Price Behavior, Inflation and

Deflation
Problems and solutions

© 2014 Gary R. Evans. May b e used only for non-profit educational purposes without permission of the author.
What is inflation?

• A general increase in the price level as

measured by y some index like the CPI ..
• 0-2% Traditional/healthy
• 3-6% Moderate
• 7-15% High
• 15+% Runaway
• 50+% Hyper-
Hyper-inflation
The German inflation of the 1920s
Date $1 equals in Marks
J l 1914
July 42
4.2
July 1919 14.0
J l 1921
July 39 5
39.5
July 1922 483.2
J l 1923
July 353 412
353,412
Aug 1923 4,620,455
S t 1923
Sept 98,869,000
98 869 000
Oct 1923 25,260,208,000
N 1923 4,200,000,000,000
Nov 4 200 000 000 000
21 April
p 1910 10,000
, Mark Note
6 Februaryy 1920 10 Mark Note
The back ((10 Mark Note))
1 March 1920 1 Mark Note
9 August
g 1923 2 Million Mark Note
1 Sept.
p 1923 50 Million Mark Note
The Back ((50 Million Mark Note))
According the the 2008 CIA Factbook,
Zi b b
Zimbabwe, with
ith an unemployment
l t rate
t
of 80% and with 20% of the adult
population identified as HIX-positive,
had an inflation rate estimated to be
100,000% per year in 2007.
In 2014:

from International Business Times, Feb 14, 2014, by Patricia Rey

Mallen.

... also Ukraine, Venezuela, Brazil, Turkey, South Africa.

How inflation is measured ..
• Consumer Price Index ((CPI))
– Measures “cost of living” for consumers
• Producer Price Index (PPI)
– Measures input costs for manufacturers
• Implicit Price Deflator (IPD)
– Used to adjust GDP to real GDP
• Employee Cost Index
– Used by FRS as early inflation indicator
Average: 4%

16.00
CPI Inflation Rate: 1960-
1960-2013
Annual %
change
14.00
Acceptable Double-digit
12.00 level (about hyperinflation
2.5%)
10.00
Green lines:
G li
8.00 BC troughs

6.00

4.00

2.00

0.00

-2.00
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

CPI for urban consumers, U.S. city average, all items,NSA. Source: Bureau of Labor Statistics
The CPI
• Prices collected monthly and bimonthly in 85
urban areas from about 45,000 housing units
and 20,000 retail establishments for 80.000
items
• Personal
P l visits
i i andd telephone
l h calls
ll
• Base year (average of 1982
1982--84)
84) set to 100
• “Market basket” weights are based upon
consumer surveys conducted 2009-
2009-2010, 7,000
families keeping diaries of everything they
bought for 2 weeks, another 7,000 in a more
general survey covering 3 months.
• The index is a weighted sum.
 Calculating the Inflation Rate
1. Each month (year) the value of n
the
h market
k basket
b k iis calculated:
l l d
the alphas are weights based
MBVt   P
i 1
i i
upon
p a consumer survey. y
2. The CPI is calculated by taking
the value of the market basket MBVt
CPI t  MBVb  100
for each month (year) is divided
by the value for the base year
(average of 1982-1984),
1982 1984), then
multiplied times 100.
CPI t
3. The inflation rate is calculated IRt  1
from the CPI. CPI t 1
 Jan 2014 CPI category weights and values
Consumer Price Index for All Urban Consumers The weights are
CPI-U NSA, January 2014 market basket
Category Weight Index Rate
weights Note
weights.
All times 100 233.9 1.6% Medical. Other than
Food and Beverage 13.9 238.9 1.1% tobacco, the highest
Housing 32.0 266.8 2.6%
disaggregated
Apparel 3.4 124.3 -0.3%
Transportation excl fuel 5.7 280.7 1.2% category is college
Gasoline 5.0 286.6 0.1% tuition.
Medical Care 5.8 459.6 2.5%
Recreation 5.8 115.3 0.4% Current data can
Education 3.2 228.3 3.0% always be found by
Tuition, other fees 1.8 636.0 3.5% clicking on the most
Communication 3.8 82.6 -2.0%
E
Energy Services
S i 37
3.7 197 9
197.9 4 5%
4.5% recent CPI news
release on the front
Purchasing power of the dollar $0.428 page of the BLS
1982-84 = 100
website.
S
Source: BLS Economic
E i News
N Release,
R l 2/10/2014 T
Tables
bl 1 1, 2
2, and
d33.

Bananas: 0.088
Note: Not all categories are shown, there are small amounts of overlap, and weights do not sum to 100.
 The CPI (all items) less food and energy (Core Rate)
Jan 2007 - Jan 2014,, monthly
y ggrowth rate,, NSA
% monthly
2.00
The core rate
1 50
1.50 0.8%,, if sustained,, would excludes food,
equal 10% inflation annually and energy
1.00
The core rate
0.50 is far less
volatile.
0.00
Energy and
-0.50 food costs
explain why
-1.00
... right while the stock All Items is
-1.50 market was crashing higher, then
-2.00
l
lower.
Jan May Sep Jan MaySep Jan May Sep Jan MaySep Jan May Sep Jan MaySep Jan May Sep Jan

