The Independent Market Observer

9/25/13 – The Inflation Problem, Part 1: Defining the Problem

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 25, 2013 11:47:25 AM

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I wrote about inflation risk at length back in January of this year. Although inflation wasn’t a concern at the time, I noted that we would have to be watchful when three things happened: a decrease in the unemployment rate, a resumption of bank lending/consumer borrowing, and faster growth in GDP. All three of these are happening now, so it’s time for another look.

Another reason to revisit inflation is the Fed. One of the arguments for maintaining the Fed’s stimulus program, albeit one that hasn’t gotten a lot of play, is that inflation is still well within a reasonable range. With the stimulus set to continue, we can reasonably expect inflation to continue at current levels, and quite possibly to increase. This is actually a goal of the Fed’s—and it usually gets what it wants.

The Fed has a dual mandate: to maintain stable prices and foster high levels of employment. Historically, the stable prices component—that is, low inflation—has taken a higher priority. Recently, that has changed. Over the past several years, with the advent of the financial crisis, the Fed has actually sought to generate inflation to combat the threat of generally decreasing prices, or deflation. Deflation is generally considered bad, since it depresses economic growth, increases the real burden of existing debt, and is very difficult to fix with existing policy tools.

You can see this with a simple set of thought experiments. If you know something will be more expensive next year—because of inflation—you’re more likely to buy it now, generating economic growth. If, on the other hand, whatever it is will be cheaper next year, you’re more likely to wait, which doesn’t generate economic growth.

Similarly, suppose you own a house worth $100,000 with an $80,000 mortgage. With, say, a 2-percent inflation rate, your house will be worth $102,000 in a year while your mortgage is still $80,000—you have, at least nominally, increased your equity. By contrast, in a 2-percent deflationary world, the mortgage is still $80,000 in a year, but now your house is only worth $98,000—you have lost equity.

The Fed has been committed to fighting deflation since the crisis, to the extent that it has pretty much said that an inflation rate of around 2.5 percent would be tolerable. What this means, over time, is that prices will double every 30 years. In the next decade, you would lose about 30 percent of your purchasing power. Needless to say, the acceptance of this level of inflation isn’t universal. Whether you approve of the policy or not, though, you will be hit by it and should understand the results.

In this post, I want to set the stage about where we are right now and to define the problem. Inflation as a concept is simple. Where it gets hard is deciding how to actually measure it.

“Laws are like sausages,” Otto von Bismarck said. “It is better not to see them being made.” The same might be said of economic statistics, but I disagree. The bedrock of most economic analysis is good data. The most fundamental data, on the economy as a whole, is provided by the government. For this series of posts, we’ll break down the consumer price index, or CPI, statistics to see where they come from and what they mean. My primary information sources will be U.S. government websites: the Bureau of Economic Analysis, the Bureau of Labor Statistics, and the National Bureau of Economic Research. These are excellent resources, providing very detailed data series and methodological explanations.

Another primary source for this series is what I might call an antigovernment website,, which is run by an economist who has made a career of attacking the methods and results of the government agencies. Shadowstats is the best known of these sites, but hardly the only one; their essential thesis is that the government statistics are systematically manipulated. Specific accusations are made, and effects are asserted—for example, had certain methodological changes not been made to the CPI, social security payments would be twice what they now are. A powerful charge, if true, and one that deserves critical examination. What does the evidence show?

Price inflation, as expressed by the CPI, is important for a few reasons. The first is that it impacts every person, every day, on every purchase. The second is that the CPI is subject to the most significant charges of manipulation. The third is that the consequences, in social security payments, interest rate changes, and wage negotiations, are so significant for so many people. Finally, I’m writing about this because my father, who has little knowledge or interest in economics, has asked me how inflation can be down when the prices of everything are up. If my dad is asking the question, then many readers probably are as well.

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