2018 Gary R. Evans. This slide set by Gary R. Evans is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.

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1 Price Behavior, Inflation and Deflation Problems and solutions 2018 Gary R. Evans. This slide set by Gary R. Evans is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.

2 What is inflation? A general increase in the price level as measured by some index like the CPI.. <0% Dflti Deflation 0-2.5% Traditional/healthy/stable 255% 2.5-5% 5% Moderate 5-8% High/Serious 8-12% Runaway/self-compounding 12-20% 20% Hyper-inflation 20%+ Explosive... and deflation is a general decrease in the price level.

3 The German inflation of the 1920s Date $1 equals in Marks July July July July July ,412 Aug ,620,455 Sept ,869, Oct ,260,208,000 Nov ,200,000,000,

4 21 April ,000 Mark Note

5 6 February Mark Note

6 The back (10 Mark Note)

7 1 March Mark Note

8 9 August Million Mark Note

9 1 Sept Million Mark Note

10 The Back (50 Million Mark Note)

11 A di th th 2008 CIA F tb k Zi b b ith According the the 2008 CIA Factbook, Zimbabwe, with an unemployment rate 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 Zimbabwe currently (2016) has an inflation rate of 1.6%

12 In 2018: Venezuela has an inflation rate of 741% (Dec-Dec 2017)... Photograph from the Latin American Herald Tribune, February 24, Argentina (25 0%) and Egypt (17 1%)... Argentina (25.0%), and Egypt (17.1%). Source: tradingeconomics.com, February 22, 2018

13 How inflation is measured.. Consumer Price Index (CPI) Measures cost of living for consumers Producer Price Index (PPI) Measures input costs for manufacturers Chain-weighted ihtdgdppi Price Dflt Deflator Used to adjust GDP to real GDP Employee Cost Index Used by FRS as early wage-cost inflation indicator Personal Consumption Expenditures (PCE) inflation index Used by the FRS as their primary price indicator

14 The CPI Prices collected monthly and bimonthly in 85 urban areas from about 45,000 housing units and 20,000 retail establishments for items Personal visits i and telephone calls Base year (average of ) 84) set to 100 Market basket weights are based upon consumer surveys conducted 2013, 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.

15 Calculating the Inflation Rate 1. Each month (year) the value of the market basket is calculated: l the alphas are weights based upon a consumer survey. 2. The CPI is calculated by taking the value of the market basket for each month (year) is divided by the value for the base year (average of ), 1984), then multiplied times The inflation rate is calculated from the CPI. CPI MBV t n P t i i i 1 MBVt MBV 100 IR t CPI CPI b t t 1 1

16 Jan 2018 CPI category weights and values Table 2 The weights are Consumer Price Index for All Urban Consumers CPI-U NSA, January 2018 market basket weights. Note Category Weight Index Rate Medical. Other than All items % Food and Beverage % tobacco (952.3), the Shelter % highest disaggregated Rent % Owner equivalent % category is college Apparel % tuition. Transportation % Gasoline % Current data can always be found by clicking on the most College tuition and fees % recent CPI news $0.405 release on the front page of the BLS website. Medical Care % Recreation % Education % Purchasing power of the dollar = 100 Weights are for Dec. 2017, Index values are for Jan Rate show n is annual December to December. Source: BLS Economic New s Release, 2/14/2018 Tables 1, 3 and 6. Bananas: Note: Not all categories are shown, there are small amounts of overlap, and weights do not sum to 100.

17 Average: 3.78% CPI Inflation Rate: Annual % change Current FRS target level 2% Double-digit hyperinflation Source: Bureau of Labor Statistics, CPI for urban consumers, U.S. city average, all items, NSA.

18 The CPI (all items) less food and energy (Core Rate) Jan Jan 2018, monthly growth rate, NSA % monthly The core rate 0.8%, if sustained, would excludes food, equal 10% inflation annually and energy The 1.0 core rate is far less volatile right while the stock market was crashing -2.0 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan All Items Source: Bureau of Labor Statistics Less Food and Energy Energy and food costs explain why All Items is higher, then lower.

19 ... from the perspective of the BLS: Note how remarkably stable the core rate is compared to the all-items. This measures the 12-month (Dec to Dec, Jan to Jan etc.) so is automatically smoothed, whereas the data in the previous slide are month to month. Source: BLS News Release, Consumer Price Index - January 2018, Feb. 14, 2018.

20 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 and services. PPIs measure price change from the perspective of the seller. Over 10,000 PPIs for individual products and groups of products are released each month, including finished i goods, commodities, i and raw materials and 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 of Labor Bureau of Labor Statistics: Note: Original source for this slide, which is mostly quoted, but since modified, was lost. It probably came from the BLS.

