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September 30, 2007

There's No Inflation, Except for Everything That's Going Up In Price

by Nicholas Beaudrot of Electoral Math

As a devoted reader of both Barry Riholtz and Brad DeLong, who have forgotten more about finance and economics than I will probably ever learn, I can only offer an uninformed take on this intellectual steel cage match.

DeLong points out that "when increases in inflation are confined to (i) energy and (ii) food prices, odds are that the increase is transitory and will be self-limiting". Historically, that's been true; in the '90s, if oil prices went up a few dollars a barrel, odds are they would come back down. Food prices follow a similar pattern (largely because energy costs greatly affect food costs). But, that no longer seems to be the case; no one really thinks oil prices will get down to even $50/barrel, and between rising energy costs and increased demand for biofuels, food also seems to have permanently risen in price. As Riholtz argues, Core CPI is low, but other market measures of the dollar's strength—currency exchange rates, gold, the dollar, other commodities—show a weak dollar. It seems that these increases are not transitory, but are really the long overdue correction that George Soros bet on back in 2004 (and Warren Buffet bet on more recently).

Now, maybe this correction is not a bad thing, and maybe the inflation in food and energy costs is self-limited (i.e. it will not have an impact on prices elsewhere in the economy), but it does seem that headline inflation is doing an awful job of reflecting reality for most Americans, for whom the increase in commodity prices definitely affects there discretionary income.

And this doesn't even get into increases in things like individually-born health care costs, college tuition, etc.

Update: See both DeLong and Riholtz in the comments. This chart from the STL fed illustrates what's going on. The orange gray line, representing the difference between headline inflation and core inflation, is the important line:

Historically, overall inflation has stayed within 0.5% of core inflation, and even after the energy crunch in the late 70s, there was a period of correction from 1984 to 1991 where energy prices grew less quickly than other prices. But since 2002, the situation has changed dramatically; food & energy prices continue to rise significantly faster than other prices. If this is part of a permanent trend -- if energy costs will continue to rise 1% or 2% faster than overall prices, should we hit the economy over the head with a brick? I don't know. At the moment, probably not ... it's not clear that slamming on the brakes, which might reduce demand for energy but also hurt employment, will make people better off. After all, the price of energy isn't a large budget item in the cost of college tuition, health insurance, or even medicine...

September 30, 2007 | Permalink


People may not think that a devalued dollar means much, and certainly with the relatively fixed US$ to China currency, a big part of our imports of goods will remain mostly cheap. If the exchange rates stays fixed. But how long can China keep propping up the US$ when it gets less valuable every day.

Even worse, a large part of our food (and costs) are now imported, and those things will get more expensive day by day - from places like Mexico, Peru, etc.

Core inflation no longer represents real inflation. Some economics observers have calculated that if real inflation is considered, the US GDP has actually dropped since 2001. Same for the S&P 500 index.

When the US$ dollar goes from 70 some cents to $1.40 when converted to Euros there is a real change, some good for our exports, but very bad for our imports. But we have less and less to export, particularly manufactured goods. It also makes the continued viability of the US$ as the international commodity currency (oil, agriculture, materials, etc.) very shakey. Some see the oil price rise as just a reflection that OPEC must charge more in dollars because the US$ is worth less.

Most worrying: there is very little that can be pointed to that would cause the dollar to Euro/Yen to improve over the mid term. Either major inflation (late 1970's) or major deflation (1930's) are real dangers, but the Fed's attention is keeping Wall Street liguid to prevent bank runs, so they are helpless to deal with inflation (which requires higher interest rates, not lower).

We are nearly fu*ked.

Posted by: JimPortlandOR | Sep 30, 2007 7:59:11 PM

I agree current notions of core inflation don't reflect real inflation... but I think the really dubious thing is the inherent equation that says inflation is the big worry here. When we're looking at a sustained, continued downturn in the home market, there's an element of deflation that (as far as I can tell) is less understood, and harder to deal with. One of the reasons inflation has been theoretically "held in check" is that the ratio of things - our salaries to our expenses, the value in our investments and their appreciation over time - has risen together. What may well be happening - and the realignment of the dollar to other currencies is a worrisome sign of it - is that our expected ratios are uncoupling. In which case, the problem won't be that prices, per se, are rising; rather that the money we used to have to meet those expenses is decreasing. I think that's behind the sense that we have "absorbed" the increase in oil from $50 to $80, and could absorb more. It's true... as long as other elements, like the value in our homes, or our incomes, don't fall. Once they do, I think all other bets are off.

Posted by: weboy | Sep 30, 2007 8:27:46 PM

"good for our exports, but very bad for our imports. But we have less and less to export, particularly manufactured goods." - JimPortlandOR

We need an industrial policy that understands the difference between burgers and machined parts, the difference between pizza and injection molding...amazingly, we would lose a sustained large scale war because we would run out of parts and could not re-tool civilian factories...because they're overseas.

