Friday, October 31, 2008

Deflation? Unemployment?

Seasonally adjusted CPI

Someone just e-mailed that there is deflation in the making. The above table (in case of viewing trouble, the chart is located here) shows the Consumer Price Index over the past year. The numbers at the end, 2.6 and 4.9, indicate the inflation rate over the three months and twelve months ended September 2008. A 4.9% annual inflation rate is historically high. Note that there was recently a more than 50% fall in oil prices due to a speculative crash. Despite this, inflation in September was zero. Between 1913 and 2008 the CPI increased more than 4.9% only 19 times. That means that this year has had the 20th highest inflation in the past 95 years and represents the 21st percentile. I would call it above-average inflation. I am puzzling over how there can be deflation and inflation at the same time, but apparently today's economists and media pundits have figured out a way. It is true that the CPI deliberately excludes an element that ought to be counted toward inflation--house prices. The problem with including house prices now is that they were excluded since the 1980s and so inflation has been understated every year since 1983. If they add it in then inflation will have been 1/4 higher. It would seem that the Federal Reserve's regime has been one of price instability.

It is true that unemployment has been increasing. In February of this year unemployment was 4.8%. Unemployment is up 24%, from 4.9% in January to 6.1% in September. This would seem to reflect the decline in construction due to falling house prices.

In days gone by some economists claimed that unemployment implied deflation or reduced inflation and vice-versa. However, in the 1970s there was both high unemployment and high inflation, earning the appellation "stagflation".

Nouriel Roubini describes his fear of deflation in a Forbes article. Roubini argues that slack consumer markets, falling commodity prices, a global recession and unemployment will cause deflation. He notes that commodity prices are down 30% from their July peak. Also, inflation-adjusted treasury bonds are selling for more than non-inflation-adjusted treasury bonds. He argues that the federal government will not monetize (print money to cover) the trillion dollar bailout and that "central banks will mop up" the massive increase in the money supply in the past few months. These last points are speculative. Why would he think that a fifty percent increase in monetary reserves will be "mopped up" by the banking system? Banks are sitting on surplus reserves and they will eventually use them to make ever worse investments.

The 30% contraction in commodity prices to which Roubini refers follows a large increase in oil prices. The average oil price in 2007 was approximately equal to the current price. Thus, there was likely a speculative run up in oil prices over the past 18 months. The current oil price of $64.42 is almost triple the average price in 2002, $22.81. Comparing gold, which has fallen 26% from its 2008 high (which is the nominal all-time). In January 2001 the gold price was approximately $280 per ounce. It peaked at approximately $1,000 in March and is now about $736, 2.6 times higher than or almost triple its low in 2001. Might there have been excessive speculation in commodity markets that exceeded inflation and so caused a pull-back? These fluctuations would be greater than normal, but occur all the time in commodities markets.

The current banking problems have reduced new construction and are causing house prices to fall. However, this does not mean that there will be no inflation. The Fed's increase in monetary reserves of 60% is on top of several decades of healthy monetary expansion. Much of the monetary expansion was invested in worthless sub-prime and other real estate development. The Fed has already expanded the money supply to create unmarketable, worthless, investments to the tune of hundreds of billions if not trillions of dollars. It is difficult to picture how food, energy and commodities will not increase in price given the destruction of resources in which borrowers from banks funded through Federal Reserve Bank Credit have engaged since 1981.


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