Tag Archives: CPI

Central Banks are seeking to devalue currencies. Will it ultimately destroy trust?

22 Mar

Fiat money is worth nothing without trust. History has shown that the general populace has great distrust of paper money, hence the need for its backing with some form of physical currency such as gold, silver or copper. Yet here we are, with no such backing (the gold standard was abandoned some 40 years ago), and Central Banks appear to be acting with very little regard to the value of trust.

The new Bank of England Governor, Mark Carney wants to adopt more unconventional monetary policies, Ben Bernanke has indicated that the Fed will continue to print and the Bank of Japan’s new governor has set his sights on aggressively tackling deflation through monetary easing. When everyone is so focused on one thing, it is easy to lose sight of what is really going on.

Inflationary expectations have risen consistently over the past three years. Equity markets have more than doubled from the market lows. The top 1% of US earners now account for over 21% of US total income. Inequality, not surprisingly, has risen substantially – see chart below.

GINI

(Source: Gini Co-efficient, Bloomberg)

The Gini coefficient is a measure of equality, where 0 corresponds with perfect equality and 1 corresponds with perfect inequality. US inequality has consistently been rising since the 1970′s along with the percentage of top earners that account for a greater portion of total income:

Top earners

(Source: Dylan Grice, The Edelweiss Journal)

Every crisis has a breaking point. That day may still be a long way away, but there is no doubt that we will face greater headwinds down the line.

Dylan Grice, the former global strategist at Société Générale, has recently joined Edelweiss Holdings Limited where he published last week an very interesting report on the value of trust.

The report is very much worth a read and while there is little one can do to prevent the ensuing crisis, there is no harm in being aware of what can happen when trust disappears within a society.

What is inflation?

4 Mar

For those of you wanting a fantastic overview on inflation and what effects it can have on society, you must read Culture and Inflation in Weimar Germany.

Here is a short summary what inflation means:

In economic terms, inflation is a measure of the change of prices for goods and services over a period of time.

Different measures of inflation track different goods and services to give consumers and producers an idea of how the overall price of goods and services they use changes over time.

The three most frequently used measures of inflation are:

  1. The Consumer Prices Index (CPI)
  2. The Retail Prices Index (RPI)
  3. Producer Price Index (PPI)

The objective of all these measures is similar but each will vary slightly and, in different countries, their calculation might also vary a little.

CPI, for example, typically takes into account cheaper alternatives if a specific product get too expensive whereas the RPI does not, hence why CPI is usually lower. In the US CPI includes certain housing costs such as rent whereas in the UK, while RPI takes into account mortgage interest payments and council tax, CPI does not.

In the UK the measures of inflation are calculated by the Office for National Statistics and in the US by the Bureau of Labor Statistics.

Is inflation bad?

It depends who is asking.

Simply put, inflation will erode the purchasing power of your money over time. For example in 1970 $10 would have bought you over 16 Big Macs whereas today it barely buys you 2.

In more general terms, $100 in 1970 had the same buying power as almost $600 today. The Bureau of Labor statistics has an entertaining CPI Calculator to measure how much purchasing power the dollar has lost over time.

So is inflation bad?

As a saver, unless you are able to achieve a level of return equal to the level of inflation, your purchasing power will be eroded over time. Typically, interest rates will be higher than inflation meaning that investors are able to achieve a real return on their cash – i.e. a return, net of inflation, that is positive.

However, in today’s zero interest rate environment, with inflation running at approximately 2%, cash savers will get a negative real return of 2% – i.e. their purchasing power will decrease by 2% a year.

Savers are therefore forced into seeking real returns into real assets that entail risks (such as equities, property etc.) if they are to stand any chance of achieving a positive real return. Not great. But this is exactly what the Federal Reserve is trying to get people to do. By keep real interest rates negative, they force savers into investments that, they hope, will kickstart the economy once again. A risky strategy, but more on that later.

Is inflation good?

As a borrower inflation can have its advantages so long as it does not impact your ability to repay your loan.

For example, let’s assume you get a 30-year $100,000 mortgage to buy a house today. For every year that inflation erodes the value of the dollar, the size of your debt – in real terms – falls. Just like the example above, we can assume that if the next 30 years experience similar levels of inflation to the past 30, the real value of your debt will have fallen by approximately 60%.

Mortgages are usually structured to be paid monthly rather than at the end of the term, so the average fall would be closer to 30%, but the example illustrates very clearly that inflation can aid those who borrow in nominal terms.

I wonder why the Fed would want to spur inflation at this moment in time..? I’m sure it’s got nothing to do with the $16.5 trillion in nominal debt owed by the US government…

Keep an eye on the FOMC minutes this Wednesday

18 Feb

Fed minutes from the meeting of January 29-30 are released this Wednesday.

Markets will be focusing on whether there will be any mention of future plans for ending purchases.

This seems unlikley, however, given the persistently elevated level of unemployment and subdued inflation numbers. CPI is also out on Thursday with consensus estimates for inflation to remain at 1.7% in the US.

Let us know what you think.

Trust, hyperinflation and the end of the dollar

13 Feb

Economists love debating the reasons for inflation. Many argue that money supply alone can result in inflation, whereas others believe it is down to capacity constraints in an economy or advancements in technology. The reality is that the causes of inflation are immensely diverse and one reason is never the sole contributor, nor is there a unique common cause of inflation in previous hyperinflationary times.

Instead, hyperinflation is typically caused by a very severe exogenous shock, that then usually forces policymakers to take overly aggressive action in order to overcome their difficulties.

