Saturday, 26 January 2013

Start Thinking Differently about Inflation

Inflation in the U.S. and the euro area is running at much higher levels than it first appears, here's one way to think about it.

In the euro area and the U.S. so called "official statistics" inform us that consumer price inflation (CPI), in main stream economics referred to simply as inflation, is modest, currently running at 1.7% and 2.2%, respectively (see here and here). The statistic itself depends of course, amongst other things, on what items are measured and their individual weighting in the aggregate CPI. In the U.S. for example, John Williams at demonstrates that CPI is currently running (and has been for a long time) substantially higher than that officially reported through calculating the statistic based on methodologies in place both in 1980 and 1990.

Leaving all that aside, and adding that it is almost impossible these days in the western world to receive a sensible real return in bank savings accounts and further assuming the reported CPI stats are indeed correct, the discussion is normally tilted toward whether the reported CPI is (too) high or (too) low, in absolute terms. But such a discussion misses a key point, namely, what would the CPI have been absent all the money printing and increases in money supply? Without it, wouldn't the CPI have been substantially lower? If we can agree that the more there is of something, ceteris paribus, the less it's worth, the answer is an unequivocal yes. As a consumer, deflation, or decreasing prices, is a good thing as it means you get more for your money. Wouldn't you rather pay less than more for the same item? Likewise, as a saver, it means your money will become worth more in the future (even without receiving any interest).

Therefore, when hearing that the CPI is 1.7%, as the case is for example in the U.S., think about what it could have been without all the money printing. The difference between the two would give you a much more accurate indication of the actual loss in purchasing power than the CPI. I am not aware that anyone has attempted such a calculation for an economy (please let me know if you are). Hence, when thinking about and discussing CPI, refer instead to increases in the money supply (e.g. M2) as a measure of inflation. And instead of running at 1.7% in the U.S. and 2.2% in the euro area, inflation as measured by increases in the money supply is currently running at 8.07%  in the U.S. and 4.63% in the euro area, or 4.75x and 2.1x higher than reported. Think about that the next time you look at the interest received in your bank savings account and when paying your bills. Not to mention the next time around you speak with your boss regarding a salary review.

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