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Different Shades Of Inflation

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I gotta do without what!?!

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In today's WSJ there is a somewhat cavalier editorial suggesting that the Federal Reserve should step up the pace of rate hikes to stem the rising inflationary tide, which it sees as the only real threat to the U.S. economy. In my opinion, this argument is unfortunately too simplistic for the kind of inflation we are beginning to see.

Inflation can be broadly categorized between "Cost-Push Inflation" and "Demand-Pull Inflation". The first is usually driven by accelerating increases in wage rates and rapid rises in raw material prices. The second is more a function of increases in the money supply, increases in government spending and, somewhat unrelated, rising prices abroad.

Aggressive interest rate hikes tend to work well against "Cost-Push Inflation" because they stunt the economic overdrive pushing rising prices. In an ideal scenario, higher rates cool the economy - and inflation - without doing too much damage to the demand side of the equation.

Higher rates also work against "Demand-Pull Inflation" but the consequences are more similar to forcing an addict to go "cold turkey": the withdrawal symptoms can do as much damage as the drug. An economy humming along on the presumption of the dual government spigots of money printing and money spending, often does not take too kindly to waking up to a dry well.

What we have today is an insidious combination of the two types of inflation, with easy money and easy spending supplemented by rising commodity prices (driven by a variety of exogenous factors), and a conspicuous absence of wage growth. Pulling the plug on easy money might leave the "easy money junkies" without their drugs AND with a call on their debt habit. This scenario might end up being far more unpleasant than the WSJ suggests.
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