How Is Inflation Related to CPI?

When Milton Friedman said that inflation is purely a monetary phenomenon, he was 100% correct. Yet, the general public's understanding of the term inflation leads to some confusion.

Over the past 12 months I have read an exhaustive amount of articles and commentaries on the CPI's inability to truly track inflation. This has never sat well with me. Although I agree that the Fed shouldn't be using CPI to gauge inflation, I don't believe it has anything to do with hedonic regression or conspiracies about the Treasury not wanting to increase payment on TIPS. Instead, I have always believed that the main component that moves consumer prices is consumer demand and producer supply. The level of money creation and the debasement of the currency is in no way represented in the CPI figures - or is at most a small component.

Can inflation rise as CPI falls?

Many people have complained that inflation has been rising as the CPI has been trending lower. In reality consumer prices have been trending lower and will likely continue to do so. The main driver of increased inflation expectations by the general public was rising commodities. From a monetary perspective, what percentage of that increase was due to currency debasement and what percentage was due to increased demand and waining supply? The inherent volatility in energy prices leads the Fed to use 'core cpi', but that doesn't get to the root of the problem. This 'core' basket is also subject to supply and demand trends.

Let's look at the Current Situation

The money supply is being expanded (Fed moments ago reported M1 rose $31.4B + $60.9B w/w). Should this credit find its way to market, this is inherently an inflationary development. I want to focus on consumer prices, but you can read more about credit reaching the market. For now let's assume this is inflationary. Let's look at the other side of the coin.

Consumer prices are falling. Clearly housing prices are falling, as is gas and food prices - at least from their highs. It's also as cheap as ever to get a car if you can find financing. Consumer credit is hard to find - the mailbox isn't stuffed with pre-approved credit cards any more. At the end of the day consumers are strapped and competition on the corporate side is increasing to keep business. This is resulting in price cuts for shoppers and smaller profit margins for corporations… hence the stock market where it is today.

Baltic Dry Index

Nowhere is this more clear than looking at the Baltic Dry Index. This index looks at the cost of shipping raw materials by sea but is a good gauge of international business in general. Earlier this year we hit a high of over 11000. At that time, businesses were really worried about inflation as the cost to ship goods from China had risen substantially. In hindsight that should have been a really bearish indicator as extremes usually are. Taking a look at the chart below you can see how demand for this service has dried up as countries like China have significantly slowed their purchases of raw materials. My point is that significantly cheaper shipping rates can easily be passed on to the consumer as companies struggle to keep business.

Treasury Inflation Protected Securities (TIPS)

Take a look at Friday's chart of iShares Lehman TIPS Index ETF. This ETF holds a basket of varying maturity TIPS. As you can see, there has been a rapid decrease in the price of TIPS which has accelerated in recent days. This is clearly not a market worried about rising consumer prices. Remember TIPS are CPI indexed.

In Summary

It is very likely that we see lower consumer prices moving forward. If you think about the bulk of your expenses, all of them have likely been reduced by falling housing and commodities prices. This is in an absolute sense. The underlying debasement of the currency can only be thought of in a relative sense and that is that goods that will suffer demand destruction won't fall to their pre-debasement levels.

Comments

[xpatUSA:]

If people, including the author sorry to say, would quit using the word "inflation" by itself without a qualifying phrase, we would all get a better understanding of what is meant.

While the Victorians were verbose and flowery in their prose, at least they did use full, grammatically correct, sentences and their meaning was, by and large, quite clear.

In modern times, we have to shorten everything down and use acronyms to the point of being meaningless to outsiders and to the point of ambiguity to insiders.

Don't even get me started on the disappearance of the hyphen ;-)

T.C.

2008 Oct 12 10:53 AM

[xpatUSA:]

Sorry, I forget to mention that the article itself was most informative!

(blush).

T.C.

2008 Oct 12 11:03 AM

[CLH:]

Very good article Adam. However, there are many who are buying gold expecting inflation. When debt is destroyed, money becomes dear causing the dollar to go up. We are in a disinflation the same as US 1930s and Japan 1990s. Gold will go down as do commodities .

2008 Oct 12 12:18 PM

[Jimbo:]

I gather that Mr. Katz is implying some form of deflation although he has not used the word. My fear is that we are looking at a form of stagflation. Prices for many goods and services may decline but people may not be able to afford them and state,local, and federal taxes rise to pay for the killer debt.

2008 Oct 12 12:33 PM

[gap:]

The article draws the wrong conclusion from the decline in the investing in Treas. Protect. In. (TIPS). I sold my investment in TIPS because the inflation factor used is the phony one created by the FED, eliminating fuel costs and food costs. Thus TIPS doe NOT reflect the CONSUMER pprices since us consumers continue to buy fuel and food. The TIPS yield is not a true reflection of the goods and services I buy. other investors are also wiseing up and selling their fraudulent TIPS investments.

2008 Oct 12 01:02 PM