"There are only two ways of telling the complete truth—anonymously and posthumously."Thomas Sowell

Monday, December 05, 2005

Inflation, Energy and Gold

Larry White is an outstanding free market monetary theorist at the University of Missouri in St. Louis. At the Division of Labor blog he notes that although the nominal price of gold is back to the level of 1987 it remains much lower in real terms, after adjusting for the 75 percent rise in prices since then. But the real price of gold has nearly doubled over the past four years, which he interprets as hedging against inflation:

“The upsurge in gold over the last four years suggests that that investor confidence may be slipping again – and not without good reason. As Bloomberg reports: So far this year, consumer prices are rising at a 4.9 percent annual rate compared with a 3.7 percent increase at the same time last year.”

Yes, but . . .

So far this year, consumer prices less energy are rising at only a 2.0 percent rate -- down from 2.2 percent at the same time last year. Energy prices in the CPI rose 12 percent in September alone, but fell slightly in October.

If we look at the superior chain-weighted CPI, prices were up only 1.7 percent over the past twelve months for all items less food and energy. Food is rarely a significant factor (I'd prefer to drop the "core" measure), and food prices were up only 2.1 percent over the year while energy prices soared by 26.3 percent. Leaving out energy alone, the chained CPI would be close to 1.8 percent over twelve months. Since even chained price indexes exaggerate inflation, because of quality improvements and hidden discounts, an inflation rate of 1.8 percent for everything except energy is really quite low.

The main reason this distinction matters is not that rising energy prices don't hurt, or even that global oil demand is only indirectly related to Fed policy. The key reason we absolutely must look at inflation without energy prices is that energy prices cannot and will not keep rising forever. When they stop rising, we'll see how the underlying rate of inflation really is.

If the chained CPI less energy remains around 1.8 percent, then total inflation will likewise drop to about 1.8 percent if energy prices merely stabilize, and to a rate below 1.8 percent if energy prices keep falling.

It is theoretically possible that non-energy prices might accelerate if energy prices fall, because cheaper energy frees-up cash to spend on other things. In the past, however, spikes in energy prices in 1974-75, 1979-81 and 2000 were always followed by slower inflation in non-energy prices for at least a year or two. The Fed’s notion that energy inflation spreads like a virus from energy to everything else is factually false.

Non-energy inflation is now lower than it was during in any year from 1967 to 2001, and also lower than last year. So relax and enjoy a happy new year. But maybe it's time to trim those hedges.


Hunter Baker said...

Alan, I appreciate your offering some insight on this issue. I've always held the view you ascribe to the Fed because it seems so common-sensical. After all, you need energy to get all the other goods to market, thus if that price is up, all the others must follow. Thanks for the further analysis on the point.

The Classic Liberal Anonymous said...

I'm trying to hash this out ... please bear with me.

Lets say that you have a fixed amount of money to purchase goods and energy. If the energy prices go up (and are inelastic) that will reduce the money supply for non-energy goods, right?

This implies a reduced level of inflation for non-energy goods at times when energy prices have spiked (this seems to be contrary to what Hunter stated).

Now, when the energy prices come back down, the money available to purchace non-energy goods will go up, resulting in inflation (of non-energy goods).

Question to you economic experts: is my analysis too simplistic, and if so, where (why) does it fail?


Alan Reynolds said...

An earlier critic complained about my using 12-month averages because it might miss turning points. Too short a period, however, confuses wiggles with trends. Years ago The Wall Street Journal suggested we look at six-month periods, at a seasaonally adjusted annual rate. For the six months ending in October, the regular (not chained) CPI was up at 1.7 percent rate if we leave out energy, and energy was up at a literally unsustainable 40.8 percent rate. For the six months ending in April, the non-energy CPI was up at a 2.4 percent rate, though energy inflation was "only" 19.3 percent.

The test question is this: Did inflation slow down or speed up over the latest six months? Not many economists, let alone Fed governors, appear able to pass this test.

Hunter Baker said...
This comment has been removed by a blog administrator.
Alan Reynolds said...

I thought my first post dealt with the comment of the classical liberal anonymous. I agree that higher energy prices should be disinflationary for every thing else, because budgets are limited. And in theory we might see other prices rise more quickly when energy prices fall. In fact, however, that has never yet happened. I suspect it has to do with smoothing of consumption -- we feel frugal for a while after suffering the burden of an energy shock. But when theories don't work, I stick with the facts. Unfortunately, many do the opposite.

Benjamin Zycher said...

A couple of comments to add to Alan's observations:

1. That the publicized "inflation" data are biased upward is suggested by longer-term interest rates, which appear low in nominal terms (the real rate plus an adjustment for expected inflation.

2. The recessionary ("deflationary") effect of rising energy prices has not been discussed very well in the mainstream press, perhaps because most of the journalists are morons.

3. At the same time, I think that Alan may be understating the overall spending effect of falling energy prices. Unless the energy spending reductions get stuffed into mattresses, the dollars will be spent somewhere. Will prices in those sectors rise? That depends on supply conditions, etc. Who knows?

4. But Alan's larger point is correct: Energy price increases cannot be "inflationary" in the classic sense, because an increase in one set of prices yielding reduced spending and thus prices in other sectors is not "inflation." It is a change in relative prices; our snapshots at various intervals of the "price level" indicates changes in the level of prices, but not a quais-permanent change in the rate at whcih prices change.

5. And that is why the Fed's (Ben Bernanke's) price rule is potentially mischievous: The Fed will be led to interpret a change in relative prices as "inflation."

Hunter Baker said...

I'd like to see a post by either Alan or Ben on the new chairman of the Fed. Like him? Don't like him? Would have preferred somebody else? Hate the fed?

Alan Reynolds said...

I like that Ben B. but prefer our Ben Z. The idea that one person should have such power is rather spooky.

Forbes wisely reprinted this pasage of mine from an October 20 column at townhall.com:

"Central banking is the last refuge of central planning -- the notion that a group of experts can meet in secret and plan the economy from the top down. But this is a game played without any rules. We speak of the "art of central banking," as though it is akin to a magic show. So long as a central bank doesn't mess up too badly, we tend to almost deify central bankers. When they do mess up, many then argue that we must have deserved the pain and suffering as penance for the good times."

tbmbuzz said...

The idea that one person should have such power is rather spooky.

True. On the other hand, being completely independent of Congressional or Presidential meddling is a good thing!