How to Predict Inflation and DeflationAuthor: Marc ProsserLast Updated: October 30, 2013 What causes inflationary pressure?Excessive Growth Of The Money SupplyEconomic ExpansionExternal ShocksWhat causes deflationary Pressure? The opposite of each of the inflation factors above plus:Productivity IncreasesA Rising DollarHow do you measure these factors? Excessive Growth Of The Money SupplyImagine that you could magically double the amount of cash that people had access. What do you think would happen? (Think about what happens when a college student receives their first credit card.) If the amount of cash suddenly doubled, people would dramatically increase their spending. While the demand for goods and services would increase in this scenario, the supply of these goods and services might take a while to catch up with demand. In the short-run if demand increases and supply remains steady, then economics 101 dictates that prices should rise.The Federal Reserve has a number of tools that can expand or restrict the money supply. The Fed Funds rate and open market operations (buying and selling treasuries) are really just ways of influencing the money supply. In theory, if the money supply is increasing faster than real GDP growth (the amount of goods and services being produced) it should be inflationary. Conversely, if the money supply is growing slower than the GDP, that should be deflationary.There are two main measures of the money supply in the United States, M1 and M2.M1 = Cash (as in US paper currency and coins), Checking Accounts, & Travelers Checks M2 = M1 + Savings Accounts, CDs under $100K, Retail Money Market Funds & AccountsAs of June, 2012. M1 was $2.3 Trillion and M2 was $9.9 trillion. Economic ExpansionEconomic expansion increases the demand for goods, services and labor. As companies are growing, they need to hire more workers and buy more supplies (which could be cement for a construction company or software licences for an accounting firm). In this circumstance, the unemployment rate should drop and existing workers will start demanding higher wages. Thus economic expansion is inflationary in two ways: Demand increases from new workers spending money andPrice increases on everything from cement to software licenses, as a result of the rising productions costs to create goods (hire labor and material costs) and greater demand enabling companies to raise prices.When looking at economic expansion, there tends to be a heavy focus on the labor market. The following economic indicators are heavily scrutinized: Unemployment Rate and Non-Farm Payrolls.Unemployment Rate – This is the Number Of People Looking For Work / (Number Of People Looking For Work + People With Jobs) Most economists consider a good unemployment rate 6%.Non-Farm Payrolls – Whereas the unemployment rate is a relative number (a percentage), non-farm payrolls is an absolute number, which measures jobs creation and losses. Many prefer non-farm payrolls to the unemployment rate, because the unemployment rate can drop when the economy is very bad. The unemployment rate does not include adults that give up on trying to find a job, which often occurs after several months of applying for jobs without success. Usually, a monthly non-farm payrolls number between +150,000 to +250,000 is considered a sign of a nicely growing economy. External ShocksThere is one key input which is vital for the US and global economy, whose price is very volatile. The volatility in the price sometimes has little to do with demand, but the supply or perceived future supply. The input is oil, which is vital for everything from transportation, heating, and manufacturing. Unfortunately, the supply of oil can fluctuate greatly with the political situation in the Middle East, Russia and Africa. For example, there is currently worry about Iran shutting down the supply of oil out of the Middle East. An Israeli attack on Iran’s nuclear program or a NATO intervention in Syria could well be a trigger of this type of action. Increased fear of such an event could easily drive oil prices over a $150 or even higher which would in turn add a few percentage points to inflation.There are several measures of oil prices, including West Texas Intermediate (WTI) and Brent Crude, which trade at different prices. These are actually different types of oil (different thickness, levels of impurities) that get delivered to buyers are different locations. If you want to track oil prices, I would pick one to follow. Causes of DeflationAny factor that leads to inflation, can also lead to deflation. A tightening of the money supply, a slowing economy and receding fears about a middle east conflict would all be deflationary. However, there are some factors that are currently having a strong deflationary impact which I would like to explore. Productivity IncreasesAlan Greenspan, the former Chairman of the Federal Reserve, credited the benign inflationary environment during the first decade of the the 21st century, to gains in the productivity of America’s workers. What took 40 hours for a worker to accomplish in 2000, might have only taken 30 hours to finish in 2010. As a result, the cost of producing an item or providing a service was reduced, because the amount of labor needed has decreased over time. This decrease in the amount of labor often compensated for increases in the cost of labor, enabling companies to absorb an increased cost of labor without passing it on to customers in the form of higher prices.Productivity is not often reported on by the financial press. However, the Bureau of Labor Statistics does publish a productivity statistic which measures the economic value of the goods American workers produce (adjusted for inflation) by the number of hours Americans worked which you can find here. A Rising US DollarThe US imports around $200 billion of goods per month. If the costs of those goods goes down, then US inflation will also go down. A rising dollar makes the costs of imported goods cheaper. In 2010, the Euro / US dollar exchange rate was over 1.40. One euro could be exchange for $1.40. More recently, the rate is trading around $1.25. Over the last couple years, the euro has lost over 10% of its value against the US dollar. Put another way, European goods are now 10% cheaper for US buyers. A stronger dollar has been a factor in keeping US inflation rates low.