Waiting for Inflation? It May Take Awhile

Talk of the inevitable incoming inflationary spike has increased as gold broke through $1000 an ounce, Chairman Bernanke discussed the Fed retracting liquidity and money supply surged. Of course this chatter has spilled into the bond market and is one of the legs of the “short the bond bubble” theme. However, a close inspection of the mechanics of inflation suggest that it may be a long time before we have to worry about rising prices.

Inflationary pressures are generally attributed to too much money chasing too few goods. The monetarists have focused on the recent massive spike in money supply, specifically monetary base. The argument goes that eventually that money will find its way into the hands of consumers who will begin to purchase goods. These purchases will prompt factories to ramp up production. In the process of increasing production the factories will demand more raw materials which will lead to supply shortages. More demand chasing the stagnant supply will lead to inflation. The following hockey stick chart has the Chicago crowd sweating in their Bears jerseys.

click to enlarge

The narrow view of simply observing money supply assumes that producing more goods requires more resources, but that is not always the case. We must also take into account the stage of the business cycle and the ability of the economy to produce more goods with current resources. One tool for measuring this is capacity utilization, which attempts to determine the percentage of “normally” operating US factories. Currently capacity utilization is running at roughly 74%; the highest level of capacity utilization in the last 36 years was 88.65% in October 1973. The implication is that the economy has plenty of slack in the system and could produce more given current resources.

Another way of measuring the production potential of the economy is the output gap. The output gap is the difference between the estimate of what the economy could produce and what the economy is actually producing. The “gap” between potential and actual output is a measure of tightness or slack in the economy. The Congressional Budget Office (CBO) produces a reliable estimate of the full potential of the economy. If the economy is producing at or above the estimated levels then businesses must increase consumption of resources, i.e. raw materials and labor. If the economy is producing below potential, then companies do not have to chase after supplies or add workers.

The US economy is currently in a period of significant slack, therefore even if the Federal Reserve’s liquidity injections do create demand, there is plenty of slack in the economy to soften the inflationary implications.

The chart above illustrates both the output gap and the change in CPI since 1967. The output gap is calculated by subtracting the CBO estimate of GDP potential from actual GDP.

Currently, the US economy is producing well below potential output, resulting in the highest output gap since 1967. The chart also incorporates CPI as a measure of inflation. Looking further into the relationship we find that output gaps lead to disinflation and when the economy is producing more than potential estimates, inflation follows.

The table above tracks all the output gaps, showing inflation peaks and troughs from 1967 to present. Since 1967, inflation has only occurred after an output gap trough, i.e. when the economy was producing more than estimated potential. In those cases, inflation peaked between 6 and 22 months later. The exact opposite occurred when the economy was producing less than potential. Since 1967, there have been five output gap peaks, and in all five instances disinflation resulted. Moreover, this disinflation continued for 9 to 29 months.

Currently, the US economy is operating with a record output gap. If by some miracle the economy recovers tomorrow, then we could expect at least nine months of disinflation and then another 6 months before a spike in inflation.

Since this appears to be the worst economic crisis since the depression, it is reasonable to use the extreme estimates. That would mean 29 months before an end to disinflation and another 22 months before a peak in inflation. For the calendar-challenged, that is over four years before any serious inflationary risk.

Of course there are many other reasons to short bonds (including an increasing supply), but those who are betting on inflation better get a good book, because it is going to be a long wait.

Disclosure: I am long Treasury Bonds.

Comments

[jswede:]

good article.

imo, the short of it is that the deflation we are seeing now in asset prices, as well as the winding down of leverage and more conservative lending (lower multiplier effect) are being severely underestimated...

inflation will only take hold to the extent that money supply EXCEEDS these incredibly huge deflationary forces.

Feb 25 09:38 AM

[Hmm?!:]

Hold on Brian. I am not sure about your article.

Waht about the fact that a large portion of US consumption is imported?
What about external demand for resources? What about a devalued dollar increasing the cost of both items above?

CPI? Please confirm you did not use the core CPI, which excludes everything that experiences price spikes.

