Tag Archives: Rate of inflation

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.

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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The current state of inflation

31 Jan

ACCORDING to Milton Friedman, “inflation is always and everywhere a monetary phenomenon.”

If that is true, then you have to wonder where the heck all of the inflation is, writes Martin Hutchinson for Money Morning.

Every central bank in the Western world is holding interest rates down, and almost all of them are printing money like it’s going out of style.

Five years ago, nearly every economist in the world would have told you this would cause inflation to skyrocket, and the big deficits governments were running would make matters even worse.

Taken together, monetary and fiscal policies are far more extreme than they have ever been.

Yet, inflation has remained rather tame at 2%. In Friedman’s world that just wouldn’t be possible.

What does it all mean?….

It means even Nobel Prize-winning economists can get it wrong-at least in the short run.

Here’s why Friedman has been wrong on inflation so far. It starts with his basic theory.

The central equation of Friedman’s monetary theory is M*V=P*Y, where M is the money supply, Y is Gross Domestic Product, P is the price level and V is the “velocity” of money, thought of intuitively as the speed at which money moves around the economy.

In this case, the M2 money supply has been increased by 11.5% in the last two months and 8.2% in the past year, while the St. Louis Fed’s Money of Zero Maturity (the nearest we can get to the old M3) has increased by 13.1% in the last two months and 8.4% in the last year.

Since GDP is increasing at barely 2%, that ought to mean prices should increase by 6%, just based on the last year’s data alone.

Needless to say, that’s not happening, since consumer price inflation is under 2%.

Of course, monetarists will tell you that money supply produces inflation only with a lag.

Fine, but it’s also true that the M2 money supply has been increasing by 7.4% over the last five years.  Admittedly, there was a year in mid-2009-2010 when it stayed flat, but otherwise the monetary base has been increasing at about 8-10% per year.

Again, growth in those five years has been below 2%, and five years is longer than anyone thinks the lag should be.  So why isn’t inflation at least 5% not 2%?

Monetarists would explain that by telling you that monetary velocity has declined over the last five years.

That’s obvious from the equation, but what is monetary velocity and why has it declined?

The velocity of money is simply the average frequency with which a unit of money is spent in a specific period of time.  And in our day-to-day activities, it’s obvious that monetary velocity has in fact increased.

More people are using debit cards, which cause transactions to move instantaneously from the bank account to the merchant, and many people are using Internet banking, which similarly increases the speed of transactions, reducing both the amount of physical cash carried and the time that old-fashioned checks spend sitting in storage at the US Postal Service.

So what is the problem?

Monetarists will tell you that the decline in monetary velocity is due to the massive balances, over $1 trillion, which the banks have on deposit with the Fed, which just sit there and do nothing.

That’s probably correct since while the deposits exist, the ordinary mechanisms of monetary movement simply don’t work, since that money has no velocity.

As a result, Bernanke and his overseas cohorts have succeeded in saving themselves from being hindered by a surge in inflation.

The Japanese experience over the last 20 years suggests that this position, with a huge money supply and no inflation, may continue for 20 years or more.

In short, thanks to the banks, Freidman’s monetary theory has simply stopped working.

It’s not clear to me whether at some point the banks will start lending the trillion-Dollar balances at the Fed, in which case inflation will revive rapidly.

However, there is one other economic theory that is relevant here.

Austrian economists like Ludwig von Mises will tell you that ultra-low interest rates will create an orgy of speculation, in which markets create a huge volume of “malinvestment” – investment that should not economically have been made, and which has less value than its cost.

Eventually, like it did in 1929, the volume of malinvestment becomes so great that a crash occurs, in which all the bad investments have to be written off, huge losses are taken and a wave of bankruptcies sweeps across the economy.

This didn’t happen in Japan.  The banks went on lending to bad companies, creating a collection of zombies which sapped the vitality from the Japanese economy and has produced more than 20 years of economic stagnation.

In Japan, the politicians have even decided to print more money and do still more deficit spending. Since Japan has debt of 230% of GDP this will almost certainly produce a crisis of confidence, in which buyers stop buying Japan Government Bonds. That will cause the government to default and will more or less shut down the Japanese economy – the worst possible outcome.

Since politicians hate periods of liquidation, they could encourage the same behavior here, in which case growth will continue at current sluggish rates until the Federal deficit becomes so great that nobody will buy US Treasuries.

Again, without a Treasury market, there will be an economic collapse.

At that point, you’re likely to get all the inflation you want – it’s basically what happened in the German Weimar Republic in 1923.

The point is, Bernanke has created something of a new monetary ground, increasing the money supply rapidly without getting inflation. But it won’t last.

At some point we’ll get hyperinflation and probably a Treasury default.

Rate of inflation

29 Jan

Global rates of inflation

The table below shows the rate of inflation in some of the world’s major economies, as at end December, 2012.

This table is updated quarterly and found on the Rate of inflation tab above.

Country Last (%) Previous (%)
Australia inflation 2.2 2
Brazil inflation 5.84 5.53
Canada inflation 0.8 0.8
China inflation 2.5 2
Euro Area inflation 2.2 2.2
France inflation 1.3 1.4
Germany inflation 2.06 1.89
India inflation 7.18 7.24
Indonesia inflation 4.3 4.32
Italy inflation 2.31 2.51
Japan inflation -0.1 -0.2
New Zealand inflation 0.9 0.8
Russia inflation 6.6 6.5
South Korea inflation 1.4 1.6
Spain inflation 2.87 2.93
Switzerland inflation -0.4 -0.4
Turkey inflation 6.16 6.37
United Kingdom inflation 2.7 2.7
United States inflation 1.7 1.8
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