Year after year and report after report, we are told that inflation is low. We have governments and central banks printing money like never before. They are seemingly handing out money with reckless abandon. Increasing the deficits by millions, billions, or even trillions of dollars. And yet, inflation remains low.
Inflation remains so low in fact, that the biggest central bank in the world had to change its inflation target last year. How can this be when we have supposedly had a decade of economic growth?
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Inflation and The Business Cycle
There are four parts of the business cycle: Expansion, Peak, Contraction and Trough. This is also the order that the business cycle runs. Inflation generally follows the business cycle. As the business cycle is in the expansion phase, inflation increases. At the peak of the business cycle, unemployment is low and inflation is generally higher.
As the business cycle contracts, inflation will lessen. And as the business cycle hits its trough, unemployment is usually its highest with inflation being at its lowest point. After the trough, expansion will begin and the business cycle will repeat itself.
If we look back through history, the average business cycle is 4.7 years. Of that, 3.2 years is the expansion and peak phases, and 1.5 years is the contraction and trough. In the chart below, the gray area is the times of recessions. The blue line is the unemployment rate.
The chart we made below, shows rough periods of recessions in orange, with the blue line as annual inflation.
We know that inflation is a lagging indicator. This means that peak inflation is only reported quite a while after the economic expansion has ended. This trend can be seen in our graph above.
Leading up to 1970, inflation is rising, we enter a recession, inflation peaks part way through and then starts to decline. In fact this trend, inflation peaking during a recession or immediately before, can be seen in every recession in the last 60 years except for 2020. It will be interesting to see what inflation looks like in the coming months and years.
Another interesting observation that can be made is the peak inflation at each recession. In the early 70s inflation was near 6%. The mid-70s was ~11%. The early-80s were close to 14%. Then after the 80s, we see a significant change. The early 90s peak inflation was around 5.5%.
If we look close enough, we can see another not quite as severe change happen after the 90s. In the early 2000s peak inflation was even lower at 3.38%. Again in the late 2000s, it failed to break 4%. Lastly, around 2020 the last time we even broke 2% was 2017 and 2018. More than 2 years prior to the COVID recession. If inflation is a lagging indicator it should not have peaked 2 years prior to the business cycle and economic peak.
If we look back prior to 1960, it is easy to see that inflation was a lot more volatile. With periods of severe deflation and severe inflation. See Chart below:
Fed Changes Inflation Target
For a long time, governments and central banks have aimed to maintain what they consider a healthy 2% annual inflation. According to many sources, in a healthy economy, annual inflation should be around 2%.
If we go back 2 full decades to 2001, average annual inflation is right on pace at 2.03%. However, during the entirety of the last business cycle (2010-2020), annual inflation averaged only 1.67%. If we were in a time of historic economic prosperity, like we were told we were, we should have had no issue reaching a healthy 2% inflation.
Due to the fact that the federal reserve has been unable to report healthy inflation, they had to change their target for inflation. Rather than trying to attain 2% inflation annually, they want to average 2% inflation over a period of time.
The two sound similar but have very different implications. Changing their goal to “averaging 2% inflation” allows them to let inflation run hot (i.e., “moderately” above the 2% level). Now since inflation has been so low, if we have a couple years of inflation at higher levels, it will supposedly be fine because it will average out to 2%. Whereas before, in years where inflation was running hot, they would have tried to cut it back to a healthy level. This would normally have been done by adjusting interest rates.
This change was done under the guise of supporting the labour market and the greater economy. This means the Fed will be less inclined to adjust interest rates if unemployment rates fall, so long as inflation does not increase as well.
Plus, what is the issue if inflation does run a little hot for a little while? Well, first they didn’t specify the period of time that will be encompassed in the average. Is it the 5-year average? Maybe the 10-year average? 20? 50? 100? That makes a huge difference in how long you let the inflation rate run hot.
Another thing to consider is that the inflation rate that we, the consumers, experience may actually be well above quoted inflation.
Quoted Inflation Isn’t the Full Picture
Inflation is based on the Consumer Price Index (CPI). Governments and central banks are concerned specifically about core inflation. Core inflation is the change in prices of goods and services minus food and energy.
However, over history, the CPI has changed. Specifically around the 80s and the 90s. There is a wonderful site called shadowstats.com. There they show you what inflation would be if it was still calculated today as it was in the 80s and in the 90s.
Paints quite a different picture. If we were going based on the way inflation was calculated in the 90s we would be sitting between 4-8% inflation. Even worse than that, if we were going based on the way inflation was calculated in the 80s we were sitting around 5-10%. With multiple peaks above 10%.
There is a lot of evidence to suggest that inflation is actually a lot higher than what we are told it is. In addition, if what they are concerned about doesn’t include food and energy, it definitely doesn’t show the full picture. A lot of household income goes towards good and energy. There are a lot of global organizations, like the UN, who are saying there is an increased fear of inflation on food. Hopefully, this isn’t the case but it seems like the probability is high. To read more on that check out Helicopter Money to Increase Short-Term Inflation 2020?
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