Feb 25 09:42 AM

[bricki:]

While there is really nothing in recent US history to compare to the current situation, there is a model to look at that is quite similar outside the US - the 1980's Japanese real estate bubble.

They ended up with a lot of debt, but no real inflationary spike.

Feb 25 09:58 AM

[Brian Kelly:]

CPI - I did not use core CPI - I have never understood why the Fed focuses on core numbers --- if oil and food go up, I still have to eat and drive my car, so I can't exclude them, it does not make sense to exclude them from policy decisions.

Imported Consumption - as with any economic analysis, looking at one number in a vacuum can be dangerous. I am just presenting one part of the equation -- although it is a big part.

I think the bigger risk to my argument is increased consumption from China, which I assume you are referencing when you ask about "external demand". If the Chinese stimulus package succeeds in creating internal demand in China then all the spare capacity we have is not going to matter.

For now my chips are placed on weak exports keeping Chinese demand in check...but in these markets...things seem to change literally overnight.

Thanks for the comment.


On Feb 25 09:42 AM Hmm?! wrote:

> Hold on Brian. I am not sure about your article.
>
> Waht about the fact that a large portion of US consumption is imported?
>
> What about external demand for resources? What about a devalued dollar
> increasing the cost of both items above?
>
> CPI? Please confirm you did not use the core CPI, which excludes
> everything that experiences price spikes.

Feb 25 10:40 AM

[Brian Kelly:]

yes--i agree that the last 50 years are not the best reference for what we are experiencing. We are experiencing something as bad or worse than the depression.

However, what the last 20-30 years does have is a central bank that actively targets inflation - and central bank policy has had a major impact on inflation. If you look at the chart of CPI you can see that since Volcker made it popular to stamp out inflation in the 1980's we have not seen extreme spikes.


On Feb 25 09:28 AM User 143167 wrote:

> What you should really look into in 1930s and 1940s, when interval
> between monetary inflaiton and CPI inflation was short. Also you
> can look into the age between 1870s and 1920s, the intervals were
> even shorter.
> We are now in a scenario that you can't find reference in the past
> 50 years. So I would skip over those decades.

Feb 25 10:45 AM

[mcadoo3312:]

Overall I understand where you are coming from, but some of your points are flawed. Using the M2 money supply growth isn't a great indicator of future inflation based on the nature of its calculation. To me, this increase is more based on investors fleeing to cash and money market accounts. There is a reason the chart above is beginning to flatten; the majority of panic selling occurred in October and November of last year. Volumes on selloffs are decreasing, indicating this mania is beginning to subside. M3 is no longer reported, so the effects of governmental spending is not quantifiable.

That being said, for consumers, it is the velocity of money that will catalyze inflationary growth, as evidenced by CPI, in the short term. This is no where near the problem we will face when the massive Treasury issuance, especially in the short end of the curve, comes due. Combine this with all of the other issuance around the world and one must ask where the buyers are going to come from. Not everyone can rely on China. The real inflationary problems we face have been pushed off further down the road, and they are much worse than whether or not the Fed can get the liquidity they have put in the system out of it.

Feb 25 10:49 AM

[softomic:]

I may be in the minority, but I am looking forward to seeing rising inflation. It will mean to me that the money apportioned for the economy is actually being used and the recovery is, at least, in progress. As long as we muddle through these uncharted waters (uncharted is right), there is no clear direction of where the economy is headed. I haven't seen a chart in months that doesn't contradict common sense.

Feb 25 11:02 AM

[Mad Hedge F...:]

If you believe that imminent and massive Treasury issuance is going to pop the Treasury bond bubble, and that Obama’s reflationary policies are long term inflationary, you have to be looking at Treasury Inflation Protected Securities. TIPS offer investors a US government guaranteed protection against future price hikes by raising the principal in line with the inflation rate. A 3% coupon TIPS facing a 10% inflation rate automatically boosts the face value of your bond from an issue price of 100 to 110, giving you a total return of 13%. You can buy these directly from the US Treasury, or buy the iShares Lehman TIPS Bond Fund (TIP). The best time to buy flood insurance is at the end of a long drought.

