The issue of inflation has remained an emotional topic of debate over the last several years. Views are harshly bifurcated among economic analysts regarding whether inflation poses any somber threat to the U.S. economy, but the question remains: could it happen? The obvious answer is "Of Course!" Anything can happen, but will it happen?
The Consumer Price Index, established in 1919 by the Bureau of Labor Statistics, is supposed to focus on inflation at the consumer level; tracking changes in prices of all goods and services purchased for consumption by urban households, i.e., the consumer basket. This promulgated index is broken down into two reports: Headline and Core. The difference between the two measures is that the core reading strips out the volatile food and energy components. It is this core reading that economists, and the Fed, focus on, but why? Simple -- because food and energy are the biggest part of almost any citizen's daily life.
The original calculation of CPI, which measured the change in the cost of an identical fixed basket of goods priced at usual market costs each period, worked reasonably well for the intended purpose into the early 1980s, but when the Clinton administration took office, the Bureau of Labor Statistics (BLS) changed the calculation of inflation by changing the weighting of goods in the CPI fixed basket. The primary result of the switch was a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price, subsequently leading to lower reported inflation.
Additionally, the BLS also instituted a system of "hedonic" adjustments. Hedonics adjusts the prices of goods for the increased pleasure the consumer derives from them. For example, the 50% more you paid for a cell phone last year did not cost you an extra 50% because the pleasure you derived from that fancy new iPhone you bought somehow suffices and offsets this real price increase. Yes, that is literally what "hedonics" is.
The problem with these manipulations is that the original purpose of the Consumer Price Index was essentially thrown away. Instead of being a measure of inflation from a cost-of-living perspective, the CPI was altered to a reduction-of-living index.
The chart above shows the original calculation of inflation (which was based on a basket of goods), versus the current measure of CPI. According to the chart, the Consumer Price Index (CPI) is understated by roughly 7% per year.
Just as rising prices for individuals and businesses can negatively impact their opulence, so too can it be a beneficial key contributor to profitable growth. Reported inflation has remained at very low levels (only a reported 1.6% in February), and some could speculate that this could be a contributor for the recent success of the market. With the Fed continuing to pump trillions of dollars into the financial system through quantitative easing, the fear of much higher inflation and the dollar becoming debased has caused gold prices to soar in recent years, despite a 7-month low in late February.
Much of the recent propagation about the fears on inflation and possible hyper-inflation has been born from the notorious quantitative easing program by the Federal Reserve. Even though this program could have a potential influence on inflation in the future, most people are missing the fundamental derivative of inflation: psychology. Various surveys and Treasury Inflation-Protected Security (GM:TIPS) market indicators have shown exponential increases in activity in recent months, representing an increase in consumer fear of future inflation. If people believe inflation will happen, it will. Worldwide news of rising commodity prices and rising wages in key nations such as China, Japan and India, could cause inflationary expectations in the U.S. to rise. If inflation picks up globally and makes headlines, we must pay attention and prepare for the succeeding ramifications.
For the sake of hypotheticals, I have come up with a few other reasons why we could experience inflation in the future:
- Government spending continues unabated, running up higher and higher deficits.
- To reduce deficits, taxation increases.
- As a result of high taxation, GDP declines, reducing tax revenues.
- The government floats even more debt to make up the new revenue losses.
- The Fed starts buying large amounts of Treasuries in order to meet revenue shortfalls and to "stabilize the market" (i.e., monetizing the debt for a different purpose than they are now doing).
- The CPI takes off as the new money hits the economy and prices rise.
- The debt is not being paid down with inflated dollars.
- Other major nations become fiscally more conservative, thereby reducing the U.S.' status as the reserve currency.
- U.S. sovereign credit ratings are downgraded.
These circumstances would likely lead to high inflation and panic in the bond markets especially, but as mentioned in the foregoing paragraph, inflation would most likely be the cause of global market influences and significant changes in consumer sentiment.
Will It Happen?
Inflation in any economy is almost undeniably inevitable -- unless you're Japan -- but just how severe is anyone's guess. While I don't believe that inflation is a major threat to our economy in the coming months, it definitely could become a considerable issue over the next few years. With that said, I certainly do not claim to have any clairvoyant qualities, but I do think it is crucial for us to pay attention to economic activity, not just domestically, but around the globe. The recent increase in TIPS is quite foretelling of current consumers fears, and the higher-than-expected Core CPI reading for January should be a concern for the Federal Reserve.