#11 – Inflation

January 13, 2021 – The U.S. Government, via the U.S. Bureau of Labor Statistics (BLS) released monthly inflation data this morning that showed inflation slightly above expectations. What is inflation? How do we measure it? Dangerous implications lie ahead if we ignore inflationary pressures building today.

What is Inflation?

Inflation is when the value of money declines relative to the goods and services that money can purchase. High inflation (like in Venezuela) occurs when the supply of money is greater than the demand for money. Prices go up when inflation is happening, but not all inflation is bad. When the outlook is for prices to modestly appreciate in the near term, this can encourage consumer demand investing, and optimism; hence, many argue that low (but above zero) inflation is actually beneficial.

How we traditionally measure inflation

The Consumer Price Index (CPI) is an index that captures the change in prices paid by consumers for a group of goods and services. The CPI is based on prices of food, clothing, shelter (rent), fuel, Rx/healthcare, transportation fees, and “day to day living”. For whatever reason, the index is based on prices of those items as they were from 1982 through 1984. Therefore, a CPI reading of 100 means inflation is equal to the level it was at in 1984, and today’s current reading of 260 (see below) means that inflation has risen 160% since 1984.

CPI Index 1970 – 2021

Outlined by the red box below you can see that today’s report shows the Year-Over-Year (YOY) change in the CPI for December was +1.4% (in green) vs. a forecast of 1.3% and a previous reading of 1.2%. This means that prices in December 2020 were 1.4% higher than they were in December 2019. That is modest (but above expected) inflation.

Taking a look underneath the hood at the actual components, we can see that there were significant moves higher across the index between Nov 2020 – Dec 2020, reflecting higher inflation month-over-month.

What’s wrong with the CPI?

To calculate the monthly CPI, a group of statisticians estimate what percentage of a “typical” household budget is spent on certain items. The higher the percentage, the more weighting the statisticians assign a given item’s price change index. There are many other criticisms of the CPI; the index is an incomplete the truth at best. Fiscal (tax) and/or monteary (interest rates) policy, such as the Federal Reserve flooding the economy with newly created dollars, can have tremendous impacts on the price of goods and services.

Inflation Outlook

Today’s report also included an inflation outlook: the U.S. central bank does not see inflation rising above 2% until at least 2023. The Fed has an inflation target of 2%, and the Fed wants inflation sustained above that level before raising interest rates. In other words, according to the Fed, record low interest rates are here to stay. The impact that this has is that people are disincentivized to save money (because we earn no interest on it) and are thus forced to either spend money (this is the Fed’s goal: to “stimulate spending in the economy”) or to allocate savings to riskier places for returns. I personally don’t understand how inflation stays near record lows with the creation of new dollars (supply).

Stimulus checks and higher unemployment benefits pushed household incomes higher even as economic output shrank – a rare combination. Rising stock and housing markets helped add more than $5 trillion to the net worth of U.S. Households in 2020. This chart shows total U.S. household income, broken down by wages/salaries (black) and benefits (blue). The more blue and the less black, the more of a welfare state we are.

Meanwhile, the St. Louis Fed’s data shows M1 Money Stock, including dollars in circulation, having gone parabolic in the last 2 years. This chart should be very alarming to anyone monitoring inflation.

Recommended Reading

A Historical Analysis of Monetary Policy – stanford

Interest rates and the conduct of monetary policy

Interest Rates, 1914 – 1965

Update 3/1/21:

The Commodity Price index ($GSCI) has experienced its’ second strongest start of any year since 1973 (only behind 2003)

Google trends data for search term “inflation” on the rise (below).

In Conclusion

What’s your take? Where do we go from here now that the Fed is Normalizing Trillions, and printing money faster than ever? We’re heading down a potentially perilous path for macroeconomics.

Success breeds complacency. Complacency breeds failure. Stay paranoid!