Feb 25 11:40 AM

[Dirk McCoy:]

The sooner we're actually confronting inflation and any need to increase supply capacity, the better- for those who care about the broader economy, anyway.

Otherwise, we'll be looking at more and more federal government control of our economy.

Feb 25 12:14 PM

[Bocaboym22:]

There is a reason that the dollar is rising, it is the same reason that there will not be hyperinflation. The spending of the US governemt will never match the drop in market value and home values seen in the US. Therefore the government spending will never lead to more dollars in circulation. In fact there are many less dollars available to spend because of the drop in assets. People missed the hyperinflation, it already happened, and no-body is talking about it. The dollar dropped to about 1.60 to the Euro. I live in Europe I saw the drop. The doubling or tripling gas prices in the US o while gas only went up 30% here. Oil at 150 dollars a barrel. This was the effect of all the FREE money created by the housing bubble and the credit swaps and the low interest rate. The reason the dollar is doing well, and that Asia is willing to borrow more dollars, is that there actually are "less dollars" (less money available for us to spend) now that 3 years ago. But this is only good for people with money and jobs. The hyperinflation will not happen because people will not have money to spend.
My suggestion of how to fix it. . . .DO NOTHING!
There is no gain without pain. Maybe this will teach the spoiled American and 2nd generation chirldren to work a bit harder and study a bit longer. And maybe it will teach the unions that if you ask for too much you get nothing as the job is shifted overseas. Maybe the true story of the global economy is that you have to move to where the jobs are. Not being lazy sitting in a home you cant afford having 16 children and invetro fertilization while you are on Social Security.
Get real, grow up, be strong like our grandparents! It is funny the day our first lady was finally proud of her country was the first day I was ashamed. Times are tough, things are bad, vote in the socialists who will give out free stuff for everyone! Do not worry about we will let the rich pay for it. As for bailing out wall street, at least at one point the banks and wall street had and made money. UNLIKE ALL THE PEOPLE WHO GOT SUB-PRIME MORTGAGES!~

Feb 25 02:06 PM

[E.D.Hart:]

There is much truth in your article, but I think that a previous response has a good point--its not just money supply but money supply plus velocity. When velocity picks up, inflation should pick up

Also, because Japanese debt bubble popped during a time of booming markets elsewhere...Japans experience may not be the best analogy. Todays debt crisis is global ---and global liquidity is being ramped up simultaneously.

Finally, I think you may have the causal relationship reversed between slack and liquidity:
"Looking further into the relationship we find that output gaps lead to disinflation and when the economy is producing more than potential estimates, inflation follows."
It seems more likely that falling money supply leads to output gaps, and that aggregate money supply growth plus velocity acceleration (inflation) leads to a pickup in economic activity.

Correlation is not causation.

Feb 25 04:26 PM

[ArtfulDodger:]

Agreed! Good points all. And I hope you're right on the wait on asset price appreciation.

Feb 25 04:45 PM

[abetterplace:]

Forget all the BS of charts and graphs. Neutralize the value lost on real estate.
You spend the same amount of money to live on now as you did before your house value dropped 35%. Inflation is well under way. Look at anything that is an
assumed or real necessity for living. Your utilities,insurance, food, clothing, etc. It is all screaming higher. If you are just now getting ready for inflation, you are late.l

Feb 25 05:49 PM

[Bartlesby:]

We must also consider the possibility that these shifts in short run supply and demand are structural and not just cyclical, in which case we are witnessing a reduction in long run GDP supply (i.e. potential output).

If this is the case, your output gap discussed here may actually be smaller than you think.

Feb 25 06:41 PM

[Brian Kelly:]

Bartlesby

That is a very good point, the destruction of financial system as we know it will likely have impacts not considered. For example, how much did securitization contribute to GDP and the potential GDP estimates.


On Feb 25 06:41 PM Bartlesby wrote:

> We must also consider the possibility that these shifts in short
> run supply and demand are structural and not just cyclical, in which
> case we are witnessing a reduction in long run GDP supply (i.e. potential
> output).
>
> If this is the case, your output gap discussed here may actually
> be smaller than you think.

