One of the most misunderstood and poorly taught subjects in all of finance has to do with the concept of inflation vs deflation. There is so much confusion when it comes to whether there is or isn’t inflation in an economy. How do you define it? How do you measure it? What does it mean for the economy, how should it affect your investments, and what impact will it have or not have on markets? And most importantly if possible, how do you create inflation in periods of deflation, and how do you reign in periods of run away inflation? The topic is complex to say the least.
To understand inflation, we need to first define it and then realize that there are multiple aspects of inflation and deflation and that this relationship is by no means one dimensional. The majority of people have been taught to think in a linear manner when it comes to this topic. Linear thinking is a thought process that is singular: there is one path toward completion which ignores possibilities and alternatives. Because linear thinking sees the world only as black and white, the person using this thinking style cannot create options. Schools unfortunately teach linear thinking – not dynamic thinking.
Dynamic thinking involves thinking “outside the box”. Dynamic thinking is being able to consider other possible scenarios and solutions with multiple causes and effects – a thought process that is not just black and white, a thought process that does not just reduce everything to one single cause.
Most of how we think about inflation comes from this linear thinking. Academia and most of the current western economic philosophy teaches inflation as a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.The opposite of inflation then is deflation.
Now this definition is not wrong however the chief measurement that often is used to measure inflation – the Consumer Price Index (CPI) – is wrong. Its well known that the government’s CPI is flawed and several major misleading revisions have been made to the CPI over the years.
This is The Way the Politicians Wanted It – the below is an excerpt from shadowstats.com
“In the early-1990s, political Washington moved to change the nature of the CPI. The contention was that the CPI overstated inflation (it did not allow substitution of less-expensive hamburger for more-expensive steak). Both sides of the aisle and the financial media touted the benefits of a “more-accurate” CPI, one that would allow the substitution of goods and services.
The plan was to reduce cost of living adjustments for government payments to Social Security recipients, etc. The cuts in reported inflation were an effort to reduce the federal deficit without anyone in Congress having to do the politically impossible: to vote against Social Security. The changes afoot were publicized, albeit under the cover of academic theories. Few in the public paid any attention.”
And most importantly about the CPI, one of the largest expenses to a consumer’s cost of living is ignored by the CPI and this is government taxation with the exception of property taxes. When we take into account that the average consumer spends slightly more than one-third or more of his total salary on taxation at the federal, state and local levels, it is outrageous to ignore this huge component of the average person’s cost of living. The cost of government as has been the single greatest added cost in everyone’s budget at the personal level. This fact is one of the major reasons why we have had no real growth in the economy.
Shadowstats.com has offered a more realistic reading of real inflation for many years. The CPI chart on their home page reflects their estimate of inflation for today as if it were calculated the same way it was in 1990. The CPI on the Alternate Data Series tab below reflects the CPI as if it were calculated using the methodologies in place in 1980. In general terms, methodological shifts in government reporting have depressed reported inflation, moving the concept of the CPI away from being a measure of the cost of living needed to maintain a constant standard of living.
We can see that a real more accurate measure of inflation has been running at much higher levels then what has been reported in the CPI. However what is most important from a trading perspective, is to understand the trends in the inflation rather then the actual absolute number be it a high level or a low level. Next we need to now understand what really causes inflation and what are its effects.
Inflation is something which most people perceive as a single dimensional force with its cause and effects one and the same. Most people view a rise in the overall market prices as simply inflation. But inflation is far from such a simplistic explanation. Its causes are numerous and this is why again I say a dynamic-thinking process must be applied to understand the muli-dimensional aspects of inflation.
There are three main types of inflation: Demand driven inflation, Cost-push inflation, and inflation from Currency fluctuations.
DEMAND driven inflation is most associated with waves of speculation which differ with each speculative boom where by demand is so high for a given asset be it real estate, commodity, stocks, or bonds, and the capital pours into that asset class because of demand. We saw this most recently in the Real Estate boom into 2007 where investors and speculators pushed asset prices to extreme highs. If the economy or market is in a boom and people are BULLISH, then you will find economic growth and the typical inflation that most people assume when they refer to inflation– rising prices that are really driven by DEMAND. Demand driven booms also tend to correlate with wage-inflation as the economic boom brings in more prosperity and thus a rise in wages.
COST-PUSH inflation is where there can be a cost-push in prices as we saw during the 1970s due to OPEC. The OPEC price rise sent a sudden shock-wave in the price of oil through the economy driving up prices because the entire economy had to readjust to higher energy. This was not the result of an increase in demand nor an increase in the money supply. We can also have cost-pushes that arise from a destruction of a crop in various commodities like wheat or corn, where adverse weather such as a drought can have a dramatic impact on the supply of a commodity pushing up prices. So a decline in the supply of some service or commodity can also lead to rising prices.
The other form of inflation or deflation can arise from the fluctuations in the value of the CURRENCY. When gold was used for money during the 19th century, it fell sharply in value with each new discovery from California and Alaska. Here inflation rose because there was a dramatic increase in money supply devaluing the existing units of gold – devaluing the currency. This is exactly what took place in Europe when Spain brought back ship after ship of gold and silver from the New World. The sudden rapid rise in the supply of money resulted in immense inflation and during both periods money (gold) failed to provide a store of value.
The 1987 Crash was the anticipation of a 40% decline in the value of the dollar. The capital flight from foreigners and the drop in the dollar created Currency Inflation where the supply of money did not increase but the drop in purchasing value of the currency resulted in the rise in the price of imports. The G5 increased the cost of everything imported including oil. They increased the cost of production that relied upon energy and foreign components. You can’t isolate just one aspect within the economy, everything is connected, there is no one black and white cause and effect.
The other side of the coin to inflation is then DEFLATION. Deflation is typically defined as a general decline in prices. But here again there are multiple-dimensions to deflation. You can have a decline in economic growth with rising prices that ends up being DEFLATIONARY for it depends upon what you are measuring. Such trends produce the rise in the cost of government (inflation) coupled with the decline in disposable income (deflation) as government expands and consumes an ever increasing amount of the society’s total productive capacity.
Such confusion and conflux of trends of inflation & deflation emerge with rising prices because of the rise in taxation and regulation increase the cost of doing business. This is the opposite of rising DEMAND. The total volume of business declines as DEMAND collapses with the velocity of money. The first is a trend of inflation with rising prices coinciding with a BULL MARKET and an increase in demand. The second form of rising prices unfolds with a BEAR MARKET driven by rising taxes and more regulation – not an increase in DEMAND. This is part of the eternal battle between Government and the Private sector.
And these different types of inflation can be affecting different sectors of the economy all at the same time. For example we have been experiencing a significant expansion of government over the last 30 years and this has produced a rise in taxes and an expansion of debt, which is an inflationary upward move in the cost of government- a bull market in government. All the while the majority of commodity prices in the last several years have been falling since 2011, we have been experiencing deflation in commodities for example like the drop in agriculture prices and the drop in energy/gas prices.
And lastly to make the point again of linear thinkers vs dynamic, the hyperinflationists are linear-thinkers. They assume the idea that an increase in money supply must result in rising prices and run away inflation like that experienced in Germany or Zimbabwe.
They assume this one-dimensional fixed relationship and they cannot see the other true aspects of DEMAND that produce the bull and bear market trends. They are locked into this linear thinking process that there must be single cause and effect, a one path forward with one single outcome and a relationship that is constant. They along with the majority still have not grasped the dynamics of the interconnected multi-deminsional real world global economy.