Inflation, Not Deflation, Is Our Ultimate Problem

The U.S. Producer Price Index (PPI) and Consumer Price Index (CPI) both fell in October. Those declines – combined with sharp downward spirals in worldwide stock and commodity prices – have caused many analysts, and even central bankers, to worry that we are on the brink of deflation.

Such concerns may be warranted in the short-term. But in the long run, deflation won’t be the challenge we face.

Thanks to an overly aggressive central bank, and more than $1.5 trillion in U.S. Treasury Department bailout programs – as well as other factors related to the ongoing global financial crisis – inflation will be the problem that ultimately bedevils us.

As long as oil and commodity prices drop, the PPI and CPI indexes, which include oil and commodity prices, also will fall. Such a decline, however, does not constitute deflation; it is simply a one-time price adjustment. This is particularly true if most of the commodity-price declines are simply a reversal of excessive increases that had occurred over the previous year. That’s essentially what we’ve been seeing here.

However, the deflation believers currently have an additional argument: With output in the United States plunging, and the stock market down around 50% from its October 2007 peak, there are very few pressures pushing prices upward. For instance:

• Manufacturers, facing sudden sales declines, cut prices in an attempt to clear inventories or engage in foreign sales drives, intensifying price competition in all markets.
• Nobody is pushing for wage increases – folks are all too pleased to keep their jobs, and their employers know this.
• So while the U.S. economy is declining sharply, prices will not increase significantly and may even decline.

But even this will not turn into deflation, unless the recession is exceptionally prolonged. Currently, output and employment are dropping very sharply, as is the stock market. This cannot continue for more than a few months – the latest being perhaps late spring of the New Year. As output declines, forces pushing it towards recovery will become stronger and equilibrium will appear.

Provided world trade remains open and healthy – and doesn’t plunge by 60%, as it did during the horrid stretch from 1929 to 1932 – we will avoid a second Great Depression, so the bottom in output cannot be all that far down, and will be reached relatively quickly.

Since inflation was running at more than 5.0% when output began its steep descent, it is unlikely to have turned significantly negative by the time the economy reaches bottom. After all, the so-called “core” PPI rose at a rapid clip of 0.4% (equivalent to 5.0% per annum) even in October, while the Cleveland Fed’s “median” CPI, which smooths out fluctuations, rose by 0.1% in October and 3.2% over the past year.

Once the bottom has been reached, the excess liquidity that has been created over the last few months through the various bailouts – such the Treasury Department’s $700 billion Troubled Assets Relief Program (TARP), which is fueling bank takeovers, and not expansionary lending, and the follow-on $800 billion credit-market stimulus unveiled late last month – will combine with the huge federal budget deficit to spur inflation. By that time, discounting will have become much less prevalent, as the most aggressive discounters will have gone out of business and inventory excesses will have been worked off. Costs will have increased, since many producers will be operating well below capacity. And the excess money supply will push up inflation.

This time, there will be no surges of foreign competition restraining price increases – Chinese producers are currently suffering high inflation in both wages and prices, so their sales prices are increasing fast.

To estimate the inflation rate we might see, you can look at money supply growth over the past year. The St. Louis Fed’s M2 money stock, the broadest money supply growth now reported by the U.S. Federal Reserve, has increased by 10% over the past year, while the St. Louis Fed’s Money of Zero Maturity (MZM), the nearest we can get to the old M3, has increased by 7.4%.

Both those rates are far higher than the increase in nominal Gross Domestic Product (GDP). In fact, money supply has been increasing about 65% faster than GDP since 1995, which is when former U.S. Federal Reserve Chairman Alan Greenspan began to overly relax monetary policy. In the most recent two months, MZM has risen only modestly, at a 3.1% annual rate, but M2 has risen much more rapidly, at a 20.6% annual rate. (The difference between the two figures reflects quirks produced by the various bankruptcies and bailouts – for example Washington Mutual Inc. [OTC: WAMUQ], nominally a “thrift,” has been taken over by Bank of America Corp, (BAC), a bank).

In any case, it seems likely that inflation in the 7%-10% range lies in our future once output stabilizes. The deflationists here have a huge problem: Their view of falling prices is in incompatible with swiftly rising money supply, so only a sharp fallback in money supply, which we are not seeing, would make deflation plausible. The Fed has been blamed so widely for not expanding money supply fast enough during the Great Depression, that it is showing every sign of making the opposite error now.

