Inflation? Sminflation!

Includes: DIA, QQQ, SPY
by: Daniel Carroll

I think I have read more articles predicting inflation than on anything else. We even hear the term "stagflation" bandied about. Better get out your bellbottoms, because it seems the 70's are back!

First, what is "stagflation"? This is a term that was coined in the 70's that described a situation where inflation and economic stagnation (recession or slow growth/high unemployment) occurs simultaneously, something which was not supposed to happen. Everyone assumed that inflation goes with economic growth and disinflation/deflation goes with recession or depression. Indeed, that was the prevailing economic theory in the 40's and 50's, and was based on prior experience with the gold standard and subsequently with the Great Depression.

Milton Friedman's Monetary Theory first disproved the link between economic growth and inflation. The experience of the 70's and subsequent decades provided sufficient empirical evidence to debunk the idea.Monetary Theory states that inflation is always everywhere a monetary phenomenon. It actually goes on to say that high inflation or severe deflation can cause economic disruption, decline, and unemployment. Recent theories such as rational expectations further explain why that is so. Thus, "stagflation" is normal. A stable money supply is necessary for healthy economic growth.Unfortunately, in a complex economy, that is hard to achieve. Indeed, measuring inflation and monetary growth is a challenge.Thomas Tan pointed out recently that the CPI (consumer price index) is a flawed inflation gauge. Indeed it is, which is why most economists don't pay very close attention to it.

In the 90s the argument was that it was overstating inflation because it failed to capture technology-related deflation (the price-performance ratio of computers supposedly declines by about 25% per year). Thus, the CPI was adjusted - it is always easier to adjust these indexes down than up: downward adjustments mean less expense for the government.

I've also heard arguments that CPI understates inflation because it doesn't fully reflect healthcare and educational inflation, and now there are arguments that it doesn't accurately reflect home ownership costs (aren't those going down?) or that excluding food and energy from it is not rational. There will always be reasons to find problems with the CPI, and the flavor of the moment will color the arguments one hears.

The reason that some commentators look at CPI excluding food and energy is because those inputs are volatile, and month-to-month movements are not that meaningful. They are important inputs into the economy, but they should be looked at in different ways.Of course, all of the other measures of inflation are flawed as well. I read a compelling argument a while back that the best measure of the money supply, and hence the best predictor of inflation, is the aggregate debt levels (private and public) plus cash. I didn't take time to investigate the author's evidence, but it certainly makes a lot of sense and he made a compelling case.

There are two kinds of inflation - the kind that you as an individual face in your personal expenditures, and the kind that the economy faces in aggregate. You individually are probably most concerned about the first kind. However, the Fed is most concerned about the second kind. At any given time, there are items in the economy that are inflating in price, and there are items that are deflating in price. For instance, in Target's recent conference call, they indicated that they are seeing inflation in some categories and deflation in others.

Currently commodities (gold, oil, etc.) are inflating. Real estate is deflating. Food is (mostly) inflating. Clothing is flat, with declines offset by the falling dollar. I believe that we are currently experiencing a speculative bubble in commodities, which is in part driving down the dollar and driving up international investments.

Gold prices have nearly tripled in 5 years, with most of the move in the last two. If gold is such a good gauge for inflation, that means that we have experienced 35% inflation in last 2 1/2 years. We can debate 2% versus 4% versus 8% inflation, but that fails to explain the recent runup in commodities. Commodities, historically very cheap, go up in price any time there are demographic changes in the world economy. In the 1970's, the baby boom came of age and women entered the workforce en mass. This put pressure on consumption, particularly raw materials but not services (since the increase in labor offset the increase in demand for services), and increased demand for highly skilled labor. Labor unions went into decline as they found their negotiating position weakened. As boomers had children, that put pressure on the educational system. The higher wages for skilled labor increased demand for colleges, driving up prices there.

As boomers aged, their consumption peaked and tapered, just as commodity supply increased, and commodity prices collapsed (and with it the Soviet Union, a major commodity producer). When boomers started looking at retirement, they started looking at ways to get rich, investing first in the stock market and then in real estate. As boomers actually retire, they will continue to cut back on consumption, increase health care spending, and save. Thus, health care prices will continue to rise, and (real) interest rates are likely to stay low. Entertainment and travel will be the consumption of choice.

We are now in the midst of another huge demographic change. Industrialized economies are experiencing declining population (the US the exception due to immigration). A billion people are on the move around the globe, placing unique demands on infrastructure and urban-planning, shifting labor constraints. China, India, and other nations are industrializing, and thus putting pressure on commodity prices again. China, with its demographic time bomb, started the trend and will likely go through a cycle similar to Japan (with more extremes, with their own centrally-planned idiosyncracies, and with the added complexity of significant migration).

India will grow more slowly, but perhaps more sustainedly (they lack the urgency, have more complexity, and can't dictate economic change from the top). As always with change, the market goes to the extreme, extrapolating current trends well into the future. The demand on commodities will continue, but alternative supplies will emerge. Thus, the spike in commodity prices has exceeded what could be explained from increased demand, in my opinion.

Oil companies' long term planning is for $40-$50 oil, not $100. The spike in commodities has both been fueled by and caused the collapse in real estate prices. Residential housing prices are a function of three factors over the long term: interest rates, acquisition and building costs, and commuting costs (both gas and time). In recent years, interest rates went up, gas prices went up, commute times rose, and building costs went up. It was only a matter of time before the real estate bubble gave way to reality.

I don't know how long the commodity bubble will last. I don't know what will cause it to deflate. In the early 1980's, the Fed raised interest rates and caused a severe recession, and commodity prices collapsed. Perhaps he will be forced to do that again, though it's not yet clear that that is the case. One other note: there is periodic commentary by some that the US should go back to the gold standard for currency. Until the early 70s, the US had (supposedly) linked its currency to gold, though somewhat haphazardly in the 20th century up to that point.

Milton Friedman has some good books on monetary history (Money Mischief, and Monetary History of the United States), where he chronicles the gold and silver standards. As much as I would like to get the government out of the equation, I don't believe it is practical or possible to go to a gold standard. Besides, why gold? Friedman points out that there is a tribe in the Pacific that uses rocks as their currency. Perhaps the government can't manipulate gold, but other market participants could. The Spanish and many of African empires collapsed a few centuries ago partly because of a significant increase in the world supply of gold, upon which their wealth was based. So much for a long-winded discussion of inflation. But that is my two cents worth.