Will high inflation persist?


Every financial calculation that you make is influenced by your expectations for future inflation:  how much to borrow, where to put your savings, and whether your last raise was a reason to celebrate or to start looking for a better job.  Even small decisions, like whether to buy a couple extra cans of tomato paste, are affected.  No dollar amount or interest rate is good or bad, except when compared to inflationary expectations.

Among the people who care most deeply about inflationary expectations are the people at the Federal Reserve who set short-term interest rates.  The reason they care is simple:   As long as inflation expectations are low, a brief shot of inflation through the economy does only moderate harm.  That changes once people start to expect higher inflation.  If that happens, getting back to a normal low-inflation environment requires a higher and longer-lasting level of pain throughout the economy.

The Fed uses various kinds of data to get a handle on inflationary expectations.  Recently, two measures have started to give very different signals.

One way to estimate inflationary expectations is to subtract the yield of inflation-indexed Treasury notes from that of ordinary Treasury notes.  The difference ought to be the inflation rate that investors are expecting.  The green line in the graph shows that calculation for 5-year Treasury notes.  The expected inflation rate is a bit above 2%, and has actually been dropping lately.

Another way to gauge inflationary expectations is to ask people what inflation rate they're expecting.  The University of Michigan does that every month.  The red line in the graph shows their results.  Until about a year ago, the survey result pretty much tracked along slightly above the "Treasurys minus TIPS" calculation (higher, but by less than a percentage point).  Since about April of last year, though, the University of Michigan survey has spiked up, and the difference between the two estimates now stands at more than 2.5 percentage points.

The implied rate from the TIPS is an estimate of inflation for the next 5 years, so one reading of the difference is that people expect the current surge of inflation to be temporary.  The series of Fed rate cuts since September last year strong suggests that the Fed thinks that inflation will come back down.  Fed policy makers have said as much:

Survey measures of households’ expectations for year-ahead inflation rose further in early April, but survey measures of longer-term inflation expectations moved relatively little.

-- Minutes of Federal Open Market Committee, April 29-30, 2008

I think it will be worth keeping an eye on that "Treasurys minus TIPS" calculation.  If the 5-year expectation of inflation begins to rise like the 1-year expectation of inflation, expect the Fed to take strong action.

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Guest's picture

The touble with inflation is that it can sneek up on you because it grows exponentially. For example, just ask yourself if you would rather have 100,000 or 1 penny that doubles everyday for 1 month. After 30 days of doubling the penny, you end up with over 5 million dollars. But, it doesn't really seem to grow until about day 25. If you put this is an excel spreadsheet you can see the curve.

Between day 25 and 30, it goes from 167,000 to 5.3 million. This is an example of exponential growth. Today we are on the verge of an explosion of inflation. The problem was started way back in 2003 with the Federal Reserve's monetary policy of 1 percent for over a year. That low interest rate flooded the market with money, which pored into the housing market. Now that the housing market bubble has burst, the money is poring into commondities and the Fed is has again flooding the market with easy money.

Inflation is already double-digits in many countries around the world. Venezuela (22pc), Vietnam (21pc), Latvia (18pc), Qatar (17pc), Pakistan (17pc), Egypt (16pc) Bulgaria (15pc), just to name a few.

The Fed government Consumer Price Index that is used to calculate inflation is boggus and its a lagging indicator - which means they are using prices from 6-months ago to calculate todays inflation. Inflation is actually more like 10-15% and climbing fast.

Here is a website that tracks the actuall inflation vs. the government inflation numbers. http://www.shadowstats.com/alternate_data

So, how does all this mean? It means that unless the Fed increases the interest rates to 8% right now, we are going to see inflation continue to climb. Inflation could be the #1 issue in America for the next decade.

Guest's picture

Great, I was thinking I had nothing to look forward to.

Guest's picture

Thanks for the analogy, Curt ...and the "shadow" link.... It seems right on.

The chart with the synthetic M3 spike tells the story.

I believe that the 8% is probably right for today, but in the geometric progression scenario, it might become 20%, or 40% or more.

The government numbers do not address the actual debt, and don't even take into consideration the forward budget deficits. Even worse, there is not even a "shadow" figure for the potential dollars in hedge and derivative funds. While no definitive offical estimate exists, some of the "bear" experts suggest a probable additional downside of 500 Billion to 1.3 Trillion in unresolved debt in the private sector.

