We now have inflation data through July, including the CPI and the all-important PCE deflators. Here are some updated charts and commentary. This situation is developing and I plan to watch these numbers closely.
Chart #1
Energy is by far the most volatile component of the CPI. Chart #1 shows the ex-energy version of the CPI, which rose by about 2% per year for almost 20 years. It’s now risen significantly above that trend line, and this suggests that the rising inflation we’ve seen this year is not likely to be temporary. The whole price level has been lifted by an excess supply of money, and the Fed has no plans to raise short-term rates or to withdraw excess reserves from the banking system for a very long time.
Chart #2
Chart #2 shows two versions of the CPI using a 6-mo. annualized rate of change—which is more representative of the current behavior of pricing. We haven’t seen inflation like this for a very long time.
Chart #3
Chart #3 shows the consequence of rising inflation for bond investors. The real yield on 10-yr Treasuries is now deeply in negative territory. This represents a significant loss of purchasing power for anyone holding Treasuries. Caveat emptor. How much longer will bond investors tolerate a government-guaranteed loss of purchasing power? How much longer will people keep tons of money on deposit in the banking system, when it pays no interest and is losing at least 4-5% of its purchasing power every year?
Chart #4
Chart #4 shows versions of the CPI year over year back to 1982, just after inflation peaked. We may well be revisiting the painfully high levels of inflation which first surfaced in the late 1970s.
Chart #5
Chart #5 shows the 3-mo. annualized change in the Core CPI. Yikes.
Chart #6
Chart #6 shows inflation as measured by the Personal Consumption Deflator, the Fed’s (and most economists’) favorite inflation statistic, given that it reflects a broad basket of goods and services and is periodically updated to reflect changing tastes and markets. There’s no denying that we have seen a meaningful increase in a broad range of prices. Only overly accommodative monetary policy can support such price action. If monetary policy were not so loose, a surge in durable goods prices would likely act to depress other prices (because people would not have an unlimited supply of cash).
Chart #7
Chart #8
Charts #7 and 8 show the behavior of prices for services, non-durable goods, and durable goods. I chose 1995 as the starting point of Chart #8 because 1) it was the first year when the China export machine began to impact global markets, and 2) it marked the first time in history in which we saw a sustained decline in the price of durable goods—which lasted for a remarkable 26 years. No longer: demand for “things” has been very strong, and shortages due to chip shortages are a fairly recent phenomenon. The numbers in green represent the total change for each component over the period of the chart.
UPDATE: Thanks to reader Peter Barnes for bringing up the subject of money velocity. I’ve written a response and I want to add a chart to this post to illustrate my argument.
Chart #9
Chart #9 shows the demand for money (M2/GDP) which is simply the inverse of the velocity of M2 (GDP/M2). I think it’s more logical to think of this in terms of people’s willingness to hold on to M2 money, which predominately consists of retail bank deposits of various sorts). I think the chart shows that there is a clear tendency for money demand to rise during recessions (gray bars) and during periods of great turmoil, such as 2008-9 and the second quarter of last year. When people are scared and faced with uncertainties, it is natural to want to accumulate cash as a form of protection against the unknown. But for the past year things have been getting slowly better, and in fact the demand for money has declined by about 5% since June ’20 by my calculations and estimates of current conditions. If the demand for money declines but the supply of money holds steady or increases, that is the classic prescription for a higher price level (i.e., inflation). And in fact that is what we have seen over the past year.
Viewed in velocity terms, what has happened over the past year is that people have been trying spend their money instead of accumulating more money. Dollars are being passed around faster and faster, and that supports a growing economy and/or rising prices.
If the demand for money were to fall back to pre-Covid levels, that would be the equivalent of unleashing a flood of $4-5 trillion into the economy (the M2 money supply is currently just under $21 trillion). And that would almost surely result in a bigger economy and much higher prices.