War, the collapse of regimes and currency pegs all feature as severe shocks in previous cases of hyperinflation. Clearly we have none of these yet, but the credit crisis was as close to a severe shock as one could possibly imagine. And how have policymakers responded? Br printing money. We are now 5 years into the crisis and the rate a which central banks globally are printing money is only accelerating.

So why haven’t we seen hyperinflation yet?

It takes time. For the last 40 years Monetary supply in the US (M2) has been growing at an average pace of about 6.75% a year vs. average annual inflation of 4.3%. Clearly the increasingly efficient economy and advancement of technology of the past 40 years have been deflationary enough to keep the CPI below money supply. John Edwards, of Shadowstats, argues that M3 is a better indication of inflationary expectations but sadly the US stopped reporting this some years ago.

m2 and cpi

In any case, if we overlay the monetary base chart over the M2 chart, it is clear that 4 years ago these decoupled SUBSTANTIALLY! This is the effect of QE which has essentially flooded the US monetary base with newly created dollars. It takes time but this will eventually feed through to M2.

monetary base and m2

As it does feed through, prices have to re-adjust (i.e. rise) as people’s perception of the value of that currency diminishes. As trust in a currency’s value disappears, so do people’s willingness to hold onto it, opting instead for alternative currencies or real goods such as property, gold etc, once again compounding the effects of rising prices. And so the spiral goes.

I have no doubt the FED intends to halt QE before we get close to this. But as every episode in history has suggested once the floodgates are opened it is very very difficult to close them again.

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What is the United States inflation rate?

6 Feb

The Bureau of Labor Statistics reports the CPI-U index. The reported end December number of 1.7% tells us that the price of goods and services has increased by that much over the past year.
Interesting, but it doesn’t tell us much about the future rate of inflation and therefore how it will affect our future purchasing power.

A better indicator of future inflation, one that the Federal Reserve keeps a close eye on, is the 10 year breakeven rate. The breakeven rate is a measure of the expected rate of inflation over a certain period of time. It is calculated by measuring the difference between the nominal yield of government bonds and the real yield of inflation linked government bonds. In this case, the 10 year bonds.

The expected rate of inflation for the next 10 years shows that investors expect inflation rates to rise from 1.7% to 2.6%.

This doesn’t appear at first to be a big change, but as the chart below shows, 2.6% is as high as inflationary expectations were before the crisis, when the economy was growing at a speedy rate and unemployment levels were low.

US inflationary expectations

Given that the economy is stalling and the unemployment rate is at 7.9% what other factors could explain this rise in inflationary expectations?

One likely cause is the FED’s QE program, which has expanded its balance sheet by US$2.5 trillion since 2007. To put this in context, it took almost 100 years for the Fed to build its balance sheet to US$0.9 trillion and it then almost tripled this in the last four years! This new money has essentially been created out of thin air and, as it continues to find its way into the real economy, its effects will increasingly be felt by consumers. The simple economic principle of prices being determined by supply and demand tell us, very simply and elegantly, that once the supply of dollars increases so substantially, surely its price must fall. Or in other words, the price of good relative to the dollar must rise considerably to balance the oversupply of dollars.

Inflationary expectations could rise considerably from here. Watch this space!

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Do official inflation numbers underestimate real inflation?

2 Feb

Official inflation numbers appear to show little or no inflation in the developed world, yet we all seem to feel a greater impact on our wallets. Whether it’s at the petrol pump, train fares, food prices or even school fees, they all seem to be rising in price at a greater pace than the reported CPI numbers suggest.

Why is this?

Shadowstats, an electronic newsletter service that exposes and analyzes flaws in current U.S. government economic data and reporting, produces the chart below. It shows in red the official CPI-U year on year change in US CPI-U as reported by the Bureau of Labor Statistics and in blue the pre-1980 official methodology for computing the CPI-U, as reported by Shadowstats.

While numbers looked identical up to the early 80s they soon began to deviate substantially.

Today the latest US CPI-U number is 1.7% while the Shadowstats pre-1980 methodology shows a change in annual inflation closer to 10%!

Interested readers should read Shadowstat’s excellent report on the changes in the methodolgy since 1980. As stated in the report, the Consumer Price Index has been reconfigured to understate inflation versus common experience:

  • CPI no longer measures the cost of maintaining a constant standard of living.
  • CPI no longer measures full inflation for out-of-pocket expenditure.
  • With the misused cover of academic theory, politicians forced significant under-reporting of official inflation, so as to cut annual cost-of-living adjustments to Social Security, etc.
  • Use of the CPI to adjust retirement benefits, private income or to set investment goals impairs the ability of retirees, income earners and investors to stay ahead of inflation.
  • Understated inflation used in estimating inflation-adjusted growth has created the illusion of recovery in reported GDP.

It is no surprise the cost of living experienced by most of us has risen significantly above that reported by the CPI. For heavily indebted governments aiming to inflate away their debt this might appear to be a way of solving, in part, this issue. Take from savers and redistribute to borrowers. However, as consumers are unable to generate incomes that keep up with true levels of inflation their purchasing power falls consequently leading to a greater economic slowdown.

If real GDP numbers were to reflect this higher inflation number it would show that the US economy has been in recession for some time now, perhaps explaining why the unemployment number has struggled to fall for so long. That assumes the unemployment methodology hasn’t changed, which of course it has. Shadowstats estimates true unemployment in the US (pre 1994 methodology) at about 22%! More on that another day..

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