Thursday, October 28, 2010

Inflation? What Inflation?

Buttonwood notes that commodities have been on a tear lately:
Higher wheat and metals price have been hitting the headlines, so it is no surprise that the all-items index is up 8.4% on the last month. It is more surprising that it has risen 28.1% over the last year. Furthermore, this is not a boom that is driven by oil. The crude price has only risen 10.2% over the last year.
Buttonwood then asks a question:
Ben Bernanke warned last week that the level of inflation was too low for comfort. Indeed, the core rate is just 0.8%. Why aren't higher commodity prices showing up in the CPI?
Buttonwood answers the question:
In part, this is down to lags; in part, it's down to the relatively small weight of commodities within the index. But it may be down to methodology. John Williams at Shadow Government Statistics runs an inflation measure that ignores all the methodological changes that have been made to the CPI since 1980; this has inflation running at 8.5%. A separate measure that ignores changes since 1990 has inflation running at 4.4%.
But then Buttonwood questions the answer:
My feeling is that, if inflation were as understated as the Shadow numbers suggest, it would have shown up somewhere else in the numbers (by analogy, if a company is fiddling its profits numbers, the evidence will probably show up in the cashflow figures). No-one is suggesting that the annual wage growth numbers are artificially low. So if prices have been rising much faster than wages, wouldn't that show up in declining consumer demand?
Buttonwood’s conclusion is that the understatement of CPI is not that big an issue.

I disagree, and here’s why. The period in question also happens to be a period of dramatic increase in the availability (and utilization) of consumer credit. Coincidence? I think not. Prices rose but wages did not; the only way to plug the gap was for the consumer to become ever more leveraged.

And then, the crash: after credit dried up in 2008, “declining consumer demand” is precisely what we have seen. It all fits.

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