What Is Not Seen

Recently we saw inflation numbers; both CPI and PPI reach record high levels. The consumer price Index in U.S. showed its biggest yearly gain since 1991 with a 5.02 percent increase since last year. Some analysts have correctly noticed how monetary inflation, measured by MZM (Money with Zero Maturity) has decelerated some what during the last couple of weeks.

Now, the million dollar question seems to be: when will price inflation slow? Looking around, we see a mixed bag of forecasts ranging from tomorrow and never. In reality inflation is really persistent. By this I mean, that once you experience a rising inflationary pressure it’s hard to make it go away, it stick to you like flypaper.

Looking back several years, I have plotted the yearly change in headline CPI in the graph below.

To get a rough measure of persistency we can look at the so called Auto correlation function, where correlation is computed for inflation with regards to its subsequent “lags”.

The result is perhaps more perplexing than one first think. In the graph below we see that inflation today is still affected by the inflation rate 140 month or almost 12 years ago!

No wonder Paul Volcker had to raise interest rates to 20 % in the 70s in order to break the back of inflation.

Based on this historical fact, I don’t intend to give a precise date when I think inflation will come to a halt. But instead, I here like to point out the strong tendency for inflation to “hang around”, for those who think otherwise.

The hottest topic of today is definitely inflation. The effects from inflation can be seen everywhere. Recently we saw oil prices, surge to over $134 per barrel.

Leaving fundamental factors aside, inflation has contributed to massive gains in commodity prices during the last year. Even deflated government figures like CPI and PPI have begun to show big increases, as monetary inflation has filtered through the economy, pushing over all prices higher.

The Austrian definition of inflation regards monetary inflation. Simply, If the money supply grows, there is inflation. One result from monetary inflation is price inflation, or increasing nominal prices on goods. The price inflation we see today is therefore the result from monetary inflation that happened in the past. Today, we experience the accumulated effect from monetary inflation, that occurred many years ago.

An interesting question is whether we should expect this historical inflationary buildup to continue to push prices higher, as we speak today? Or, as some people argue, that we should expect prices, or price inflation to moderate as the economy slows.

The problems involved with trying to measure statistically, the effect from monetary inflation on for example PPI, is evident. First, there is no “rule” determining how long time it takes for monetary inflation to show up in prices. Second, the effects from monetary infllation on prices is asymmetrical. Third, monetary inflation tends to accumulate over time, making the effects larger when they finally hit the economy. And fourth, not all monetary inflation show up in statistical measures like CPI and PPI.

With these problems in mind, I have tried to create a rough estimate for future price inflation, given the current monetary inflation we can observe. I have looked at the percentage yearly change in money supply, here measured by MZM (Money with zero maturity), and the percentage yearly change in PPI: All commodities, trying to map the changes in MZM to the apropriate effects in the PPI. The red line signifies PPI and the blue line MZM. Number 1 is intended to map on A, and 2 on B, and so on.

Even if this approach is very basic, I belive it can serve as a rough guide for what lies ahead.

Looking at 8 and H, we see something interesting. When the rate of monetary inflation slowed after the tech-boom crash in 2001, PPI didn’t slow at all. Historically a decrease in MZM has followed by a similar decrease in PPI, as we can see for example with 3 and C.

Ever since late 2001, price inflation has grown significantly faster than than it did, any time since the 80’s. This has happened in an environment where MZM has been decreasing. One explanation for this buildup in PPI, is precisely the historical increases of the money supply, that has been building up, and not until recently starting to puch up prices on goods.

This is supported by what happened when MZM once again picked up. After MZM had bottomed in 9, PPI quickly increase from I to new record levels.

Looking ahead, we hypothesize that the bottom I for PPI coincides with the bottom 9 for MZM, and construct a likely scenario for the development of future PPI and price inflation. The time elapsed between 9 and I is 16 months, between June 2005 and October 2006. This means that the last 16 months change in MZM does not yet show up in the PPI numbers.

According to the chart, money supply, MZM has been growing exponentially ever since 8, and currently by 16 % per year. Even if the rate of change in MZM would slow some time soon, we should still expect prices continue to increase. And even if we would see a temporary decline, the trend in PPI is clear. We are entering a period with on average higher prices, both producer prices and consumer prices.

The latest economic reports, from the euro area and the US, show signs of worsening inflationary pressure. Consumer price inflation in EMU rose to 3.6 % since Mars last year, revised up 0.1 % from the earlier estimate. In US, consumer prices climbed 0.9 % during the month, and 4.0 % since Mars 2007.

Earlier in the weak we saw US producer prices surge to new highs, as index for finished goods increased by 1.1 % since February and 6,9 % since last year. The story is very similar, as energy, food and transportation are the goods currently experiencing the biggest gain in prices in both regions.

In the producer price report there is an interesting table that shows prices in different stages of the production process. By looking at how prices change from one stage to another, we can get a better understanding of where in the business cycle we are at present.

The PPI report looks at three stages, crude goods, intermediate goods and final goods. Crude goods are goods that enters the production process for the first time, as raw materials they have not yet been processed. Intermediate goods are goods that have been processed but require further processing, for example, supplies, steel mill products, lumber and diesel fuel etc. Final goods are goods that need not undergo further processing, but can be sold to either business or consumer for final use. The last category is very similar to the consumer price index as both indecies measure the final stage in the production process.

As “hot money” enters the economy in the capital goods sectors we should expect crude goods to be most affected by rising prices. This is confirmed by what we can see in the producer price report where crude goods together with intermediate goods are going through the roof, with an increase of 8 % and 2.3 % since February. Eventually, if monetary conditions are reversed or when prices reaches the breaking point, we will enter the last phase of the business cycle, when excess activity will have to be liquidated.

The resent buildup in consumer price inflation does to a large extent reflect the already present conditions in producer prices. To maintain profits, producers have for years wrestled with higher prices.

Companies have been implementing more efficient production techniques, outsourcing manufacturing to low cost countries and importing cheap labor etc. in order to adjustment to higher prices. However, because of escalating monetary inflation, we now see signs that higher prices no longer can be contained in the production process alone.

In the picture we see that PPI for crude materials have risen at a faster rate than finished goods, since 2003. This divergence is not sustainable and can not continue indefinitely. In the future we can expect prices for finished goods to rise, reducing the gap to crude goods. This will also result in accelerating consumer prices inflation and higher readings in the CPI.

Like the rings from a stone thrown in water, the effects of inflation ripples through the economy, raising prices as it moves. Presently, the rings have reached the final stage of production, namely consumer goods and consumption.

There is an ongoing debate regarding inflation targeting, look here. Today, most countries have adopted the “comfort zone” idea, where monetary policy aims at holding price inflation inside a defined interval, most often between 1-3%. The discussion is about whether central banks should use a price objective instead of a zone, as their target. The debate could not be more misdirected! The result of using a comfort zone of 1-3%, instead of a price objective of, let say 2,5 % is highly marginal, if not infinitesimal if the average rate of inflation, in this case, is higher than 2,5%.

The force that makes capital appreciate over time, is also present when it comes to inflation targeting. Capital, invested to a constant interest rate grow exponentially, as interest is “compounded” to the principal. As inflation targeting is supposed to achieve a certain percentage rate of inflation every year, this rate of inflation is also subjected to compounding. By looking at the numbers you can see for yourself the effect of different average rates of inflation.

Inflation targeting of 1% results in a reduction of purchasing power by 130% after 100 years. A 2% inflation rate results in a reduction of 624%, and a rate of 3% a reduction of 1822%. Because of the compounding effect, the smallest change in the rate of inflation will have enormous implications in the long run. If 100 years seem like a long time, remember that we are now in the 95th year of the federal reserve system.

Inflation has numerous other problematic features other than the diminishing of purchasing power, like the business cycle and the Cantillon effect. In this post, I primarily wanted to highlight the result of compounding and the importance of a low average rate of inflation. The discussion about inflation targeting should instead be focused on keeping inflation as low as possible, not whether a comfort zone or price objective should be used.