that the Federal Reserve may soon start raising rates again. Nevertheless, there are a group of individuals who believe that the inflation numbers are actually worse. Our friend Barry Ritholtz has been leading the charge claiming that BLS data is understating inflation and unemployment (some have referred [hyperlink] to these claims as conspiracy theories). I think that Barry is correct to assert that inflation is worse than the numbers indicate; however, I do not think that the numbers are the problem.
The real problem is that our focus is always on the overall price level rather than relative prices. Commodity prices are on the rise, and will continue to be, so long as the world remains awash in liquidity and real interest rates remain low. The former stokes the demand fire and the latter provides a disincentive for discovery and investment. Looking at the overall price level, it seems as though inflation is quite modest all things considered. The reason that inflation seems so much worse than the numbers indicate is because the prices of things that most consumers consider necessities, like gasoline and food, are experiencing the most rapid increases. In an economy where homeowners were (are?) more leveraged than they have ever been, they are now seeing their wealth decline.
The best solution that the Fed can provide is to begin raising the Federal funds rate. Aggressively raising rates should start to reign in liquidity and lower inflation expectations. Higher real interest rates should provide the incentive for an increase in oil production and reigning in liquidity should reduce demand, thereby putting downward pressure on oil prices.
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