21 Commodity PPI vs. CPI-U, annual rates, (J) NSA % Note the high volatility of the commodity PPI compared to CPI. Monthly numbers of PPI at release are too volatile to have much meaning. But over time CPI-U PPI-Commodities

22 BLS Employment Cost Index Total compensation, all civilian, annualized % change, quarterly, , 2017, NSA shown with 2-yr MA. 4.0 This is inverse to what is called productivity and is 3.5 probably the variable that most mitigates any inflation threat : Is this cause for concern? (I don't think so, at least not yet) This progress is mostly technological (computing, robotics, the 0.5 internet) anything that reduces the labor component of cost, but also aging job market Source: BLS Employment Cost Index database, CIU A (inflation file)

23 The new FRS inflation indicator.. the chain weighted price index for Personal Consumption Expenditures from the NIPA accounts

24 Costs of inflation Distributes income and wealth unfairly To: owners of real assets, borrowers, those who understand the system From: renters, savers & lenders, semi-skilled 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 to be self-compounding

25 Costs of Deflation Effects during Great Depression Made loans impossible to pay Destroyed banking structure Resulted in 1933 Roosevelt Banking Holiday Generally undermines any economy with large levels of debt contracts in nominal (nor adjusted for prices) amounts Today a problem in commodity exporting nations Especially raw materials exports

26 Deflation during the Great Depression CPI annualized monthly rates, 1920 to 1940 Post WWI Source: BLS The Great Depression, although we were an agricultural economy then.

27 The Price of Corn and Wheat during WWI and the Great Depression, $ per bushel, U.S. annual national average WWI Great Depression Source: Historical Statistics of the United States , published by the U.S. Department of Commerce, Bureau of Census

28 Deflationary Fears: Context 2016 (last year) (From Japan): Corporations in a deflationary environment find it more profitable to hoard cash at very low nominal rates (1%), but real 2% if deflation is 1%, than to put the money at risk creating capital goods that will manufacture commodities that will fall in value, (From Europe): The all-important real estate and possibly durable goods sales will tumble with deflationary expectations. Corporations generally do not like a deflationary environment, especially if they have stick wage contracts. Deflationary expectations puts relentless downward pressure on nominal interest rates, even pushing them into negative territory y( (shown below).

29 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 and interest t rates are correlated To cure inflation, interest rates must rise

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32 Inflation and Recession! 10 How to we explain this? Inflation and Recession!.. and again! GDP growth IPD inflation

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35 Anti-inflation inflation policies i Monetary policy approach Tighten up credit conditions Raise interest t rates Price controls don t work Causes acute shortages Encourages black market Easy to circumvent in non-commodity economy with new product design

36 The FRS tightening g r SF2005 The FRS tightens while Continued through SF2004 r2005 r2004 a b consumer borrowing continues to grow strongly DF2006 DF2004 The last FRS anti-inflation policy was during this period. Now we are restoring this policy (with less emphasis). Volume of Credit

37 Quantitative Easing Programs ( ) 2014) Using programs called quantitative easing (TALF - QE3), the FRS is severely cutting target interest rates to ease a credit crunch and prevent a serious recession. SF 1 r SF 2 Govt expansion Private collapse DF 1,2,3 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 DF 1,2,3.

38 In 2015, FRS is promising to slowly raise interest rates, but...!! 2014: Tapering/Ending of QE3 QE3 purchased $45b U.S. Treasuries and $40b mortgages g monthly. The first taper reduced that by $5b each monthly, the second taper by another 5, program ended in Nov 2014, kind of... SF 2014 r Qualify this... SF 2013? Govt expansion DF 1,2,3 Private collapse The government demand for funds is falling (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,

39 Negative Nominal Interest Rates by Central Bank Policy! In this scenario, a central bank like the Bank of Japan, the European Central Bank or the Federal Reserve System increases the supply of funds until targeted nominal market rates are negative. SF 1 SF 2 r 1 0% r 2 DF 1 If you made a deposit in a bank account, the balance would gradually go down. If you bought a bond, you would owe periodic interest payments to the borrower (perhaps implicitly).

40 Possibly compounded by the impact of deflationary expectations upon nominal interest rates... r The FRS tries to stimulate the economy while SF 0 0% r 0 r de b b SF de real estate and corporate borrowing shrink DF 0 DF de The central bank tries to stimulate the economy back to life as corporations hoard cash while credit demand for real estate etc. sinks (who wants to buy a home in a declining real estate market)? Volume of Credit

41 Context 2018: Fiscal side cuts taxes and increases spending while the FRS tightens!! (Maybe) r 2018? r 2017 r The FRS want to raise rates slowly e18 e17 SF 2018 SF 2017 but the budget deficit is surging gabove $1 trillion. DF 2018 DF 2017 The shift outward in the DF is already underway and unavoidable. The FRS states that they want to tighten and raise rates. [Note: DF is so large the FRS can actually increase funds and still raise rates]. Volume of Credit