Fabius Maximus...(click this link to see graphs and further links...)
Summary: The boomers lust for inflation. Conservatives fan this fear for political gain. The government hopes for gentle inflation to deleverage the US economy. Evidence suggests that disappointment lies ahead for all. Here we review the evidence.
Most were too young, too poor, too inexperienced to get rich during the Great Inflation of the 1970′s. Some benefited by inheriting their parents’ gains. But for most boomers this is their last chance to win the life lottery. Loaded with debt but able to borrow, ignorant of economic theory and history but eager to speculate, they hysterically warn of the Big Bad Ben causing inflation. Please don’t throw us in that inflation patch they cry, while buying gold and silver — holding short-term debt, buying that third rental property with 10% down, and investing in foreign debt. Most of all, the magic of inflation is their only way to shed debt without drastic cuts to their standard of living in retirement.
Governments use unanticipated inflation as their magic sauce for policy. Slowly accelerating inflation played a big role in evaporating the massive US WWII debt, reducing it from 108% of GDP in 1946 to 25% in 1975.
Now we’re primed and ready for it. Probably to be disappointed, since anticipated inflation has none of the magic we and the government hope for. See this post for an explanation why.
This is an update of the 22 February post More invisible signs of looming US inflation! The situation remains unchanged. Hysteria with little factual basis. Before we start, some important notes about this complex subject:
•There are good reasons to worry about future inflation. And future deflation. That’s a difficult aspect of our situation.
•No known metric reliably forecasts future inflation; data must be evaluated with respect to the overall context of macroeconomic conditions. These things are complex.
•Inflation is a monetary phenomenon. Rising raw material prices are not inflation. Also, raw materials are only a small fraction of end prices (e.g., raw food is only one-third of food costs, approx).
•Wages are a large fraction of end prices, and in real terms, they’re falling! Serious inflation is almost impossible without rising wages (people cannot pay the rising prices without more income).
•Increased private sector borrowing typically accompanies inflation. Outstanding consumer credit is flat (only education loans by the government are rising, much of which are the new subprime — almost worthless courses by for-profit schools). Bank credit is flat.
•The combination of rising sector prices, flat wages, and tight money is deflationary. As it was in 2008 (remember the big inflation scare, ending in a bust). We have the first two today; QE2 prevents the third. Without wage growth, rising food and energy consume more of people’s budgets — so expenditures on other things must drop. This looks like America today. For more see this post and this post.
•Inflation is rising in the emerging world, becoming a serious problem. That’s natural, as they’re growing rapidly (we wish we had such problems!), and many of these nations keep their currencies undervalued (see this explanation by Dave Altig at the Fed) . This divergence between the developed and emerging nations could force the long-expected decoupling, and perhaps a new world order. For more see this post.
Some indicators that can warn of inflation
2.Is the Fed printing money?
3.Measures of the money multiplier and velocity
4.Watch the dollar drop in value!
6.Direct measures of inflation
7.Why the hysteria about inflation?
8.For more information
(1) Monetary measures
In 1976 Milton Friedman was awarded the Nobel Prize for ”for his achievements in the fields of consumption analysis, monetary history and theory and for his demonstration of the complexity of stabilization policy”. Most importantly this, from The Counter-Revolution in Monetary Theory (1970):
Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. … A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society.
Friedman’s insight laid the foundation for modern analysis of inflation. It’s widely ignored in laypeople’s analysis of inflation, of the sort now flooding the media. Let’s look at some measures of the money supply. First, a reminder of some vital details:
•The supply of money is a concept; it’s not like counting apples. There is no one right way to measure it. Like the blind men examining an elephant, we must view it from different perspectives.
•Experts construct alternative versions of these measure to produce new perspectives.
•Private home-cooked versions abound of these measures. IMO most are worthless.
•These variables vary with statistical noise. Only the longer-term moves have meaning (at least, meaning that we can understand).
•Put these numbers in context; compare them to US GDP of $15 trillion per year, and global GDP of roughly $62 trillion per year.
As Friedman explains, the money supply must increase as the economy grows, despite the oft-hysterical warnings that the money supply has increased to a new high. Over time, growth of the money supply should be proportionate to the economy’s rate of growth (in the real world this is a lumpy process). Compare changes in the money supply to that of US GDP: in 2010 M2 was up 3.3% while nominal (current-dollar) GDP increased 3.8% (real GDP grew 2.9%, per the BLS). Totally normal.
(a) The adjusted monetary base
The adjusted monetary base is the monetary measure over which the Fed has the most control. Down 0.3% in 2010; up 142% during the last 3 months (seasonally adjusted, annualized rate). The Fed’s QE2 program frantically pumps money into the economy. So far most of it remains idle in bank reserves (for confirming evidence see the money multiplier and monetary velocity below).