Feb 25 06:49 PM

[Tony Petroski:]

Anecdotally: I just saw an add for fish filet sandwiches from McDonalds, their annual lenten offer. Last year it was two for two bucks. This year, two for $3.33.

Feb 25 08:10 PM

[Moon Kil Woong:]

The reason for no inflation right now is lack of demand more than bank hoarding cash, etc. I agree as long as demand stays low large jumps in inflation will not occur unless stimulated by trade wars or other dramatic outside forces.

However, the oversupply of money into the system can easily overwhelm the system when inflation rises. It takes months to increase supply of raw materials and then for goods to ramp up and arrive on shelves if demand rises. Likewise, with so much of our economy based on services, a rise in demand must be offset by increases in labor as much as factory utilization rates. Even though there may be many unemployed people, unless the demand is for basic labor it can take years to fill that demand.

There are numerous factors that can lead to shortages beyond this. Simply put, the Fed and government always say they can control inflation and effectively fight economic downturns. We are finding out how untrue the second government assurance is. When inflation heats up 2 or 3 years from now I think we will find how untrue the government's first assurance is as well.

I just don't buy the fact that the market will automatically add labor and production as fast as the government can and has flooded the market with cash to bring the supply and demand line into balance without inflation. It seems patently implausible.

Feb 25 11:48 PM

[kelm:]

Good article and a very good comment stream. I think the biggest problem people have when considering inflation in our current environment is "where does it come from?" With the large level of unemployment and massive drops in housing and commodities it is hard to imagine.

There are a few clear paths though:
1) as stated in the comments, we import inflation from China as their stimulus takes hold. Remember we imported deflation for many years and loved every minute of it.

2) The economic crisis forces the closure of mines, farms, oil capacity etc. causing supply restrictions and in turn driving the price up. The credit conditions, rising rates, and increasing uncertainty of paper currencies ensure that capacity isn't re-expanded as prices rise.

3) The massive monetary increase "finds a way" to leak into the system and drive up prices. This is the 30,000 foot view. It will cause inflation, the exact mechanism is merely interesting.

It is interesting that only a few weeks ago deflation was all the rage and now the Fed releases an inflation target. "Oh, we won't need it for ages. This is just to communicate better with the people..."

Uh,..yeah...

Feb 26 11:40 AM

[Chris B:]

I think the author's visual (not mathematical) correlation of inflation with the output gap is intriguing, but certainly not sufficient evidence to make predictions, as he has done. Are we to assume that government actions regarding interest rates and open market activities are irrelevant? Are oil prices irrelevant (were they irrelevant in '73?)?

Two decades of inflation almost entirely constrained within the ideal 2-4% range suggests that the federal reserve has learned a thing or two about managing money supply since the early 80's. Despite the occasional outlier period, such as 1990 or 1st half 2008, their adjustments have quickly been successful. Is that 2% nominal yield you are earning on 10 year treasuries enough to compensate you for the risk of a treasuries price collapse that will occur if you turn out to be incorrect about inflation and future yields?

Also, since housing is such a large component of CPI, wouldn't we expect an utter collapse in housing prices to have a disproportionate effect on CPI? Are you misinterpreting CPI as a sign to buy ultra-low-yield treasuries, when in fact you are just witnessing the statistical effect of the housing bubble popping?


Disclosure: up 14% on TBT in 2 months

Feb 27 02:19 PM

[zapzappa123:]

Overly academic

Every country in the world has announced stimulus plans,to the tune of several trillion dollars, lowered rates and printed money, the world will soon be overflowing with money as these stimulus packages are put into effect
Banks all over the world have been given trillions of dollars which they are now hoarding but as soon as they see the slightest sign of recovery (and they will when these plans start going into effect) they will begin lending because thats what banks do, they lend money, earnings will improve and commodity prices will creep up and everyone will jump into the market with a vengeance, interest rates will soar, the us dollar will collapse and commodity prices will also soar as massive inflation kicks in,

Mar 02 07:55 PM