As the Fed "talks" a rational policy, the facts say differently. The FED "Rate" as a means to influence the economy may be passe.

We'll have to watch the commodity markets for the coming weeks. If the current speculative growth should continue, double digit inflation may end up looking good. Some parts of the commodity market have reached 100% to 200% increases, in less than 2 years. These increase do not exist in a vacuum.

There are many ways to say that everything is going to become more expensive. Devluation of the dollar, increased personal debt, reduction of asset values, inflation... words that lead to the same end.

Crystal ball? My guess is 20% inflation by years end. Eventually, wages will rise... The losers will be those on fixed income.

The best indicator will be whether the banks and brokers can weather the storm. All bets are off, if the hedge funds deflate, and credit derivative swaps implode. In that case, buy a wheelbarrow to carry in the money for that loaf of bread.

If galloping inflation happens, it may be 7 to 10 years before the US economy recovers.

I really hope I'm wrong!

Philip Brewer's picture

It's important to remember that not all price rises are inflation.  Inflation is the money becoming less valuable.  Sometimes, though, price increases are something different.  Sometimes, they're an indication that people are becoming poorer.

Right now, for example, a good bit of the price increase that we're seeing is not inflation--it's the US domestic price effects of formerly poor countries like China and India becoming better off due to trade and investment.  In a world where there are resource constraints (i.e. the real world), that inevitably results in formerly rich countries getting a little poorer.

Since the symptom is the same in both cases--rising prices--it's hard to know which of those two things is happening.  And, in fact, I've got no doubt that both are going on.  (I don't have a good handle on how much of the present surge in prices is due to which cause, though.)

To the extent that it's just inflation, we know how to stop that--reduce the growth in the money supply.  That was proven in the 1980s--if they want to, the Fed can always stop inflation, no matter what's happening with other factors.  (In particular, the government deficit hit record highs all through the period when the inflation rate was being brought down.)

The problem is, to the extent that what we're seeing isn't just inflation, but rather is an actual decline in standards of living (due to globalization and resource limits), shrinking the growth in the money supply won't help.  (In fact, it'd do a lot of harm.)  Since it's hard to tweeze those two things apart, the Fed is really groping for the right policy.

I think 20% inflation is very unlikely.  Thirty years ago, an inflation rate well under 15% was enough to produce a dramatic change in monetary policy.  I don't think the economy (or political system) is any better positioned to tolerate such high rates of inflation now than it was then.

Guest's picture

This is a great post. The expected inflation is always lower in the short-run, yet should begin to spike once prices begin to affect the economy. I would be interested in seeing what will happen to the Treasury minus tips line within the next year. As inflation begins to increase expected inflation will begin to rise.

This is a very insightful outline of what is to come.

Guest's picture

I don't think the general public understands the reasons for inflation. I urge all readers of this blog to find a dictionary and look it up, especially an old dictionary.

Websters dictionary puts it as "A continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services"

The key being the increase in the volume of money. The Federal reserve has the power to print money in unlimited amounts. In the old days say in the German Weimar Republic they just printed it. Nowadays its created electronically and the commercial banks then lend it to the general population.

If the Fed really wanted to they could create deflation/dis-inflation. Easy, hike rates to 20% and cut off the supply of new credit. Essentially the money markets are trying to do this because of the sub-prime mess, however we have the Fed doing the opposite. The Fed lowers interest rates and then it supplies huge amounts of money to commercial and investment banks!

If say we were on the gold standard or using gold/silver as money the general prices of goods and services would be dropping every year. Remember the supply of goods and services rises each yr (gold/silver barely). This is an important notion to understand. Before the advent the Federal reserve this was the case.

I am not saying that inflation has not happened in the past. It has. Commercial banks always have a habit of lending out too money in good times without anything hard to back the loans. Deflationary recession/depressions however have always tended to correct the previous inflation. Imagine a situation where a bank has a run because it has a reputation of making dodgy/inflationary loans and then goes broke. You no longer have a bank that makes these loans anymore.

With the current banking system, whenever there's been too much money lend out they just bail out the banks and create more inflation! Everyone should look at the inflation statistics since the great depression. I think there has only been 2 occasions where the prices levels declined. There have been numerous recessions since then.