Inflation or Deflation? Part 1 – Jets versus the Sharks and Lady Gaga

I intended to write one post about the situation with inflation and deflation but have had tons of fan mail telling me to keep my posts shorter than “Atlas Shrugged.” So let’s call this post Part 1. This post has nothing to do with Lady Gaga but I promised some people I would put her name in my next post.

At the center of the debates about macroeconomic policy today is the question of the future course of prices. One side (or should I say gang – let’s call them the Jets) looks at past money growth and future government deficits in the USA and posits a rise in inflation. Before things get out of hand, the Jets would like to see a more conservative macroeconomic policy. The Sharks, in contrast, see nothing but recession and excess capacity and recommend continued low interest rates and more fiscal stimulus. Some sharks worry about deflation. So, the expected future course of inflation is critical right now. Will we have inflation or deflation?

Given my last post about the complexity of the macro economy it should not be surprising that economists can have such different forecasts of an important economic indicator like inflation. Given the spate of recent news about the slowing world economy and the ensuing decline in stock markets, you might be wondering how I can even say the word inflation…so let’s get to it.

Before we get all sweaty and crazy let’s make sure we use the right terminology. Economists, like astro-physicists and dry cleaners, use a lot of technical lingo. So it won’t hurt to make sure we understand the terminology as it is used to describe changes in national prices. First, when we talk about inflation, we are talking about a percentage change in a price index. There are lots of price indexes (The Richmond Fed has a data table with some of the more popular versions at http://www.richmondfed.org/research/national_economy/national_economic_indicators/pdf/all_charts.pdf#page=34 and the St. Louis Fed has some graphs at http://research.stlouisfed.org/publications/net/page8.pdf .

Most of us are used to following the percentage change in the CPI (consumer price index) and the truth is that most of these other inflation measures are highly correlated to the changes in the CPI. So for most purposes it is okay to focus on the CPI measure of inflation.

Second, articles that report inflation information describe these percentage changes over one-month and/or over one year, yoy (year-over-year). One has to focus and concentrate a lot to get things straight when reading these articles. Just like your weight can vary a lot from week to week, your doctor seems more concerned with how much weight you gained in the last year. Nevertheless, we weigh ourselves every 18 minutes to confirm that the 36 ounce t-bone with mashed potatoes and macncheese really did add a few pounds this week. In May the Bureau of Labor Statistics (press release: http://www.bls.gov/news.release/cpi.nr0.htm ) reported that the CPI fell .1% in April 2010 and then fell by .2% in May but came in at 2.2% and then 2.0% yoy. The former information tells you that the average level of prices fell for two consecutive months but that a whole year of past price change had inflation averaging around 2.0%. So we are keen to see what happens in June – will the one-month rate return to something more normal (it rose by .1% in March of 2010) or will it be negative again? If it is negative again then we might be thinking that the trend is changing. How much will it impact the yoy rate?

Third, you need to know that sometimes the one-month rate – in my example above the decline of .2% in May-- is usually also annualized. That is, they report a number that shows how much that one-month change would amount to if it kept up for 12 months. The annualized rate is NOT the actual change over a year and it is not a prediction – it is a hypothetical to help put one month into an annual perspective. Annualized rates are useful. Suppose Kobe Bryant scores 9 points in the first quarter of an NBA game. Is that a good performance for him? Bryant’s season average this year was 27 points per game. So the 9 points in the first quarter can be “game-ized” to 36 points by multiplying by four quarters. So if he kept scoring at 9 points per quarter, he would score 36 points and be well above his average. So you say – “way to go Mr. Kobe Bryant – you did great in the first quarter.”The -0.2% change I mentioned above for the CPI in May is often multiplied by 12 (yes, compounding is usually ignored) to get an annualized monthly change of about -2.4% per year. The annualized inflation rate for May was approximately -2.4%.

Fourth, articles also report core inflation. Core inflation deals with apple cores. No it doesn’t. I am just checking to see if you are still awake. Economists care about the sustainability of inflation. There are some elements that comprise the inflation index that are bad actors and confuse us about sustainability. Food and housing prices are not very well-behaved. They have a reputation of jumping around unmercifully. All this spasmodic activity hurts the eyeballs for those who read graphs too often and it is misleading as to what the future inflation will be. So we put food and housing prices in the corner – we remove them from the other children – I mean from the other parts of the index. The Core inflation rate, therefore, is less affected by dramatic short-term changes in food and energy and seems more closely attuned to the factors that contribute to a sustainable inflation rate. The CPI less food and energy rose by 0.1% in May, (a 1.2% annual rate) and increased by 0.9% during the past 12 months. If the yoy Core rate were to decline for a few months to reach a rate of about 0.6% yoy, then Mr. Bernanke would stroke his beard and say, Aha – I think we are disinflating.

Am I kidding – disinflating? Children, take out your dictionaries. Disinflation is a frequent phenomenon in the USA – it simply means that the inflation rate is declining. If inflation was 2% last year and 1% this year – that is disinflation. This must be distinguished against datinflation. No I am just kidding again. There is no datinflation – but there is deflation. Deflation means the inflation rate is negative. That does not happen much in the USA. But that is what the Sharks are worried about. Since we are doing vocabulary there is one more term – reflation. The Jets worry about reflation – a rise in the inflation rate.

I had hoped to fully solve the issue of inflation or deflation in this post but alas I see that a few of you have drifted off. Naps are good and I don’t discourage such behavior but it does tell me that I should be napping too. So I will continue all this in my next post. Please stay tuned. In the meantime, review what you learned – inflation, yoy, annualized, deflation, disinflation, reflation, and antidisestablishmentarianism.

Note – For those of you born within the last 40 years or so – there was a musical called Westside Story that premiered in 1957. It is a wonderful love story about a bunch of guys who race around on Jet skis and get eaten by sharks. http://en.wikipedia.org/wiki/West_Side_Story