Types of Inflation and the Economy

Macleans magazine has a terrific article on accelerating inflation across the world. It picks up my worry that 2008 is starting to look a lot like the 1970s:

Does this herald a return to the 1970s, when inflation ran wild, and you were lucky to get a mortgage at 10 per cent? Most economists won't admit that's a possibility — but it's a scary thought. Back then, Led Zeppelin's Stairway to Heaven blared on eight-tracks, Bob Barker began hosting The Price is Right, new cars cost $4,000, and Canada entered its worst economic decade since the Depression. Years of rampant government spending followed by the expensive Vietnam War had weakened the American economy, and Canada's soon followed suit. As then-prime minister Pierre Trudeau twirled for the nation, our economy sank into one of the longest slumps in Canadian history, marked by soaring unemployment and, in 1974, the largest stock market crash of the last 50 years.

Now, as Canada gets ready to sail past the four per cent inflation mark, it's hard not to notice that our situation is eerily similar to the situation back then. As Donald Coxe, global portfolio strategist at BMO Financial Group, notes, the inflation crisis then was first kicked off by a sudden rise in food prices (partly due to Nixon's "Great Grain Robbery" of 1972, and partly due to the loss of the anchovy crop off Peru, which created a shortage in protein supplements for animal feed). That was followed by a hike in oil prices, which helped create an inflation crisis in developing countries. By 1972, inflation in Canada pushed past four per cent, just as it will by the end of this year. One year later, the inflation rate hit 14 per cent.

The article does a good job of describing Cost-Push Inflation vs. Demand-Pull Inflation but I found this section puzzling:

The first is "supply-shock" inflation. That happens when oil prices go up, because a company selling you, say, plastic storage containers must pay more for the oil it needs to make the plastic, heat its factory, run its machines and fill up its trucks. The company must then pass along those higher costs to consumers through higher prices. (Incidentally, Rubbermaid has just sharply raised the prices of its storage containers, citing a 60 per cent increase in resin costs.) This often leads to "stagflation," where you have a stagnating economy as prices soar.

Then there's "demand-pull" inflation, which you get when your economy overheats and workers are in short supply. This more dangerous and entrenched form of inflation pushes up wages and other business costs, which pushes up prices. "It's like if you want to get a deck built at your house right when everyone else is getting a deck built," Ragan says. "You have to wait longer, and you have to pay more."

I'm not sure what the author means by more dangerous form of inflation. Consider the AD/SRAS/LRAS model. In the case of demand-side inflation due to a rise in aggregate demand, the Fed can cut the money supply, pushing AD to the left and get the economy back into equilibrium.

Supply-side inflation, due to a leftward shift in aggregate supply, is a different story, as the shift has caused the economy to be below potential (that is, slow economic growth or a recession). The Fed has three options here - First,it could cut the money supply, which eliminates the inflation problem but causes the economy to get worst. Second, it could increase the money supply, which benefits the economy but makes the inflation problem worse. Or it can do nothing and let the economy get back to equilibrium on its own.