Inflation Update

The latest “inflation” data again illustrates the correctness of Marx's theory of inflation as a monetary phenomena, i.e. a rise in average unit prices relative average unit values, resulting from a fall in the value of the money commodity, or standard of prices. It also demonstrates what I wrote some time ago, that central banks claim to be fighting inflation by raising their interest rates, rather than curtailing the supply of liquidity, was false.

The argument that it was necessary to raise central bank rates to curb inflation was that inflation is caused by an excess of aggregate demand over aggregate supply. Marx, in A Contribution To The Critique of Political Economy, shows why that argument is fundamentally wrong. Suppose, we have a gold standard, and the currency unit/standard of prices is £1. Now, let's assume that aggregate demand is 1,000 units, and aggregate supply is also 1,000 units, at an average unit value of 10 hours of labour. In other words demand and supply balance. What is the average price of these units? Its impossible to say, unless we know the value of the money commodity/standard of prices, because, whilst values are measured directly in labour-time, prices are measured in money. I can no more say what the price of any commodity measured in money/gold is, without first knowing the value of gold than I can say what the exchange value/corn-price of shirts is, without first knowing, also, the value of shirts and corn! That is, also, precisely what Marx sets out in Theories of Surplus Value, Chapter 20 against Samuel Bailey.

Price is exchange-value measured against money/standard of prices. So, if £1, in the example above, is equal to an ounce of gold, and an ounce of gold has a value of 100 hours of labour, the total value of commodities is 1,000 x 10 = 10,000 hours of labour, and its money equivalent is, then, 10,000/100 = 100 ounces of gold = £100. So, the average unit price of commodities is £0.10. As Marx sets out, if the state chooses to reduce the gold content of £1 to ½ ounce of gold, then the value of the £, as standard of prices, also falls to 50 hours of labour, and the money equivalent of the total value of commodities rises to £200, even though there is no change whatsoever in the value of commodities, or in the levels of aggregate demand and supply. The average unit value of commodities remains exactly where it was, and their exchange-values one to another, remains exactly where it was. However, the total of prices, now, rises to £200, with the average unit price rising to £0.20.

With fiat currencies, the value of the currency unit/standard of prices, however, is not determined by any quantity of gold for which it is redeemable, but as Marx says, simply by the quantity of such currency units thrown into circulation. But, on that basis, this same argument applies. If the state doubles the quantity of these tokens thrown into circulation, the value of each one is halved, just as if the state had reduced the quantity of gold represented by a £, in half, which is really just another way of saying that a £ represents a quantity of social-labour-time, which has been halved. So, just as prices can double without any change in the value of commodities, or any change in the balance of aggregate demand and supply, so changes in aggregate supply and demand, may result in average prices remaining constant, if there are equivalent changes in the value of money/standard of prices. Aggregate demand might rise to exceed aggregate supply, and, yet, unit prices fall, if the value of the standard or prices rises by a greater proportion, and vice versa.

The argument that it was necessary to raise central bank rates to reduce inflation, was a fallacy, and used to cover the fact that, what was really being proposed was not to reduce inflation, but to reduce wages, by throwing the economy into a slowdown or even recession, so that unemployment would rise, the steady rise in the demand for labour-power, seen over the last 25 years would be reduced, and consequently, the pressure of that on rising wages, squeezing profits, and driving additional demand for wage goods, would be reduced. Larry Summers, sought to throw millions of US workers on to the dole to that effect, arguing that the unemployment rate needed to rise to over 5%, for more than a year.

But, US unemployment has not risen, despite the rise in US interest rates, and the US economy has not gone into recession. Indeed, the last quarter's data showed growth of around 2%, and the first quarter figure was also revised up. US employment has continued to expand, and as more workers get jobs, so household incomes have increased, fuelling additional demand for wage goods. Yet, the latest US data does show the rise in prices slowing down, with headline CPI, now, rising at 3.1% year on year, and Core CPI rising at 4.8%, year on year. Why? Precisely for the reasons that Marx's theory states. Over the last year or so, the Federal Reserve, as well as raising its interest rates, has been undertaking QT, rather than QE. That is, it has been taking currency out of circulation rather than massively throwing it into circulation.

