Start eating out more?

Economic models take it as a given that, in the face of expected inflation, savers start to spend more.

In practice, this isn't at all clear. I keep posting a simple example, and nobody seems to have a good story for how the actions taken by the individual in the scenario will lead to broad CPI increase.

Here's the example again -- please post your mechanisms in the comments:

You're a responsible Brazilian living in your decent Sao Paolo apartment (paid off!). You have a tidy pile of cruzeiros in your local bank, saved from the income your reasonable private sector job generates. But it's 1979 and you're worried about inflation looming on the horizon. What do you do?

I'm interested in two things, but all ideas are welcome. First, the above situation is not hypothetical, so people actually made decisions in these circumstances. If anyone knows what folks did in real life, I'd love to hear them. Second, this example is meant to focus on exactly how increasing inflation expectations actually leads to rising CPI. No hand-waving please, I need transactions!

Happy Thanksgiving!

Best wishes to all!

QE2 is about rates, not prices

A big thank you to Fernando for stepping up and playing the Monetarist. If there's a better source for why Monetarists have no understanding of money, and therefore the economy, I cannot think of it. And if any of your are wondering, Fernando is not a plant! He's the real deal. I could not make him up if I tried.

In the last couple of posts I outline why QE2 is a non-event. I assert that 1) you cannot move consumption forward, and 2) inflation expectation has no channel that leads to CPI. Fernando makes two claims:

[If there was a positive inflation expectations shock]... I would buy commodities and demand a rise in my salary.

When people expect more inflation they tend to spend more today, velocity rises.

The scenario was a sober minded Brazilian rich in Cruzeiros circa 1979.

Fernando has not responded yet, but I think it's fair to assume that, in the face of inflation, the commodities he would buy would be commodity futures, not actual sheafs of wheat. So Fernando is swapping one financial asset (nominal savings) for another financial asset (commodity futures). This would increase the price of commodity futures, but as far as I know, futures are not part of CPI. Going long futures only makes sense if the anticipated inflation comes to be, and Fernando continues to come up goose egg for any actual mechanism for this inflation. If everyone anticipating inflation goes long futures, it will have no impact on actual inflation and that positioning will come to naught.

Real life actual third world countries take a different approach to expected inflation.

Krugman is part of the problem

This post totally sums up the problem with macroeconomics, and by extension, Krugman:

The simple fact is that we have a global excess supply of savings, which is doing terrible things to workers. The reasonable thing is to do something about it; it’s deeply unreasonable, and deeply irresponsible, to invent reasons not to act because you’re clinging to simplistic slogans.

Got that? Households are groaning under impossible debt burdens, they've seen their income cut and their job prospects dim, and the problem is that they have too much money in the bank.

Surreal.

You can't move consumption forward

Paul Krugman gives you half the story for how inflation expectations is supposed to work. The poverty of the model is clear:

So what the Fed needs for inflation targeting is a way to tie its own hands — or, more accurately, the hands of future Fed officials. That was the whole point of my line about credibly promising to be irresponsible.

In practice, that’s really hard, especially when you have such divergent views among Fed officials themselves. The best precedent is 1933 — which was first pointed out by Peter Temin and Barrie Wigmore. In that case, the end of the gold standard convinced people that there really had been a pro-inflation, or at least anti-deflation, regime change.

When the US went off the gold standard in 1933 it switched to a fiat currency, and therefore was able to deal with the liquidity and solvency problems holding down aggregate demand in the 30s, and keeping the country in the Depression. People didn't suddenly say "Oh, our savings will be inflated away -- let's buy stuff" nor did they say "Oh, our savings will be inflated away -- let's build factories". They kept banks from collapsing and ultimately funded WW2 without worrying about the bank vaults being empty now that they had a printing press.

In economic models, expected inflation feeds into the discount rate, which then governs individual decisions about whether to postpone consumption. The idea is that when inflation expectations go up, the individual will move consumption forward, wheras if inflation expectations go down, the individual will defer consumption (ie. "save").

In reality though, it's easy to defer consumption (just buy the thing later) but it's very hard to move it earlier. You cannot pre-eat a years worth of meals, nor can you pre-live in a years worth of housing, so you won't need either of those things in the future (when it's more expensive).

Third world countries tell you what people actually do when they expect high inflation. And it isn't buying cars nor building factories.