CPI Unexpectedly Increases


“I graduated from the college of the streets,

I've got a PhD in how to make ends meet,

inflation in the nation don't bother me,

'cause I'm a scholar with a dollar,

as you can plainly see”

Quincy Jones, The Dude


Actually, the scholar with a dollar should be especially worried about inflation, because once his dollar turns into 80 cents of purchasing power, he will be down 20%. Rising consumer prices are currently probably not yet what one would call a big problem, but a combination of even fairly slowly rising prices and stagnant or falling incomes certainly is.

This is the combination of news that hit the Street on Thursday: “Consumer prices rise the most in 10 months”, we heard, closely followed by the observation that:


“The increase in prices meant that hourly earnings adjusted for inflation dropped 0.3 percent on average in April after falling 0.1 the prior month, according to another Labor Department report today. Over the past 12 months, real hourly pay declined 0.1 percent.”


(emphasis added)

One day earlier, producer prices were reported to have increased by a whopping 0.6% month-on-month, driven by a big rise in food prices. What 'price inflation' means to citizens depends largely on what they spend most of their money on. A sharp rise in food prices obviously hits the poorest strata of society the most.


However, the mythical 'general price level' is one thing, inflation is really quite another: simply put, it is the increase in the money supply. The modern use of the word 'inflation' is designed to obscure the cause for rising prices, by a clever semantic trick. The cause has been switched for the effect, so to speak.

Below is the most recent chart of the US money supply TMS-2 (without memorandum items, which make only a very small difference; the most important items are currency, and money in sight as well as savings deposits, all of which can be withdrawn in the form of standard money, i.e. banknotes, on demand). Looking at this chart, it becomes clear that there has been a lot of inflation – and this is a big problem regardless of what CPI is doing.


TMS-2-LTMoney TMS-2 has recently crossed the $10 trillion barrier (outer space comes next) – in 2008, it stood at $5.3 trillion – click to enlarge.


A Few Observations on Inflationary Effects

Apart from obvious effects, such as the rise in the prices of titles to capital, an artificially suppressed interest rate and huge expansion of the money supply will affect the economy's production structure. It is easy to envisage why: the further removed in time a good is from the consumption stage, the more its discounted value will rise when interest rates decline. This is not a problem when interest rates are falling due to an increase in genuine savings, as that means that  the amount of produced-but-not-consumed final goods available to function as the economy's pool of real funding will be large enough to support a longer and more capital-intensive production structure. It becomes a problem only when the savings do not actually exist, but the level of interest rates nevertheless seems to suggest that they do.

Then capital will be invested unwisely, and a production structure will tend to be erected that does not conform to the time preferences of consumers. Not only that, it will also end up producing too many goods that will later not be demanded, while failing to produce enough of those that will be. In the end it will turn out that it is unsustainable.

As Mises wrote:


“The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder's fault was not overinvestment, but an inappropriate employment of the means at his disposal.”


A credit-driven boom usually ends when the malinvestment is eventually revealed as relative prices begin to reverse. Since an inappropriately lengthened capital structure will eventually tie up far more consumer goods than it releases, the effect on prices that initially actuated the boom will flip around. The trigger is usually the abandonment of the inflationary policy, or at least a slowdown in the inflationary policy (we leave the special case of the inflationary policy being continued or even accelerated aside here). If less money from thin air is forthcoming, less real wealth can be diverted toward bubble activities.

In what way this phenomenon precisely manifests itself depends on the contingent data of each case: it could be that a strong rise in consumer goods prices begins, but it could also be that prices for capital goods begin to decline, or a combination of both. Definitely though, the previous distortion of relative prices will be subject to a movement in the opposite direction, this is to say, capital goods prices will begin to decline relative to consumer goods prices. This is why the capital goods industries are among the biggest beneficiaries of a boom and suffer the most in the subsequent busts.

When prices of consumer goods are 'unexpectedly' rising not long after a long-lasting and extreme inflationary policy has been slowed down, one must be alive to the possibility that the turning point is coming closer, not least because it may motivate the monetary authority to tap the brake more forcefully. Here is a chart of the year-on-year change rate of CPI, which has moved back up close to the 2% level:


CPI-annCPI, y/y change rate – click to enlarge.


In the annotation we mention that there 'was a failure of consumer goods production to recover'. We often look at the following chart that shows the ratio of capital to consumer goods production, as it gives us a rough idea of how inflationary policy affects production:


cap-cons-goods-ST-annThe ratio of capital to consumer goods production. As imperfect as such data are, this chart does give us an idea of how the boom-bust cycle tends to play out in the realm of production – click to enlarge.


We decided to also take a closer look at the individual components, adding  production of non-durable consumer goods to the next chart as well, which is especially relevant in terms of the pool of real funding (workers employed in production processes that are temporally very far removed from the consumer stage must after all have something to eat until their input ripens into consumables).


production - capital and consumer goods-annCapital goods (business equipment), consumer goods and non-durable consumer goods production. Since at least the late 1940s, the former has eclipsed the latter only twice: in 2007/8 and today – click to enlarge.


As can be seen, consumer goods production has indeed failed to rebound much since the 2008 crisis – but capital goods production has almost increased back to the 2007 peak. It is a very good bet that the current structure of production will once again prove unsustainable.

The long term increase in capital goods production relative to consumer goods production is very likely not only a result of inflation. However, a large part of this shift can probably explained by it – it is no coincidence that the capital goods production index is so extremely volatile and that the ratio shifts sharply downward during recessions. In this context, one must also consider the longer term chart of the ratio:



The ratio of capital to consumer goods production, long term – click to enlarge.


What can be clearly seen on the longer term chart is what we would term the 'pre-bubble era' and the 'bubble era'. The cesura between the two eras is Nixon's gold default – this was when unfettered debt growth started. The most startling factoid about this is that real economic growth was far higher in the pre-bubble era than thereafter. We realize that GDP is a very flawed measure of 'growth', but the difference is still striking: from 1948 to the end of 1972, average annual GDP growth was 4%. From 1973 to 2013, it was 2.8%. Due to the compounding effect, that 1.2% difference adds up greatly over time.



Inflation of the money supply only appears to help the economy for certain periods of time. In the long run, it weakens the economy at a fundamental level. The production indexes for different classes of goods indicate that monetary pumping has produced large distortions in the economy again. Should the recent rise in CPI prove to be more than just another fluke, it could be that the amount of monetary pumping will be reduced much faster by the Fed than is currently expected. Even if the Fed remains 'behind the curve', the echo bubble will at some point run into trouble anyway. It will be interesting to see how it will play out this time and what trigger events will appear on the scene.


Addendum: Bonds Unimpressed

Interestingly, both the 10 year note and 30 year bond yield kept falling sharply in spite of the unexpectedly high CPI reading. The bond market seemed more focused on scattered signs of economic weakness as well as a bout of selling in the stock market.



Bond yields kept falling in spite of high CPI and PPI readings. The 10 year note yield has already reached the next level of support – click to enlarge.



Charts by: St. Louis Fed,StockCharts




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One Response to “Inflation in the Nation”

  • rodney:

    It is easy to envisage why: the further removed in time a good is from the consumption stage, the more its discounted value will rise when interest rates decline.

    i.e. inflation falsifies economic calculation.

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