Doesn't that mean that, if its reduced liquidity, and so raised the unit value of the currency that prices should have been falling, deflation, not rising more slowly? No, for several reasons. First, let's deal with one more point. The value of each currency unit is not solely determined by the quantity of currency thrown into circulation, for the reasons set out above. That is, if the total value of commodities is 10,000 hours of labour, their money equivalent is also 10,000 hours of labour. Assuming each currency unit only performs one transaction a year, if 1,000 £1 tokens are thrown into circulation, each token is equivalent to 10 hours of labour. If, however, the economy (supply and demand) grows, so that the total value of commodities is, now, 15,000 hours of labour, its money equivalent also rises to 15,000 hours of labour. If the same 1,000 £1 tokens are thrown into circulation, each token now represents, not 10 hours of labour, but 15. Consequently, average unit prices would fall, accordingly.

So, if the currency supply even remains constant, but the economy expands, so that more commodities are produced and exchanged, average unit prices would fall, all else remaining the same. So, if the US has been curtailing the currency supply, whilst the economy has expanded, shouldn't that mean, even more, that there should have been deflation, rather than just slower inflation? No, because, firstly, it takes time, around two years, for changes in the currency supply to filter through into the economy, and its measurement of prices. As Marx describes, even with gold as money, changes in the value of gold did not result immediately in changes in prices, for this same reason that those involved in the process of exchange have to become aware of the actual changes in relative values.  Those closest to the change in the value of money/currency notice first.

Secondly, even the Federal Reserve has had to qualify its policy of QT, over the last year, as, for example, the failure of SVB, and other banks caused it to make liquidity available to prevent a new banking and financial crisis. Thirdly, the supply of currency by the central bank is not the only source of liquidity in the economy. Commercial banks create additional liquidity via the creation of bank credit, for example. If the economy is growing, then firms may seek to take out bank loans to fund the purchase of additional fixed capital. In a fractional reserve banking system, banks know that only around 10% of their deposits will be withdrawn by depositors, leaving them with the other 90%, which can be loaned to borrowers.

If borrowing rises, then, the borrowers use the loan to purchase commodities, and the seller of the commodities, deposits the proceeds in the bank, which, then, means that 90% of this deposit is available for the bank to make as loans, and so on. As a consequence, the increased borrowing results in increased liquidity, reducing the unit value of the currency tokens in circulation. One purpose of raising central bank rates is to discourage such borrowing, and to increase saving, so taking currency out of circulation, and so reducing liquidity. However, as I have set out previously, with inflation running at levels above the rate of interest, there was still an incentive for firms to borrow to buy additional fixed capital, and an incentive for other consumers to use disposable income, or continue to borrow, to buy durable consumer goods, and more expensive services/holidays and so on.

There is evidence, now, in the US, that firms have been spending on fixed capital for the construction of additional production capacity that has not yet fed through into output, but, there is also evidence in the latest data that, as interest rates have risen, firms are starting to use their profits, and balance sheet reserves to finance their purchases of additional fixed capital. That means that the demand for money in capital markets is reduced, but it also means that those profits, previously thrown into money markets, directly by firms, as deposits, or indirectly, via the payment of dividends, or share buybacks to shareholders, is also reduced. Consequently, as economic expansion continues, this demand for money-capital will rise relative to supply, causing real market rates of interest to rise.

Thirdly, as I have set out before, Marx explains in Capital III, that a major source of liquidity in the economy is neither the currency provided by the state/central bank, nor bank money, but is simply the commercial credit created by firms in their dealings with each other. If all firms give each other 90 days to pay invoices, on average, firm A, who buys 100 units from firm B, for £100, can buy £120 units from firm B, for £120, if they seek to expand, without any increase in currency, or bank lending, because they simply pay the additional £20 to B, at the end of 90 days, out of their increased sales. But, also, that applies equally to B in its purchases from other firms, and, in aggregate, all of these credit claims between firms get cancelled out, so that the amount of additional currency required to finance the increased economic activity is much less, or might even be reduced. In short an increase in economic activity and exchange, brings its own increase in liquidity whatever the central bank might do.

Consequently, although the Federal Reserve has been curtailing the currency supply, via QT for the last year or so, it has not yet, fully, filtered through into the effect on prices, which takes around two years. Moreover, for the reasons set out above, the curtailment of liquidity is not entirely in the hands of the central bank, and so that curtailment has not been as great as might be thought, resulting from QT.

The evidence also comes from looking at the “inflation” in other economies, in Britain, and the EU. In those economies, where the curtailment of liquidity started later, and has been less than in the US, the rate of price increases remains elevated.