If inflation does return with renewed force, we need to invest accordingly. One way of doing so would to use Treasury Inflation Protected Securities (TIPS). TIPS yields have recently risen, as investors have focused on deflation. Indeed the 10-year TIPS currently yields 3.11%, only 0.08% lower than the 10-year conventional Treasury, so the market is saying inflation will average 0.08% over the next 10 years. That’s nonsense, and such a mispricing makes TIPS an attractive investment, even though conventional Treasuries are vulnerable.

Another investment that benefits from inflation is gold, which has declined in price, albeit less than oil, and is currently selling around $770 per ounce. If inflation is expected to take off, gold prices will rise sharply, and a gold price of $1,500 per ounce is by no means out of the question. The most efficient way to buy gold is through the SPDR Gold Shares ETF (GLD).

Original post

Comments

[PastTense:]

TIPS don't accurately reflect inflation. They use the same misleading government inflation numbers which understate actual inflation rates.

2008 Dec 03 09:25 AM

[Alex Filonov:]

Money supply is only one variable in the equation. Velocity of money is another. Velocity is down a lot, that's deflationary.
I'd like to know what forces are pushing towards recovery. I don't see any right now.
Deflation is much harder to defeat than inflation, just take a look at Japan in 1990s (and picture in later years is not pretty either).

2008 Dec 03 11:25 AM

[Chris B:]

Do you have a better plan for measuring price levels? CPI is based on a monthly survey of what consumers actually buy and excludes only those items that are too volatile to provide good information about currency value. Extreme efforts are gone through to account for improvements in technology, seasonality, and outliers.

If you can come up with a better way, you might as well put it in a dissertation and earn your PhD in economics.


On Dec 03 09:25 AM PastTense wrote:

> TIPS don't accurately reflect inflation. They use the same misleading
> government inflation numbers which understate actual inflation rates.

2008 Dec 03 01:12 PM

[Czar:]

Perhaps Mr. Greenspans mental picture of inflation maintainance during his tenure was really a misunderstood effect of productivity growth which is not properly understood by economists in general.

Japans level of process automation was the cause for it's deflation. In response to the lower price pressures more automation was built to maintain corporate profits which in turn led to higher levels of unemployment. The common thread is that Japan's economy was the first truly moden economy to substantially produce more than it could consume.

A more accurate understanding can be achieved through a look at the percentage of Americans and to a greater extent the level of factory automation has reduced the value added sector of the economy to 10% of the population. There is a popular misconception that the Chinese economy is dependant on large numbers of unskilled workers. Although this is an accurate picture of China 15 years ago they have made relentless advanced cap-x investments that have made them largely as efficient as us in many manufacturing areas and more efficient in some.

In short, we produce more than we need as a global society and don't have enough people involved in those processes. You can only have so many individuals involved in service and government before the value added chain gets disturbed and deflationary pressures overwhelm inflationary ones regardless of the amount of fiat currency printed.

I point to the deflation in the cost/performance ratios of virtually any technology which in iteslf is a deflationary influence as it is a powerful first order feedback amplification loop. I point to the ratio of discretionary vs. non-discretionary spending which has exploded (excluding housing)that is not only an American past-time but has become a global one. Perhaps Greenspan saw this macroeconomic effect and never understood the causal relationships with efficiencies as they include service sector effects that dissapear with discretionary purchasing power.

Expansion of the money supplies was the only thing keeping it afloat, and yes it caused an inflationary bubble in commodities and real estate as these areas were not demand driven or manifested short term volitility which people couls clearly see until recently, but real estate kept a lot of people off the street as it is difficult to automate the fabrication of stick built houses.

People always forget that wealth is not created by any other mechanism that production. Do not confuse transferrance or currency exchange for wealth in a macroeconomic system sense.

I wish everyone good luck. I am going to toiling over developing my next industrial automation project.

2008 Dec 03 02:15 PM

[Chris B:]

1%,

You're not the first to feel that way...

en.wikipedia.org/wiki/...

2008 Dec 03 05:07 PM

[Tony Petroski:]

I agree with the author, inflation, not deflation, is in our future (we will start to see furrowed brows at the Fed and callls to raise interest rates before the end of 2009). The author recommends gold. What about good old Real Estate? All those "toxic" assets and those who hold them will become the toast of the town.

2008 Dec 03 07:29 PM

[Long Silver...:]

Your explanation of technological innovation in Japan as causing the reported deflation is interesting. So Obama would be correct in funneling money into infrastructure improvement, as it's something (like housing) that can't be automated or outsourced?

2008 Dec 03 07:48 PM

[ozcutty2:]

Funny how the market is currently shunning stocks that hold debt. But if we inflate, debt is good

2008 Dec 04 11:27 PM