Posted by: S Brennan | Sep 30, 2007 9:21:08 PM

The most important part of Barrys critique is that this inflation that isn't measured would have destroyed most of the GDP growth we've "experienced" in the last few years, which to him (and me) explains the great chasm between the official figures and the reality faced by most Americans over the Bush years.

Posted by: mickslam | Sep 30, 2007 11:39:15 PM

But core inflation isn't supposed to represent real inflation. Real inflation represents real inflation. Core inflation is a tool to forecast future persistent inflation, and an excuse to give the Fed other options than hitting the economy on the head with a brick...

Posted by: Brad DeLong | Sep 30, 2007 11:47:24 PM

But the inflation in food and energy appears to be persistent rather than transient. Does anyone think oil will suddenly drop in price?

Posted by: Nicholas Beaudrot | Oct 1, 2007 12:03:25 AM

Brad DeLong makes the technical point that Mark Thoma also makes. I think the problem with that point is that really there are two phenomena going by the name "inflation" and referring to them by the names "core" and "real" doesn't help the confusion in public policy.

"Core" inflation is a narrow technical measurement which as they say, is a predictive number for future "inflationary potential."

"Real" inflation is the measure of how much less you can buy with your money in the bank today than you could have done yesterday.

The problem is, many in public policy and politics and even many economists base their assessments of things like GDP growth using "core" inflation numbers. This puts their estimate of our wealth at odds with our experience of it.

Posted by: Meh | Oct 1, 2007 5:53:27 AM

According to DeLong, lining investors' pockets is more important than stopping inflation from hurting the working class. DeLong uses a sleight of hand to equate investors with the economy.

Posted by: kazumatan | Oct 1, 2007 6:41:14 AM

Be sure to read the comments and posts at DeLong's & Thoma. I read that whole paper by Yellen of the Fed at Thoma's about behavioral economics an it helped clear up how the Fed thinks about inflation and why

Economics and ...knzn is an economics Professor somewhere, commenting everywhere. Very good. There is also Calculated Risk, and William Polley showed up recently at the Angry Bear.

I know, after much study, much less about inflation than I did six months ago.

DeLong puts it pretty simply & straighforward with his brick. The alternatives are worse by most people's standards. Dems simply have to get control of fiscal policy and priorities, so that the benefits of inflation don't all flow to Capital.

Posted by: bob mcmanus | Oct 1, 2007 7:24:43 AM

Price increases in food and energy have been transitory and self-limiting ?


Over the past 5 years, we have heard this emphasis on the Core levels.

Over that same time period, Oil has risen from ~$15 to over $80 (Gee, that doesn't sound either transitory or self limiting); Food prices have risen nearly as much, with beef, Dairy and grains all up tremendously. (Milk and cheese have nearly doubled over the past 12 months).

Outside of the absurdist core, BLS has not done a very good job capturing the increases in Health care costs, Housing or Education.

Look, if you want to pull out one month as aberrational (i.e., Nat Gas post-Katrina) that's fine. But to ignore a multi year trend where "volatility" is essentially in one direction is to accept an analytical misdirection that only serves to obscure Reality.

Ever since the Fed dropped rates to 1%, the dollar's purchasing power has fallen, nearly every asset class denominated in dollars has soared, and Inflation has risen dramatically.

Except in the core. Inflation ex-inflation, prices are stable.

No thanks.

(Note: This link takes you to a long list of prior commentary on inflation: http://bigpicture.typepad.com/comments/inflation/index.html)

Posted by: Barry Ritholtz | Oct 1, 2007 7:35:05 AM

We had similar issues in the 70's with the prime lending rate exceeding 20%. President Carter's 'solution' was wearing a WIN button which literally meant "Whip Inflation Now". Other than that, he had little to offer. In comes Reagan who encouraged the Fed to raise interest rates and cut taxes. Within a couple of years, things started to straighten out.

Lesson to be learned here is this inflationary cycle was easy to predict with the rediculously low interest rates for almost a decade. Couple that with oil's price rise on fear of mideast problems and here we are today. The cure is to raise interest rates and take the hit now.

Posted by: El Viajero | Oct 1, 2007 8:38:13 AM

"In comes Reagan who encouraged the Fed to raise interest rates and cut taxes. Within a couple of years, things started to straighten out"

Yeah sure, massive permanent debt covered by increase FICA taxes.

"The cure is to raise interest rates and take the hit now."

I hear the Pres is gonna ask for $200 billion more for the Greater War on Everybody soon. With the current deficit, any steep decline in growth with the usual associated decrease in revenue and increase in spending pushes the budget close to bankruptcy & default. PAYGO Democrats may be the stupidest people alive who aren't Republicans.

You want a recession? You couldn't handle a recession.

Posted by: bob mcmanus | Oct 1, 2007 9:35:35 AM

"Whip Inflation Now" was Gerald Ford.

Posted by: Ohio Mom | Oct 1, 2007 11:05:04 AM

Apologize in advance if this turns into a double-post.

"Whip Inflation Now" was Gerald Ford's slogan, who of course preceded Carter.

Posted by: Ohio Mom | Oct 1, 2007 11:08:12 AM

Great! So Ford didn't have anything....and neither did Carter.