All Items Less Food and Energy

2007 2014
2008 2010 2012

Source: Bureau of Labor Statistics

The Producer Price Index ((PPI))
The Producer Price Index is a family of indexes that measures the average
change over time in the selling prices received by domestic producers of
goods
d andd services.
i PPIs
PPI measure price
i change
h ffrom the
h perspective
i off theh
seller.
Over 10,000 PPIs for individual products and groups of products are released
eachh month,
h including
i l di finished
fi i h d goods,
d commodities,
di i andd raw materials
i l andd
food. PPIs are available for the products of virtually every industry in the
mining and manufacturing sectors of the U.S. economy.
Currently, most PPIs have an index base set at 1982 = 100.
The PPI is assembled by and very comprehensive data are available from the
U.S. Department
p off Labor Bureau off Labor Statistics:
http://bls.gov

Note: Original source for this slide, which is mostly quoted, but since modified, was lost. It probably came
from the BLS.
 Finished Goods and Commodity PPI
% vs.
vs CPI-
CPI-U,
U monthly @ annual rates,
rates 2007
2007--2014 NSA
20.0

15 0
15.0

10.0

5.0 ??
0.0

-5.0 Note the high volatility of the PPI

measures compared to CPI. CPI
sometimes acts like a weighted moving
-10.0
average.
g Monthlyy numbers of PPI at
release are too volatile to have much
-15.0 meaning. But over time ...
2011
-20.0
Jan MaySep Jan MaySep Jan MaySep Jan MaySep Jan MaySep Jan MaySep Jan MaySep Jan
2007 CPI-U PPI Finished Goods PPI Commodities
2014
Source: BLS
BLS Employment Cost Index
Total compensation, all civilian, annualized change,
quarterly, 2001
2001--2013, NSA

... shown with trendline.

This is the inverse of what is

called “productivity” and is
probably the variable that most
mitigates and inflation threat.

This progress is mostly technological (computing, robotics,

the internet) – anything that reduces the labor component of
cost, but also crummy job market.
Costs of inflation
• Distributes income and wealth unfairly
– To: owners of real assets, borrowers, those who understand
the system
– From: renters, savers & lenders, semi
semi--skilled and unskilled
• Affects financial markets
– raises interest rates
– reduces the value of debt
• Tends to lower real income
– nominal income doesn’t keep up
• Interjects yet more uncertainty
– which retards economic growth
• Tends
T d tto b
be self-
self
lf-compounding
di
Costs of Deflation
• Effects during Great Depression
– Made loans impossible to pay
– Destroyed banking structure
– Resulted
R lt d iin 1933 R
Roosevelt
lt B
Banking
ki H Holiday
lid
• Generally undermines any economy with
large levels off debt contracts iin nominal
i
(nor adjusted for prices) amounts
• Today a problem in commodity exporting
nations
– Especially raw materials exports
Deflation duringg the Great Depression
p
CPI annualized monthly rates, 1920 to 1940

Post WWI The Great Depression,

although we were an
Source: BLS agricultural economy then.
Theories of inflation (a review)

• Aggregate Supply/Aggregate Demand

– Inflation can be demand pull or cost push
– Impact of variables depends upon context
– Inflation tends to get worse automatically
• Loanable funds model
– Inflation
I fl ti and d iinterest
t t rates
t are correlated
l t d
– To cure inflation, interest rates must rise
Inflation and Recession!
How to we explain
p this?
10
8
Inflation
6 and
Recession! .. and again!
4 GDP growth
IPD iinflation
fl ti
2
0
-22
-4
70 72 74 76 78 80 82 84
A
Anti
Anti-
ti-inflation
i fl ti policies
li i

• Monetary policy approach

– Tighten up credit conditions
– Raise
R i iinterest
t t rates
t
• Price controls don’t work
– Causes acute shortages
– Encourages black market
– Easy to circumvent in non-
non-commodity
economy with “new product design”
 The last FRS tightening
g g 2005-
2005-2006
Continued
through
g 2006.
SF2005
r The FRS tightens
while … SF2004

b
r2005
… consumer borrowing
r2004 a continues to grow strongly

DF2005

DF2004

The last FRS anti-inflation ppolicyy was Volume of Credit

during this period. When QE3 stops, this
might happen again. To what effect??
Quantitative Easing Programs (2007-
(2007-2013)
Using
U i programs called
ll d quantitive
titi easing
i (QE1 - QE3),
QE3)
the FRS is severely cutting target interest rates to ease a
credit crunch and prevent a serious recession.
SF1

SF2
r
Govt expansion

DF1,2,3
Private collapse

Consumer and business demand for credit fell, and lenders curtailed
certain types of lending (like mortgages), but U.S. Government demand
for credit has hugely risen (to finance stimulus package). Hence DF1,2,3.
 2014: Tapering of QE3
QE3 purchases $45b U.S. Treasuries and $40b
mortgages monthly. The first taper reduces that by $5b
each monthly, the second taper by another 5 ...
SF2014
Qualify this ...
SF2013
r
? Govt expansion

DF1,2,3
Private collapse

The government demand for funds is falling sharply (smaller deficits)

and consumer and business demand for funds is stable but could grow
some or shrink some, so the effect upon interest rates is unclear,
 Federal Funds Target Rate
Federal Funds Target Rates
March 2003 - February 2013 Actual target
in Feb 2013 is
6.00
0.0 - 0.25%
anti-inflation
5.00

anti-recession
4.00
and aversion of
credit crisis
3.00

2.00
Nowhere
l ft to
left t go
1.00 here.

0.00

… a general tightening after June 25,

25 2003,
2003 to forestall inflation and curb low
interest speculation, followed by recent severe reductions to combat credit
crisis and prevent recession, finally dropping rate to 0-0.25% in Dec 2008.