Years ago, at the Rugby 7s in New Zealand, I found myself talking to a young lady from England. She’d found a working holiday job with the New Zealand inflation statistics gathering team.
We were both intoxicated, leading to speculation from our groups of friends as to the nature of our animated conversation, though being dressed as Wally from Where’s Wally probably didn’t work in my favour.
But our chat was really all about how New Zealand collects its consumer pricing data…
She wasn’t impressed with their methods, to say the least. And intended to find out if the UK’s methods were just as rubbish once she got back home.
After a few jokes about the hedonic adjustments which statisticians make to inflation data, we went our separate ways.
The experience only strengthened my suspicions that the inflation statistics on which the world’s central banks base their decisions are probably useless.
They’re definitely rather subjective. I mean, hedonic adjustments alone are a bit fishy.
A computer that’s twice as fast still has me typing just as slowly on it. But, as far as the statisticians are concerned, it’s not the same as last year’s computer, and the price should be adjusted down to account for the improved quality.
Hey presto, the rising price I pay for a new computer is not captured in the inflation data in a way that reflects my actual experience.
Now, if you ask me, we’re at the stage of inflation where the government must act. And, if it can’t get inflation itself under control, well at least it has control over the inflation data.
Adjustments will of course be statistically robust – there are enough theories out there from which to cherry pick your justification.
And they will also be made with the most honourable of intentions, too.
You see, a key part of inflation, particularly based on the way academics theorise about it, is inflation expectations. If business people or labour expect prices to go up, they raise their own prices and cause the very inflation they’re expecting. It becomes a self-fulfilling prophecy.
This implies that you can bring inflation down merely by making people believe it’s lower. Which justifies massaging the statistics. But only if nobody finds out…
This presumes people don’t know how much their costs are rising, and that they trust their government. Which could be a bit iffy right now.
Just ask Japanese people about their government’s inflation statistics and you’ll see what happens when statisticians get such manipulation wrong.
But surely the media will hold the statisticians to account?
Well, something popped out at me after reviewing yesterday’s Fortune & Freedom. We looked into the Bank of International Settlements’ warning about inflation becoming entrenched. Better to nip it in the bud, it said. Don’t let expectations kick in a self-fulling prophecy.
But, as ever, the media went a little wayward in their coverage of the BIS report. The headline to the Telegraph’s article is “World is on ‘tipping point’ of permanently high prices”.
The problem is, inflation has nothing to do with “permanently high prices”, as readers of our recent inflation primer might recall:
The most important thing to understand about inflation is that it is a rate of change – the first derivative of prices.
It isn’t high prices. It is rising prices – with secondary-school teacher-style emphasis on the “ing”.
Let’s explore the difference.
If prices go up, that’s not inflation. If prices keep going up and up and up persistently over time because the value of money continuously falls, that’s inflation.
The distinction is especially important right now, as I explained here. If central banks panic about high prices instead of continuously rising prices, they tighten monetary policy at precisely the wrong time.
In that article I asked a question and, helpfully, left it unanswered. But a reader pulled me up on the omission.
Afternoon Nick
Love your articles but which is it?
Inflation driving oil price or oil price driving inflation?
Honestly, I’m not sure.
But, having anticipated inflation and referred to the monetary sort in my predictions, as opposed to the commodity price shock sort, I’m very hesitant to declare victory.
The rest of the commentariat has moved on, for the most part. And they’ve declared the inflationistas such as myself as the winners.
Inflation really has surged and broken out, just as we predicted. It has been persistent, as we anticipated. And it is going over double digits, as the more extreme inflation warnings suggested.
But I’m not convinced we’re right… yet.
It’s not like those who predicted inflation also foresaw the invasion of Ukraine and the sanctions in response. Nor the nature of the supply chain crisis.
In fact, many inflation predictions were about an economic boom after pandemic lockdowns. Now the opposite – stagflation – is happening. The economy is set to go into recession.
Being right for the wrong reasons should be a warning about whether you’ll continue to be right.
I remember, years ago, my best-performing recommendation was the Korean stock market ETF. I was lauded for my foresight. The only problem was that my prediction about the reunification of Korea beginning didn’t exactly play out. Korean stocks rose for completely different reasons.
Anyway, the point is that rising prices don’t make inflation predictions accurate. Particularly when the reasons for those rising prices are reversing.
The commodity prices that triggered our current bout of inflation are plunging back down.
Oil is in a bear market, and metals prices are crashing like it’s 2008.
High commodity prices look to have triggered a recession, crashing demand and, thus, said commodity prices.
The cure for higher prices is… higher prices, and for two reasons. First, the steeper prices reduce demand (a recession in the extreme); second, they lift supply (by incentivising more production).
If consumer prices come back down, as they would in a free market with sound money, we’ll know that our bout of inflation was nothing more than a commodity price shock. Prices went up because costs did. And they’ll fall as costs decline.
Of course, there’s a lag. And the rate at which producer price inflation exceeded consumer price inflation suggests there may be some more pain to come for consumer prices.
But, if inflation was fed by commodity prices, then it should be over soon and it will fall again as the coming recession unfolds.
The problem is, it’s difficult to tell true inflation apart from such a shock until it’s too late. True inflation being the persistent devaluation of money.
This makes prices go up, too, but it’s the value of money that’s falling, it’s not the price of things rising.
But if the value of money is falling, doesn’t that mean inflation makes all prices go up at the same time?
Contrary to what your high-school economics teacher might have taught you, money is not neutral. Money neutrality only plays out over very long periods of time.
In other words, when inflation rises because of the devaluation of money, prices don’t go up at the same pace right across the economy. Some parts are affected more than others.
So, to answer the reader’s question, the commodity price shock might have been caused by inflation…
It’s at least plausible that we’re facing true inflation, even if I’m not convinced it’s here yet.
The moment of truth will come if inflation falls alongside GDP in the coming recession. If inflation doesn’t come right back down, then we’re in trouble.
Nick Hubble
Editor, Fortune & Freedom
There’s no Southbank Live this week as the guys are on holiday.
But, Boaz has thrown down a challenge for you and the winner will receive an ounce of silver!
If you don’t know, during Southbank Live, the guys name a long and short for the week.
That’s something their bullish on, and something their bearish on for that week.
Could be a specific asset, a whole sector or anything in-between.
It’s for entertainment and sometimes it’s done purely in jest. For example, at Christmas they were long eggnog futures.
So, Boaz’s challenge to you is to come up with a comical long and short for this week in the markets.
The winner will be the wittiest answer as decided by Boaz and John on next week’s show.
And the winner will receive an ounce of silver.
To enter, just send your answer here and let us know your answer by midnight on Wednesday 6 July (terms and conditions apply).
May the best in-jest-er win.
Paolo Cabrelli
Publisher, Southbank Investment Research