Posted by: El Viajero | Oct 1, 2007 12:42:17 PM

I might also add that nations whose currency is tied to precious metals don't have this problem. The government doesn't like that idea because they cannot fiddle with the economy for their benefit by creating and destroying money as they see fit. Precious metals are elements and cannot be created nor destroyed.

Posted by: El Viajero | Oct 1, 2007 12:47:28 PM

Didn't Carter have Volcker at the Fed really tighten the money supply -- at least this happened (whether at Carter's instigation or if he just acceded to it I don't remember for sure) and did control inflation, although it may have helped cost Carter the Presidency.

Are we all going to crucified on a cross of gold, ElV?

Posted by: BillCross | Oct 1, 2007 2:20:56 PM

Let me add that what makes this less likely to be "transitory or self-limiting" is that the global economy has recently added ~2 billion people from China and India, who are no longer merely subsistence living.

As they enter the "middle class" (whatever that is in Asia) we can expect their demands for food, energy, consumer goods, transportation, technology, etc. to continue to pressure prices higher.

Lastly, short of causing a global recession, I do not think there is a whole lot the U.S. Fed can do about this . . .

Posted by: Barry Ritholtz | Oct 1, 2007 2:40:36 PM

Here's what YOU can do for yourselves.

Put your assets in non-dollare denominated investments. Even if you only have a savings account, there are foreign banks that will convert your savings to Swiss francs, gold, or some other medium.

Anything that is tangible is also good such as low-end real estate that has not been affected by the recent bubble. Fortunes can be made if you invest with leverage in these things during times of high inflation.

Posted by: El Viajero | Oct 2, 2007 8:33:17 AM

Dow Jones: Dean Foods Co. (DF) said record dairy prices are forcing it to slash its earnings forecast and trim its work force to deal with what it called an "extreme commodity environment."

This is by far the most difficult operating environment in the history of the company," Chairman and Chief Executive Gregg Engles said in a prepared statement ...Dean said it's in a vice between dairy producers demanding higher compensation and consumers who have cut consumption in response to higher retail prices.

Food companies have been facing sharply higher commodity prices in the past year, especially for grains and oil. The BLS, in its PPI, has ‘finished consumer foods’ up 4.7% y/y.

WSJ: At Heinz, overall costs for ingredients rose 4.7% for the quarter ended Aug. 1. The company responded by raising prices, on average, 2.8% during that time, and it expects to hike prices further as commodity costs continue to rise.

BLS in its PPI has ‘finished consumer food’ prices -0.8% for June, -0.1% for July and -0.2% for August. At the ‘intermediate’ stage of production, ‘material for food manufacturing’ are 0.8% for June, 0.3% for July and -0.7% for August. ‘Crude materials for foodstuffs and feedstuffs’ are 0.3% for June, 1.2% for July and -3.0% for August. So, for the same period in which Heinz experienced a 4.7% increase in food ingredients BLS, for PPI purposes, has ‘finished consumer food’ and ‘crude’ food prices declining, with intermediate food prices increasing only a few tenths of a percent!

Yet some people still believe PPI accurately measures inflation.


Need more proof that PPI and CPI aren’t telling the real inflation story? Dow Jones: GM Purchasing Chief: Raw Material Prices 'Scary' The purchasing chief of General Motors Corp. (GM) said that price increases on certain key commodities are "scary" and that the auto maker is looking to reduce consumption and find alternate materials in some cases. We’re tying to "Use less aluminum and more magnesium and less steel and more plastic."

How can this be with Core PPI up just 0.2% the past three months? http://www.easybourse.com/Website/dynamic/News.php?NewsID=311639&lang=fra&NewsRubrique=2

Posted by: Barry Ritholtz | Oct 3, 2007 7:31:55 AM

I am beating a dead horse here, but let's see what Jean-Claude Trichet, President of the ECB, had to say on this very subject (of core inflation) today:

Risks to the outlook for price developments remain on the upside. They continue to include the possibility of further increases in the prices of oil and agricultural products as well as additional increases in administered prices and indirect taxes beyond those announced thus far. Taking into account the existence of capacity constraints, the favourable momentum of real GDP growth observed over the past few quarters and the positive signs from labour markets, stronger than currently expected wage developments may occur, and an increase in the pricing power in market segments with low competition could materialise. Such developments would pose upward risks to price stability. It is therefore crucial that all parties concerned meet their responsibilities.

The monetary analysis confirms the prevailing upside risks to price stability at medium to longer-term horizons. A broad assessment of the monetary data supports the view that the underlying rate of money and credit growth remains strong. However, the August annual growth rate of close to 12% in the monetary aggregate M3 as well as the annual growth rate of loans to non-financial corporations, which reached a record level of more than 14% in August, may have been influenced by a number of temporary or special factors, such as the flattening of the yield curve and the recent financial market volatility, and may therefore overstate the underlying rate of money and credit expansion.


Posted by: Barry Ritholtz | Oct 4, 2007 11:50:19 AM

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