Getting to know inflation

townhall.com ^ | 6/24/04 | Larry Kudlow

[kattracks]

There's no foolproof way to forecast inflation -- a big buzzword these days. The Milton Friedman definition of too much money chasing too few goods is always a good place to start. But we've learned through the years that simply using a monetary aggregate to predict inflation doesn't work. This is because the velocity -- or turnover, or demand -- for money is not stable. It hasn't been since President Nixon took us off the Bretton Woods gold-exchange standard. Nowadays, there's no policy anchor to reliably preserve monetary value.

 Begin with the Fed, the only place new money can be created. Excess money is inflationary, where dollar purchasing-power value falls. A shortage of money is deflationary, where dollar value rises. Though pure monetarism has dimmed, the model of too much money (created by the Fed) chasing too few goods (money required for financial and economic transactions) is still useful.

 Economist Arthur Laffer pioneered a subdivision of traditional money-supply measures into supply and demand categories. Through the monetary base, the Fed controls the true supply of money. With transaction balances, such as M1 (currency and demand deposits) or MZM (money at zero maturity), the public's demand for money can be quantified.

 Over the past year, these money supply-and-demand proxies have been in balance. But core inflation has still gone up. Measured over a 12-month period, the consumer price index has increased to 1.8 percent in May from 1.1 percent last December. Year to date, the core CPI (excluding food and energy) is advancing at a 2.9 percent annual rate.

 Importantly, monetary policy also interacts with tax policy. Lower marginal tax rates usually raise liquidity demands, as higher after-tax returns to work and investment generate increased economic activity. Hence, more money from the Fed is required to finance the economy's expanded potential to grow. This has certainly been the case in the year following the Bush tax cuts.

 As economist Victor Canto has long argued, supply-side tax cuts raise the volume of available goods and services, thus absorbing any monetary excess. Think of it as more money chasing even more goods. This is profoundly counter-inflationary. In fact, it is the reason why virulent inflation seems highly unlikely today.

 But most academic and Wall Street economists are demand-siders. They believe that excess demand during times of rapid economic growth causes higher inflation. Twenty years ago, Lawrence Summers and Paul Krugman, then staffers on the president's Council of Economic Advisors, predicted higher inflation after the Reagan tax cuts. They were dead wrong. Inflation declined to 1 percent in 1986, as the volume of goods surged during the Reagan boom.

 This supply-side fiscal effect strongly suggests that inflation is not only a monetary phenomenon. But how can we forecast it?

 Inflation-sensitive market prices best capture the relationship of money supplied and demanded. Prices efficiently encapsulate all available information regarding the inflationary or deflationary processes. Friedrich Hayek's "knowledge problem" is best solved by markets, not government.

 This discipline is fleshed out in "Monetary Policy, A Market Price Approach," by Manuel Johnson and Robert Kelleher. The authors, both of whom served in the Federal Reserve System, draw heavily on the classical theories of Swedish economist Knut Wicksell. In the Wicksell system, future inflation expectations can be charted through the movement of gold and commodities, the exchange value of the dollar and Treasury-bond spreads. When the Fed policy rate is set below the economy's real or natural rate, inflation fears will rise. When it's set above the real rate, deflation fears will develop.

 Between 1996 and 2002, the economy experienced episodic deflation. Since then, however, emergency liquidity and rate-cutting by the Fed have caused sensitive market-price indicators to signal a revival of inflation expectations. Essentially, the Fed lurched from too tight to too loose. How much of a problem will this be?

 A shorthand version of the Wicksell model has been developed by Wall Street supply-siders Michael Darda and Michael Churchill. They compare the current dollar price of gold with the 10-year average gold price, with Churchill using the pre-deflation period of 1986 to 1996. Both gentlemen acknowledge the emergence of excess liquidity in the form of a rising gold price in 2002 and 2003. However, both note that the recent slump in gold (and metals) suggests that rising inflation pressures may turn out to be rather muted. Still, the Fed must remove the unnecessary emergency liquidity and raise its base target rate.

 If they do, inflation will turn out to be a non-problem.

 Think of this: The Bush tax cuts, along with rapid productivity gains and hopefully a steady dollar-gold exchange rate, could recreate the economic booms of 1982-1989 and 1995-2000. In both periods, economic growth came in above expectations and inflation below them.

 Certainly, the better part of economic and market wisdom today still suggests that an optimistic outlook is far more likely than a pessimistic one. This would be very good news for George W. Bush -- for as go the markets, the economy and inflation, so goes his re-election prospects.

©2004

Contact Larry Kudlow | Read Kudlow's biography

[Moonman62]

Essentially, the Fed lurched from too tight to too loose.

Essentially, all Greenspan has ever done is follow dollar policy set by the White House. Kudlow has to make things way too complicated to justify his love for gold, although his approach is still simpler than most.

[Moonman62]

This is because the velocity -- or turnover, or demand -- for money is not stable. It hasn't been since President Nixon took us off the Bretton Woods gold-exchange standard. Nowadays, there's no policy anchor to reliably preserve monetary value.

