An Inflation Indicator To Watch, Part 3

<An Inflation Indicator To Watch

“During the 1980s and 1990s, most industrial-country central banks were able to cage, if not entirely tame, the inflation dragon.”
—Ben Bernanke

Ben Bernanke began his oft-cited “helicopter speech” in 2002 with a few kind words about his peers, including the excerpt above. Speaking for central bankers, he took a large share of the credit for the low inflation of the 1980s and 1990s. Central bankers had gained a “heightened understanding” of inflation, he said, and he expected the future to bring even more inflation-taming success.

Of course, Bernanke’s cohorts took a few knocks in the boom-bust cycle that followed his speech, but their reputations as masters of inflation (and deflation) only grew. Today, the picture he painted seems even more firmly planted in the public mind than it was in 2002, notwithstanding recent data showing inflation creeping higher.

Public perceptions aren’t always accurate, though, and public figures aren’t the most reliable arbiters of credit and blame. In this 3-part article, I’m proposing a theory that challenges Bernanke’s narrative, and I’ll back the theory with data in Part 3. I’ll show that it leads to an inflation indicator with an excellent historical record.

But first, let’s recap a few points I’ve already discussed.

The Endless Tug-of-War

In Part 2, I said inflation depends on a tug-of-war between purchasing power (on the demand side) and capacity (on the supply side), and the war takes place within the circular flow, in which spending flows into income and income flows back to spending. Two circular-flow patterns and their causes demand particular attention:

When banks inject money into the circular flow in the process of making loans, they can boost spending above the prior period’s income, thereby fattening the flow (or the opposite in the case of a deleveraging).

When foreign imports exceed exports, spending might not adequately recycle back to income, opening a leak in the flow (or the opposite in the case of a trade surplus).

Those points might sound obvious to some (if not, they might look obvious in the diagrams included in Parts 1 and 2), but they’re inconsistent with mainstream economics. According to models favored by mainstream academics and central bankers, the circular-flow pattern involving bank-created money doesn’t exist. In other words, my way of thinking yields conclusions that you don’t find in mainstream theory or at, say, the Fed.