Type 1 and Type 2 Inflation

More than 40 years ago, America’s Paul Volcker killed goods and services inflation, which we shall define as Type 1 inflation. In the following decade other nations, including Australia, worked hard to reduce this category of inflation. Asset inflation – type 2 inflation – continued with occasional setbacks. Economic analysis has no model for continued near zero goods and services inflation and continuing asset inflation.

Paul Volcker

Still, this conjunction is alive and well, although Type 2 inflation has slowed and is perhaps taking some adjustment, leaving room for Type 1 inflation to be revived. (Leaving room is a summary of what a model with both kinds of inflation might contain.)

US goods and services inflation has hit 6.2 %, exceeding just about every pundit’s expectation, and similar results seem to be following elsewhere. Except in Australia, a country that often follows overseas trends with a lag. As Type 1 inflation takes hold everywhere, as I expect, a general shifting of inflation types is likely.

My guess is that inflation of both types depends on expectations. Type 1 inflation is low when worker-type women and men have low expectations of reward. Paul Volcker’s hit to Type 1 inflation was followed in the early 1990s by the largest economic downturn since the 1930s. Type 1 inflation became embedded for the next 30 years. With renewed easy money, Type 2 inflation returned and has generally been strong. Investors and speculators have flourished.

If serious Type 1 inflation returns, my guess is that Type 2 inflation will be reduced, perhaps until a brave central bank chief repeats Paul Volcker’s bold monetary tightening.

On this issue, there is a major weakness in economic analysis. ‘Excess money’ (the inverse of ‘monetary disequilibrium’), when estimated within a well-constructed economic model I have built with Clifford Wymer suggests excess money generally has a larger effect on Type 2 inflation than Type 1 inflation. In the case of this work we have included a measure of ‘Animal spirits’ in our share price equation and allowed for no such influence in our equations for Type 1 inflation and wages. Technically, we have been assuming that expectations of Type 1 inflation has been constant and low.

We are now thinking about adding a different expectations variable to these Type 1 equations. An obvious starting point is to add the rate of unemployment to equations for wages and goods and service inflation. When this is done, if successful, we shall have fixed an important weakness in macroeconomic analysis.

A link to our near-finished UK model is available on request.

KULTURE

Fiona Prior finally sees the latest James Bond film and ... More here:)