Inflation has announced a surprise tour of Europe this autumn…or should I say spring? Recent German, Spanish, and French inflation data accelerated unexpectedly, signalling inflation is not yet a has-been after all.
In the US, inflation data is still declining, but the stats are starting to surprise economists by coming in higher than expected too.
All this has upended the narrative that inflation is set to fall steadily downwards — the same narrative we were told in 2021 and 2022, funnily enough…
Now, I’m not saying inflation is going to return to double digits. I’m saying that the risk it could is being completely underestimated by the markets.
Indeed, financial markets globally got a bit upset about the European data because it signals that central banks will have to hike interest rates higher for longer after all. The markets had been expecting central bankers to fold on their tightening plans as inflation plunged and the economy along with it.
Higher interest rates spell more trouble for crashing housing markets, wobbling government bond markets, and down-but-twitching American tech stocks after an epic rout last year.
The big fear of economists and investors had been that inflation could settle at an unacceptably high rate, rather than falling back down to the 2% target, which most central bankers are supposed to meet.
The solution proposed to this scenario was, of course, to raise the inflation target. But that’s another story.
The idea that inflation would turn around and make for higher ground altogether is a theory I’ve only seen from one person — Peter Schiff. And let’s just say, he has a reputation for calls like this.
The bigger question now is whether inflation is going to come back for another go at asset prices in 2023. By which I mean that higher inflation prints hammer stock, bond, and property prices lower again.
It’s ironic, really. Inflation is the devaluation of money and debt, indistinguishable in today’s monetary system. Such inflation is supposed to be good for asset prices. I mean, what could make prices go up more reliably than the value of money falling?
And yet, prices of assets keep going down in many asset classes when inflation strikes.
The reason why is the anticipated hikes in central bank interest rates to deal with inflation. But consider a different point.
For decades, we had low consumer price inflation but high asset price inflation as a result of central bank policy. Property prices in particular boomed. Central bankers and governments could create and spend vast amounts of money, pushing up investments, but not the cost of living.
Now that combination is reversing. Central bankers are watching consumer prices go up, and asset prices go down.
At least they’re getting the blame for it.
The website Daily FX used an interesting scientific term to describe the inflation surprises out of Europe and the US: ‘sticky’. It’s a word that comes with a lot of baggage in the field of economics. And its misuse is particularly enlightening this time.
John Maynard Keynes used the idea of ‘sticky prices’ and ‘sticky wages’ to justify government intervention in the economy. Markets don’t clear perfectly because prices don’t move fast enough, in other words. This creates inefficiency, especially in the labour market. Because people don’t accept wage cuts (like the Japanese do), we get unemployment during a recession. If everyone’s wages just fluctuated like the oil price, the supply and demand in the labour economy would balance, leaving unemployment constantly very low.
The sticky prices market failure justifies stimulus spending to try and get the economy through any rough patch with minimum disruption.
The first problem with claiming that inflation is sticky is that it rose. It’s not even going in the right direction.
But the real trouble with claiming inflation is sticky is that it’s a rate of change itself. A car may have inertia, making it sticky to get moving and slow down. But for it to accelerate, an external force must be applied. Somebody must be doing the accelerating.
But who? The answer may surprise you.
To understand what’s going on inside the inflation figures, let’s take a quick detour into the murky world of statistics.
There’s a quirk when it comes to inflation figures. Well, there are loads, actually. But let’s focus on a few with a simple example…
Imagine an inflation data set that showed 0% inflation for two months, 10% inflation for one month, then 0% inflation for the following 11 months.
What would inflation be, according to that data?
Well, monthly inflation would be running at 0% for the last 11 months, so inflation would be 0%, right? After all, the inflation ended 11 months ago.
But we tend to make comparisons based on annual data, which is often called ‘year over year’. Compare prices year-over-year and a single monthly inflation spike of 10% 11 months ago means you have year-over-year inflation stuck at 10% for a full 11 months after inflation has actually stopped. That’s because prices are up 10% on a year ago.
If you have another month of 0% inflation after the last 11, bringing the string of no inflation months to 12, your year-over-year inflation statistics suddenly hit 0%. Prices haven’t gone up for a year.
Prices also haven’t come down from high levels, it’s important to note. And nothing actually changed that month — it was just another 0% inflation print. But because the month during which 10% inflation occurred dropped out of the year-over-year comparison, because it happened more than a year ago, the inflation rate plunges.
In other words, when measuring inflation, you need to pay attention to what was happening a year ago, not just what happened last month. You need to understand the month that dropped out of the data, not just the month that was added. Changes in what happened a year ago can amount to a better explanation for why inflation figures rose or plunged than anything recent.
Of course, inflation data is never that simple. Especially for the last two years…
But can you think of anything that happened a year ago that might’ve impacted inflation data over the subsequent months…?
In other words, the inflation prints we’re getting may be reflecting the lockdowns in various parts of the world and the invasion of Ukraine rather than recent price data.
Indeed, the frequency with which inflationary shocks appeared over the past year is what made inflation data spike so much. Rather than one month with big inflation prints that mangled year-over-year comparisons, we had the war in Ukraine, lockdowns, and more spike prices repeatedly within 12-month periods.
But those bulges are making their way out the other end of the python, bringing year-over-year inflation stats crashing back down, even as prices continue to rise.
Here’s another way to put it: inflation isn’t reported in a cumulative way because you lose a month’s inflation each time a new month’s data comes in. A two-year inflation comparison might be more helpful to highlight what’s going on over time.
According to the Reserve Bank of Australia’s inflation calculator, prices in Australia are up almost 10% over the two years to 2022.
Which is also a reminder that inflation is subject to compounding — another reason to stick to year-over-year comparisons only if you want to hide the overall impact of inflation.
One reason why older people are more alarmed about inflation is that they’re more likely to notice this compound effect. Prices are not just going up fast, they’re rising multiples of the prices they used to pay a long time ago. Young people don’t know that items that saw prices go up by a dollar used to be sold for a dollar.
Keep this in mind when you ponder the government’s superannuation tax changes. Who will be caught up in the thresholds in a few years’ time?
But back to the topic. If inflation continues to surprise to the upside, we can expect a replay of 2022, but in Europe instead of the US. And given 2022 was the worst year ever for investors in the US, that should make things interesting…
Until next time,
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Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend
