Wednesday, July 09, 2008

Stagflation: I can't shake it! I can't shake it!

Thursday's employment report paints a pretty bleak picture of the economy. Consumers are already facing a massive wealth drag from housing, and now more and more are facing lay-offs as well. Yet somehow the consensus is for rising inflation. The 1-year inflation expectation, based on TIPS trading levels, is currently 4.31%, up from 2.24% at the beginning of the year. The weak economy and the relatively high inflation outlook has some uttering the S-word: stagflation.

The pervasive inflation talk in the media may be hard to ignore, but ignore it you should. The conditions for a real inflation spike just aren't in place, and making investment decisions with an inflationary view will wind up costing you money.

First, let's talk briefly about what inflation really means to economists. It isn't rising cost of living, which is probably how the average person thinks of inflation. Clearly with energy and food prices rising, the cost of living is going up. But inflation is defined as too many dollars chasing too few goods. In other words, inflation is always and everywhere a monetary phenomenon, the result of the intersection of money supply and money demand. Surging oil prices due to increased demand from China is not inflation. Higher cost of living? Sure. Inflation, no.

Unfortunately, measuring the effective money supply and demand is nearly impossible. But what we can do is estimate how much money people have to spend vs. how many goods are being produced. This should get at how many dollars are in the hands of consumers versus how many goods those dollars are being chased. A combination of unit labor costs and productivity should do the trick. The following chart compares Unit Labor Costs, Non-Farm Productivity, and Total CPI (all from the Bureau of Labor Statistics). We'll specifically look at 1974, 1979, and 1980 (the three double-digit inflation years) as well as 2007 and 2008 (annualized Year-To-Date).

We see that labor costs surged (blue bar) in the 1970's inflation spike, while productivity (yellow bar) waned. So it was costing more per unit of labor, and each unit of labor was producing less. Sure sounds like too many dollars chasing too few goods. Looking at 2007 and 2008, we don't see the same pattern. Unit labor costs advanced at a modest pace, while productivity has been robust.

Another definition of inflation is a pervasive rise in prices over time. In the 1970's, we certainly saw large price increases across a wide variety of goods. Today, not so much. The chart below is a histogram of CPI components for the same years as above. Again, the data is from the BLS, and again, the 2008 data is annualized.

To build this chart, each CPI component was categorized based on its percentage change, with the groupings done in 5% increments. The bars show the percentage of all components which registered a change within the indicated range. For example, in 1974, 74% of all CPI components clocked at least a 10% price increase, whereas only 2% showed a price decline. 1979 and 1980 showed a similar pattern, with at least 90% of all items showing a 5% increase or more.

Today's pattern is completely different. So far in 2008, the distribution of price increases is more evenly distributed. If inflation were on the rise because of loose monetary policy, or a weaker dollar, the price of everything would be rising at once. That just isn't the case right now.

Finally one needs to consider the impact of contracting consumer credit. Part of the effective money supply is how much banks are willing to lend to consumers. When the Fed cuts interest rates, it is in part trying to encourage borrowing to expand the money supply. But it is clear that consumers access to credit will be tight for the foreseeable future, mitigating any direct impact from the Fed's actions.

There is scant evidence that we're currently experiencing monetary inflation. And therefore it is unlikely we'll see any Fed hikes in the near future. Yet Fed Funds futures still price about an 80% chance of a hike by October. Investors holding on to cash hoping to see better investment rates in the future will be in for a long wait. There are much better opportunities in 2-5 year bonds, both in municipals and high-quality taxables.


James said...

You need to understand that China and other dollar peggers are defacto states of the US because they use US monetary policy instead of there own and inflation is ballooning out of control in those places. What are the chances that the chinese have to revalue and drop there pegs therefore causing interest rates to rise? I think its inevitable. The world is growing far to fast for the resources available right now.

DG said...

Are CPI figures today comparable relative to CPI figures of the 1970s? Substitution and "quality adjustments" post 1994 have made the series an apples to oranges comparison relative to the 70's...unfortunately, I am unaware of a legitimately calculated inflation figure.

Accrued Interest said...


I grant that EM needs to tighten policy. I'd see this as strengthening the dollar.


Consider the underlying logic of my argument tho. Take a basket of goods from 1979. Its mostly up 10%+. Then take a basket of goods from 2008. The increases are more evenly distributed.

It doesn't matter than the set of goods aren't comparable accross time as you are suggesting. Only that the pervasiveness of price increases is not evident.

santcugat said...

I like the argument. Very innovative.

The price of oil had a completely different impact in the 1970s than it did today (where are the long lines for gasoline?). Granted there have been some minimal price increases, but the main impact seems to have been to drive to improve efficiency and productivity rather than raise prices.

Look at airline tickets as an example, you'd think that prices would have gone sky high (err sorry). Instead, they took away all the freebees and try to reduce costs. People complain, but inflation remains contained.

Accrued Interest said...

I think if there were too much money sloshing around, then airlines would be able to raise prices. Same goes to autos. They can't because the demand isn't there.

SG said...

The deflation argument is self-evident. I'm surprised there's still any argument about it.

What's less clear to me is how a collapse in the dollar (which given our aggregate public and private debt situation strikes me as not inconceivable)would play out. The commodities bubble has been, after all, in no small degree a dollar hedge play as it has drifted lower over the past five years.

Could you please expand on your reply to James above (which scenario is also being newly raised by Roubini) about the effects of current account surplus countries dropping their dollar pegs ... effectively ending Bretton Woods II?

Why do you say the result would strengthen the dollar? Wouldn't the effective relative devaluation of our currency make everything we buy on the world market feel like inflation, even if there was no wage spiral to complete the loop (or maybe the loop is the dollar keeps falling)?

That may not technically be monetary inflation, but the result would certainly be a lowering of our standard of living resulting from price increases, no? At which point, arguing over whether it is due to the technical definition may seem like splitting hairs.

As a practical matter I'd greatly appreciate it if you would walk though the likely effects on the dollar of de-pegging as a stepped time series. I suspect that a lot of my deflationary investment bets would be upended in absolute value terms by such an event.

Anonymous said...

Inflation is a monetary phenomenom and we are, for the most part, avoiding it. But, if it were to kick up, one way or another, there is a known path to fight it. However, what is more important in my mind, is how to break the acceleration of the decline in the quality of life. The downward pressures of higher consumer prices and restricted consumer access to credit and extremely high household debt loads aren't going to waved away at the next turn of the business cycle. The general welfare of people, for whom the economy exists, cannot be ignored. Calvin Coolidge thought that, history proved him wrong.

santcugat said...

I wonder if the mortgage crisis has actually been a blessing in disguise... think of a giant vacuum cleaner sucking up all the excess credit in the bond-market. There was really no equivilent of that in the 70s.

Regarding the dollar:

Europe still hasn't felt the brunt of its own banking/mortgage crisis. There is a huge property bubble bursting in Spain & Ireland for example... and there's no equivilent of the Fed to stop bank-runs. The European Central bank has authority on interest rates, but each country has its own scheme for managing bank insolvency(think the Northern Rock fiasco multiplied several times).

spagetti said...

i think this is an excellent piece, and i agree with Steve; surprising how people (and mainly the media) are fixated on arbitrary measures of price increases to point to 'rampant', 'runaway' ..etc inflation

comparing the cpi's is in my opinion indeed dangerous because of the adjustments made. its not a good argument to defeat the inflation crowd because the fact that the distribution of price increases is different doesnt prove that its not a monetary phenonemon, it rather proves how misleading these various measures of inflation are.

onthe other hand, to those who dont understand what inflation really is, the difference between money and credit, and what a credit contraction really means, to them maybe this was the best way of explaining what might be going on. as opposed to running around screaming 'hyperinflation' because of the spike in oil prices

excellent post overall
i wish views like this would get more attention. although in recent weeks i have noticed more and more of the mainstream market commentators (banks' research teams) pulling in this direction

Noonan said...


The "quality of life" for the people of these United States is better than 99.99999999999999999% of the humans in the history of the world have experienced (Our poorest live better than the King of England did a thousand years ago). People living in "poverty" in this country have cable TV and air conditioning (and free health care despite complaints to the contrary.) Our average life expectancy has increased 25% over the last 40 years. How has the general welfare of the people suffered?

Accrued Interest said...

I'm not a currency expert, nor do I play one on the internet. But I think weaker growth out of EM causes commodity prices to fall. I think that would be better for the dollar in the long run.

I also think that EM inflation (caused by bad policy there) has a positive impact on US inflation, especially in pegged countries. So perhaps for now we are avoiding inflation because the economy is shit, eventually we get through this and at that point, the inflation risk becomes much higher.

There is a relatively simple counter argument, and that is that higher EM interest rates attract capital there, as opposed to the U.S., resulting in a weaker dollar. Or conversely, that lower inflation in the EM zone makes US inflation higher (relatively) and therefore weakens the dollar.

But anyway, if you read it the way James wrote it (China is a defacto state of US b/c of the peg), then anything to retard inflation there retards inflation here, and that helps the dollar.