The Chart That Shows Why Inflation May Not be Around The Corner


Increasing The Money Supply Does Not Mean the CPI Will Rise

(October 2012) There seems to be tremendous confusion between asset price inflation and consumer inflation. “Printing Money” or expanding the Federal Reserve’s balance sheet, has caused asset price inflation. Specifically, the price of financial assets (stocks, bonds) and real assets (commodities, real estate, gold) have all risen as a result of the FED’s actions.
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However, the amount of trickle down to prices that families pay for rent, cell-phones, cable, transportation may be limited. As the chart below shows, The connection between commodity prices and inflation (as measured by the Consumer Price Index) has been broken since the early 1980s.


Commodity Prices Don’t Have Much Impact Inflation

Consumer inflation (CPI-U) moved in almost perfect unison with the cost of commodities (PPI -All Commodities) from 1970 to about 1982. Then, the relationship fell apart. From 1982 to 2003, while consumer inflation rose about 80% , commodity prices had a much milder increase of 40%. Recent spikes in commodity prices, first down in 2009 then up in the following  two years, have only the smallest impact on CPI.

The Fed increasing the money supply by buying bonds does have an impact on prices, just not the ones that you and I use the family checking account to pay. To quote Edward Harrison of Credit Writedown, “In sum, the problem with central bank policy is not that it leads to consumer price inflation, except via commodity and food prices.”

Why don’t higher commodity prices lead to inflation?

On an intuitive level, the cost of the raw materials that go into making a product or delivering a service should have a major impact on that product’s final price. However, over the last several decades, the percentage of a product’s costs that can be attributable to raw materials and energy inputs, has declined dramatically . The cost of labor, marketing, sales, and technology have become much more important than energy and raw materials.

The current theory that is circulating is that the FEDs current actions to increase the money supply (QE1, QE2, QE3) are inflationary. The FED is increasing the money supply, which will push up asset prices. This will eventually trickle down to consumers and lead to inflation.  (Don’t know what QE is? Go here)

Why is this important?

Investors should differentiate between investments that will be benefit from consumer inflation (Treasury Inflation Protected Securities – TIPS) and those that will benefit from asset price inflation like gold and real-estate. Inflation in asset prices, like commodities, does not mean that CPI will rise.

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  1. I tend to think commodity price inflation has had a massive impact on the economy – it’s deflationary. Services now make up such a large component of demand that they dominate inflation outcomes. As the prices of commodities rise, they squeeze, materially, household consumption elsewhere, mainly services. The great problem with services is that prices and wages are much less sticky: they’re piece based, tip based, hourly pay etc. Prices can adjust quickly to reflect lower demand because of higher prices for energy and food. I’ve written about this here I suspect though that QE Infinity has the potential to create a different outcome.


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