(b) The narrow money supply, aka Money of Zero Maturity (MZM)
Money of Zero Maturity (MZM) is up 1.9% in 2010; up 4.6% during the last 3 months (seasonally adjusted, annualized rate). Quite appropriately growing at the rate of nominal GDP (the economy cannot grow without money).
The M2 was up 3.3% in 2010, roughly the same as nominal GDP. Up 4.2% during the last 3 months (seasonally adjusted, annualized rate). Quite appropriately growing at the rate of nominal GDP (the economy cannot grow without money).
(2) Is the Fed printing money?
We’re told that the Fed’s wildly printing money, causing inflation throughout the $62 trillion global economy. As shown in this graph showing the result, a gentle rise in the size of the Fed’s balance sheet. A few hundred billion since QE2 started — at that rate the Fed will have flooded the world with dollars – in a generation or so.
This expansion of the Fed balance sheet may have had (and be having) large effects on US domestic financial markets. As for the effect on world markets, the relevant measure to watch is the aggregate (total) action of the major central banks. Including the big one, the People’s Bank of China.
(3) Measures of the money multiplier and velocity
Increases in the monetary velocity and money multiplier are indicators of inflation, although explaining them is beyond the scope of this already too-long post. They’re now falling, suggesting deflation (data from the Fed). These might be the most important metrics to watch!
The first graph is biweekly through 6 April; the second is quarterly through Q4 of 2010 (expect Q1 to continue the decline of Q4). The M1 multiplier is the ratio of M1 to the St. Louis Adjusted Monetary Base.
Fed definition: “Velocity is a ratio of nominal GDP to a measure of the money supply. It can be thought of as the rate of turnover in the money supply–that is, the number of times one dollar is used to purchase final goods and services included in GDP.”
(4) Watch the dollar drop in value!
A falling currency can cause inflation. We often told that the US dollar is declining so fast it will soon be trash. As shown in this graph, showing the value of the US dollar vs. that of other nation’s currencies – weighted by US trade with each nation. Note the index is set for .
•After 24 years of decline the broad USD index is down aprox 4% (from January 1987); And down approx 2% since December 2009. Not exactly Code Blue!
•The USD is down big in terms of the major currencies (March 1973 = 100), or rather what were major currencies (and are now far less major).
•There are good reasons to fear that the US dollar might decline or even collapse in value. On the other hand, a large decline in the USD might (painfully) cure our persistent trade balance — making US goods and services again competitive on world markets. But it’s not the ideal medicine. Given the small role of imports, it would take a large decline to put strong pressure on US prices.
(5) Energy Prices
We are told that energy prices are skyrocketing! Here are three problems with this inflationary story.
•Petroleum provides 35% of US primary energy (see this EIA graphic). Natural gas provides 23%.
•The price of crude oil (West Texas Intermediate oil) is aprox $108, the same as in March and September 2008. Up approx 25% from year-over-year (YoY). And down from its spike high of $140+ in Summer 2008.
•The price natural gas is approx $4, unchanged YoY. Down from its 2003-2009 range of $5 – $9. And far below its spike peaks of $12-16
(6) Direct measures of inflation (updated with March)
Like most macroeconomic measures, inflation cannot be counted like apples. It’s largely conceptual, involving choices and assumptions. The Urban Consumer Price Index is a well-designed measure of inflation, implemented by grossly underfunded experts. We get the economic data we pay for, which is one of the great laws of economics. This shows the monthly rate CPI, seasonally adjusted and annualized.
The following graph shows the year-over-year change in the CPI, more akin to what we actually experience. Inflation is running at the low half of the last 30-years range.
(6) Why the hysteria about inflation?
There are few signs of imminent inflation, let alone the hyperinflation we’re daily warned about. Why do so many people feel that prices are skyrocketing?
•We are not mentally equipped to sense tiny changes in economic variables (i.e., 2% over a year), any more than we can sense a 2% change in room temperature if it happens over several hours.
•We grew up with inflation, and believe that it’s the normal state of affairs. So we suffer from confirmation bias. We see prices rising, but not those that are stable or falling (e.g., drugs). See Wikipedia for details.
•Perhaps the major factor shaping people’s perception of inflation: loud voices constantly blaring announcements of inflation RISING FAST. From experience with the now-closed comments section of the FM website, I can testify that no amount of data quenches the inflationistas’ belief of imminent hyperinflation. They seize on any evidence, however bogus, to demonstrate that inflation lies under the bed — about to pounce.
A recent example is the data from MIT’s Billion Price Project. It’s a bold and brilliant concept, probably of great long-term value. But today we buy only a narrow range of goods via the Internet, and almost no services. A survey of internet prices does not well measure consumer prices. Yet disinformation merchants cite it as a better measure of inflation than the CPI. So far the BPP Index tracks with the CPI goods-only index, although it is too new to draw conclusions. See Paul Krugman’s article for details.