Alan Reynolds

"Some Fear Inflation Is Ready for a Comeback," or so says the headline of a Wall Street Journal story by Ken Brown. Only six months ago, I felt obliged to debunk deflation scares that were in vogue at the time. Now we are suddenly being urged to worry about inflation. Do things really change that quickly, or do journalists just have to keep discovering something new for us to worry about?

As with the deflation scare earlier this year, the inflation stories in the popular press don't hold up too well on close examination. The Wall Street Journal's version mainly relies on veiled theories about inflation. A table of statistics includes only the lowest measure of inflation, the core CPI. And any figure about past inflation tells us little about the future. Inflation is always lower before it moves higher. Other numbers in the table would be informative only if some theory could link them to inflation.

One theory relies on a syllogism: "If the Federal Reserve shares that view (about a strong economy being inflationary), it will push up the federal funds rate, which ... could slow or stop the recent economic rebound." The first premise is that strong economic growth causes interest rates to move higher. The secondary premise is that higher interest rates cause weak economic growth. Accept both premises, and your conclusion must be that strong economic growth causes weak economic growth.

To avoid that paradox, scrap the second premise. Real interest rates always move higher when real GDP speeds up and lower in recessions. Real interest rates are what is left after subtracting inflation, so it is wrong to treat every increase in interest rates as evidence of inflation.

Brown says, "If the Fed starts to jack up interest rates ... (investors) will sell stocks. That's because with interest rates higher, stocks will look less attractive." Less attractive than what? Not less attractive than bonds. If interest rates move higher because a strong economy creates more profitable business opportunities, then the rise in earnings will far outweigh any decline in the ratio of stock prices to earnings. The economy often moves the Fed, rather than the other way around.

Alan Reynolds

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