Looking at the latest US data, we also see a sharp drop in Producer Price inflation. As I have described, over the last year, one reason that GDP data has understated the actual expansion of economies is that it only measures revenues, and, in conditions where input prices are being inflated, there is a tie-up of capital, which appears superficially as a smaller rise in profits than is actually the case, because a portion of profit must be used to replace the consumed constant capital, at these inflated prices. In fact, globally, profits have continued to rise, as have profit margins, as I set out recently. But, that simply means that firms have been able to protect and increase their profits – described in the media as “greedflation” - because they have been able to reduce workers' real wages, as hourly wages failed to keep pace with prices.

In other words, total revenues/GDP is reduced by the amount of this inflation induced tie-up of capital, and it is only a question of the proportion between wages and profits. However, with producer price rises falling significantly, or even prices falling, whilst firms continue to raise end product prices, the reverse occurs, i.e. a release of capital. Even without a release of capital, the superficial reduction in revenues, resulting from a tie-up of capital, disappears and so GDP would rise, as would the rate of profit. But, what is now appearing is also a reversal of the other aspect of the above, whereby profits were maintained in the face of the tie-up of capital, by a further reduction in real wages.

Average hourly earnings rose by 4.4%, year on year, compared to the 3.1% rise in headline inflation, and compared to forecasts of a rise of 4.2%, as the US labour market remains tight. Compared to the rise in Core inflation of 4.8%, that means that US hourly wages are still barely keeping pace with the rise in prices, but that is a change from the larger falls in real hourly wages seen previously, and the predictions and hopes of speculators that rising interest rates would slow the economy, and cause real wages to fall significantly, so as to boost profits, and permit lower interest rates, and fuel a renewed asset price bubble. Indeed, as I've pointed out before, the average hourly wage figure is not the end of the story, because workers earnings are not made up just of those hourly rates, and with employment expanded significantly, household wages have risen much more. In fact, US wage growth is currently running at around 5.6%, year on year.

But, this has other ramifications, which I have described before, and which means that pundits should not get over excited about this fall in US inflation, which represents only an ebbing of the first wave. Despite all attempts to curb the economy, and so cause unemployment to rise, and wages to fall, the US economy has continued to grow, employment has continued to rise, and wages have continued to rise alongside profits. Real hourly wages are now rising, or set to rise, which would act to squeeze real profits (a tie-up of variable-capital). However, as described, those profits have already risen, along with profit margins, and, as the effect of the tie-up of capital, from rising input prices, abates that will become more noticeable, masking the squeeze on profits from rising real wages.

But, firms will not want to see their profit margins or rate of profit falling. The central bank may want to discourage “greedflation”, by not rushing to slow down QT, or make additional liquidity available, to facilitate higher prices, but, as described above, in conditions of economic expansion, which is likely given increases in real household wages, fuelling demand for wage goods, and with rising profits, firms can simply create the additional liquidity required to facilitate those rising prices, by automatically increasing the amount of commercial credit. So, we are likely to see, any further falls in US inflation be very hard to come by, especially as this latest data is skewed by the statistical effects of comparisons for many of its components with the data a year ago, which now falls out of the calculation.

Moreover, the falls in input prices, particularly for energy, in recent months, have been somewhat of a peculiarity. Last year, the US and its allies drew down their strategic petroleum reserves in an attempt to undermine the Russian economy, and its sales of oil. That failed, and now they face the need to replenish their dangerously low stocks. In addition, EU countries having been bullied into boycotting Russian oil and gas, by the US, saw their energy costs rise massively during last Summer, as they sought to build up stocks for the Winter from alternative sources. A mild Winter meant that they did not need to substantially buy additional supplies to supplement those stocks, leading to global energy prices then falling significantly. But, as Autumn approaches, again, they also need to replenish those stocks, which will cause global energy prices to start to rise.

As firms begin to face rising real wages, and rising prices for other inputs, they will again seek to maintain profits and profit margins by raising their own prices. So, a second wave of price rises looms for the Autumn/Winter. That second wave may not reach the height of the first wave, which reflected the amount of liquidity previously thrown into circulation, but it certainly means, as I said at the start of the year that inflation does not go away. Moreover, as real interest rates rise, so real asset prices will fall, which is already being seen in property prices. As asset prices fall, so the liquidity locked up in those sterile assets will also be released, facilitating a further rise in commodity prices, and/or increase in economic activity.