Economist Milton Friedman’s assertion that “inflation is always and everywhere a monetary phenomenon” is good to remember as the United States faces increasing prices for some goods and much debate about how sharply the Federal Reserve should restrict money-supply growth.
It is easy to confuse cause and effect if one does not heed Friedman’s warning.
It is also important to remember that price increases for a handful of items, however visible, are not the same as inflation. That is an increase in the overall level of prices. We dislike paying more for milk or gasoline, but the fact that these goods cost more is not evidence of inflation.
Inflation and deflation are measured with price indexes, and the most common are the Consumer Price Index and the Gross Domestic Product Deflator. These indexes measure the weighted average change in prices for thousands of different items.
Housing is an important “good” for most households, but measuring changes in housing prices is difficult. Just this past Monday, an organization of local real estate agents reported that the median sales price of homes in the metro area had increased by 7 percent from August 2003. While substantial, this increase is somewhat below that for the nation as a whole and considerably less than increases in hot markets such as Boston or Los Angeles.
While home prices may have increased 7 percent, the cost of housing for most households did not increase proportionally because only a small fraction of households actually bought a new house. Those of us already in a house saw an increase in an asset value, but no increase in monthly payments.
Tabulating how much a marginal increase in house prices for a small proportion of households contributes to overall price increases is not easy. The U.S. Bureau of Labor Statistics computes something called “owners’ equivalent rent” as their best estimate.
However that figure changes, it is important to remember that increases in housing prices are not a cause of inflation, but a symptom of it. General prices do not rise because people are demanding more for the goods they sell. Rather, it comes from increases in the money supply relative to the goods and services available.
Reporters often get this wrong. A recent Reuters’ story argued, “An expected rise in demand for rentals will result in a spike in inflation.” As with gasoline price increases, an increase in the demand for rentals does not cause inflation. As long as there is no increase in the money supply, prices in general will not rise. Higher prices for gas, milk or housing will force affected households to reduce their expenditures on other items. But they do not cause inflation.
People do not like having to cut back elsewhere when prices of key items rise. Trying to prevent that discomfort by pumping up the money supply, however, only causes much greater pain in the long run.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.