Inflation and Deflation: Why it's important to get the definitions right

Below is an extract from a commentary originally posted at www.speculative-investor.com on 19th May 2005:

We aren't aware of any words that are used in as many varying and confusing ways as the words inflation and deflation. When the word inflation is used by a journalist or analyst, for example, it often means a increase in the general level of consumer prices, but it could also mean an increase in asset prices or an increase in the supply of money. However, it is very important to settle on a definition that makes sense and to then apply the definition consistently in the analysis of all things financial/economic because the failure to do so leads to huge errors.

When we talk about inflation at TSI we are referring to an increase in the total supply of money and credit, not a rise in the general price level; and when we use the word deflation at TSI we mean a contraction in the total supply of money and credit, not a fall in the general price level**. Inflation and deflation CAUSE prices to change, but not all price changes are EFFECTS of inflation and deflation. Which brings us to the main reason why it is important to define the terms consistently and correctly: defining inflation and deflation in terms of price changes fails to distinguish between cause and effect.

As a hypothetical example of how mixing-up cause and effect can create a big problem consider the case of the doctor who couldn't, or who didn't think it was important to, distinguish between a pain in the chest caused by heart disease and one caused by indigestion. A pain in the chest can have many different causes with very different consequences as far as the patient's longer-term well-being and required treatments are concerned, so our hypothetical doctor's inability or unwillingness to differentiate between the various possible causes of the pain could have catastrophic results for the patient. A financial market analyst or economist who can't, or doesn't think it is important to, distinguish between price changes caused by inflation/deflation and price changes caused by other factors is making a similar mistake, although unlike the doctor the financial analyst is not running the risk of being sued for mal-practice as a result of his/her mistake.

In addition to the mixing-up of symptom and disease (effect and cause), there is the issue -- an issue that will likely be overlooked by those who think inflation is an increase in prices -- that during the early and middle stages of an inflation cycle some prices will FALL. In fact, Ludwig von Mises and other great economists of the Austrian School have explained that this particular characteristic of inflation -- the way it affects prices in a non-uniform manner -- is what gives it great appeal to the financial and political elite. After all, if a 10% increase in the money supply immediately pushed all prices higher by 10% then nobody would have the opportunity of benefiting from the inflation. The way it actually works, though, is that the prices of some things will rise earlier and faster than the prices of other things, thus allowing some people to profit from the inflation before others become aware of what is going on. Inflation is, in actuality, a surreptitious means of wealth distribution.

Another problem faced by those who insist on defining inflation/deflation in terms of price changes is that they are effectively pulling the wool over their own eyes. For example, take the case where a) the money supply is growing at a rapid rate, b) the year-over-year increase in consumer prices is zero, and c) labour productivity is growing at a 5% clip. In this situation the definition-challenged analyst will proclaim that there's no inflation, but prices should have FALLEN by around 5% due to the productivity growth. In other words, in this case there was enough inflation to offset any benefit that the 'man on the street' would have otherwise received as a result of the increase in his productivity.

A related problem to the one just mentioned is that any analyst/economist/commentator who defines inflation and deflation in terms of price changes is unwittingly helping the central bank to manage inflation expectations by keeping the public in the dark. Inflating the supply of money, you see, is not a major challenge for the central bank under the type of monetary system we have today, but keeping inflation expectations low can be an enormous challenge at times. One method that is used to keep inflation expectations in check is to calculate the widely-watched price indices in ways that substantially understate the true effects of inflation, but going to the trouble of manufacturing artificially-low price indices is not useful unless almost everyone believes inflation to be an increase in the general price level. Furthermore, if most people believe that falling prices somewhere in the economy represent deflation, or a 'deflationary threat', then whenever prices fall the monetary authorities immediately have the justification to promote more inflation. This concept is very relevant right now because, as warned at TSI over the past several months, there will probably be a "deflation scare" during 2005-2006 as a result of falling commodity and stock prices. This 'scare' will, in turn, set the scene for the next big wave of central-bank-sponsored inflation, but the whole charade is only made possible because most of the people whose job it is to report on the financial markets and the economy are clueless when it comes to the true meanings of inflation and deflation. In effect, the inability or unwillingness of most analysts to define inflation and deflation correctly enables the engines of inflation (the Fed and other central banks) to masquerade as inflation fighters. Refer to http://www.mises.org/story/908 for additional discussion on this issue.

OK, so there are some very good reasons to differentiate between inflation/deflation (the cause) and price changes (the effect). Can we, though, avoid the confusion by describing changes in the money supply as "monetary inflation" or "monetary deflation" and changes in the general price level as "price inflation" or "price deflation"? The answer is no, because if you do this you are using the words inflation/deflation to mean one thing one minute and another thing the next. "Monetary inflation", for example, would mean MORE money whereas "price inflation" would mean HIGHER prices. Also, if you do this you will, in many instances, be associating the words inflation and deflation with price changes that have absolutely nothing to do with inflation or deflation. That is, you will be adding to the general confusion.

In conclusion, getting the definitions of inflation and deflation right paves the way to a better understanding of what is really happening in the financial world. There's simply no need to make an inexact science (economics) even more inexact by using nonsensical, inconsistent, and downright misleading definitions.

**A more technically correct definition of inflation would be an increase in the supply of money that causes the general price level to rise, and a more technically correct definition of deflation would be a decrease in the supply of money that causes prices to fall. However, we think these definitions add an unnecessary layer of complexity because:

a) It is very difficult, perhaps even impossible, to measure the change in the general price level with accuracy
b) The effects of inflation are sometimes seen mostly in financial-asset prices whereas at other times they are seen in commodity and consumer prices
c) It is extremely unlikely that there would ever be a substantial increase in the supply of money that did not eventually lead to higher prices somewhere in the economy or a substantial decrease in the supply of money that did not eventually lead to lower prices.

In any case, the important thing to understand is that a price increase cannot possibly be related to inflation unless it was preceded by an increase in the money supply and a price decrease cannot possibly be related to deflation unless it was preceded by a decrease in the money supply.