I take it Kudlow thinks Bretton Woods was a good thing. It was a disaster waiting to happen. It was the tool used by the crooks in Washington to overspend while keeping a phony value for the dollar. When we were forced off the standard by our enemies the french, a disaster did happen with all the inflation of the 1970's.

[expat_panama]

Kudlow thinks Bretton Woods was a good thing..

I didn't get that impression. To me, Kudlow was saying what Samuel Goldwyn said-- "nobody knows nottin"! Most of us have a handle on inflation and are ready for surprises. The rest are like Krugman who have all the answers and are consistantly wrong.

SAJ, your thoughts?

[Moonman62]

Larry Kudlow has written many other articles in which he fawns over the so called gold standard of Bretton Woods.

[expat_panama]

Let's see, he's made a lot of money bemoaning the fact that we ditched the Breton Woods accord. 

Well, there you have it.  One more success story of someone who's gotten rich because we dumped the gold standard.

[SAJ]

Well, first of all his statement about ''velocity'' is false-to-fact. Money velocity started rising in 1966-1967, much to the dismay of any Veblenites, to whom the formula MV = PT is essentially a mantra (they tend to assume that V, velocity, is constant over an arbitrary period of time). By the time Nixon ''shut the gold window'' in two stages, 1971 and 1973, inflation was already well out of hand by the standards of the day, as witness Nixon's resort to the asinine statist concept of wage and price controls. Of course, Dec 1972 was the first oil crunch and 1973 was also the Great Grain Robbery and the start of the huge commodity bull runs of the decade (all the history you want on these, ANY time you want it; I was a futures broker in 1973, and there are some absolutely wonderful stories about mkts gone wild).

Second, his en passant redefinition of velocity as ''demand'', implied monetary demand, in context, is an outright crock. It's the REVERSE of demand, f'Heaven's sake -- velocity is the rate of exchange of money into goods and/or services; in short, it is NOT monetary demand, but a reflection of aggregate demand. I hadn't known that Kudlow was that economically illiterate, but perhaps I should have supposed so, given that he spends too much time with that garrulous self-promoting nitwit, Cramer.

That Kudlow has been an off-again on-again gold bug of sorts in inarguable; where he stands this minute, I've no idea, but it wouldn't be surprising if he were to be one of these ''$1000 or and Bust'' clowns.

Anyone who believes that inflation is not alive and well right this second is either purblind, pumping an agenda, or both. There are more commodity mkts at or near multi-decade highs (in NON-constant dollar terms) today than at any time in history. Further, this notion of ''core'' inflation is simply risible; the figure is useful only to those who don't eat, heat/cool their homes, or drive anywhere, and of course to theoretical economists, the market for which is one of the very few wherein supply ALWAYS exceeds demand.

Don't even get me started on Krugboy, except to note that a Marxist is always and everywhere a Marxist (please note my tip of the topper to Freidman in the phrasing), hence by definition insane (deffn: insanity -- the mental state characterised by making the same error over and over, and expecting a different result).

BTW, for a very interesting and likely profitable short-term trade, consider buying the Sep 30-year bond at-the-money straddle, specifically tomorrow about 10:00 CDT. With the FOMC meeting Tuesday and all the politico-economic flap (don't forget Venezuela here, either), chances are excellent to see a 3- or more-handle move in the bonds in 3 weeks' time. Also, the tagline trade is still a killer.

Best regards,

[expat_panama]

Yo SAJ!

I printed out your post and pasted it in my copy of Trading Options To Win.  

You really got to consider compiling your posts into another book (suggested title "Seeing through Yellow Economics - How investors can gage the economy in spite of the biased media".  I did a search in Amazon and got a huge pile of hits on investing, economics, and 'conservative' separately, but for 'conservative economics' all you get is an out of print Econ 101 text book and some diatribe by Pat Buchanan calling for raising import taxes and government control of consumption (a real conservative there).

But having a book on mining data off the internet, cutting through the hype and the crap, exposing clowns like Krugboy (love that name) would be golden.  Then I could listen to you being interviewed by Laura Ingram.   There's lots of books on investing, lots on how bad the liberal media are, but 'nobody knows nottin' when it comes to the 'jobless recovery'.

Just a thought.

[SAJ]

Thanks for the kind thought, but, bar a lightning strike, my book-writing days are done. It's fun to write (and there are certain fringe benefits to it that I won't mention just now...wink, wink, nudge, nudge...), but it's absolute h*ll dealing with copy editors who are slaves to the style-book AND who don't know the first thing about the subject matter of the text to boot.

As regards conservative economics, though, there are plenty of fine books and authors. Read Tom Sowell's recent book on basic economics, anything by Walter Williams, and of course the classics from von Mises and Hayek. Try looking up these chaps on Amazon, you won't have any problem finding a dozen excellent titles.

[expat_panama]

I should have done a Walter Williams or Sowell search first because hardly anything came up with "conservative economics".  You know, ever since Amazon's merger with CBS News I've been sensing more and more an agenda although I must be imagining it.

I hear you on editors.  I worked for 14 years writing tech specs for the Feds, and I had a sign over my desk:

It gives me the hives just thinking about it.

[SAJ]

RICLMAO! Great sign!

I've about half a mind to give you my editor's mailing address, heh heh heh!