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Inflation/Stagflation/'Flopflation' - Conditions under which prices are 'sticky'

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March 03, 2011 – Comments (4)

In a recent post Inflation V Deflation – Which Door Do You Pick? I gave a list of both inflationary and deflationary pressures in the US economy. I was trying to illustrate that in some respects this is similar to the stagflation of the 70s (which was both inflationary and deflationary), that calling what we have now stagflation is really not correct and will lead to incorrect conclusion due to the fact that wages are not increasing at the same pace as commodity prices, whereas they were in the 70s.

If wage growth keeps up with input cost growth, then producers can pass along costs and they are 'sticky' (such as the 1970s). If wage growth does not keep up with input cost growth, then produces can't pass along costs which cuts demand and input costs drop dramatically (such as in 2008).

My thoughts are that given this situation, massive inflation (or hyperinflation) is unlikely to be a major problem in the foreseeable future. I think core inflation will tend to be mildly inflationary (most likely) or perhaps even mildly deflationary, with food and energy periodically spiking and crashing as producers cannot pass higher prices onto consumers and they cut production. There will be alternating periods of strong inflationary pressures from rising prices that will then reduce since economic growth is not the primary driver for the increases. This will serve to periodically 'squeeze' consumers.

checklist made up a terrific term that describes the periodic inflationary clamp / deflationary un-clamp, he calls it 'flopflation'. I think it is a perfect description.

Here is a little more background on why I don't think the current environment can correctly be called stagflation: http://caps.fool.com/Blogs/inflation-v-deflation-which/547393#comment547965

Periods of inflation are characterized by an increase in money supply that is accompanied with economic growth. The economy heats up based on increased (and hopefully legitamite and sustainable) economic activity. Demand for goods and raw materials increases. Prices increase based on this demand, than includes both for the price of goods and labor (wages). The main reason why price increases 'stick' is because consumers have the ability through either wages (80s/90s) or private sector debt expansion (00s: hence our current mess and balance sheet recession) to buy them and support them

Stagflation is different in that economic activity is not the primary driver of price increases. Inflation expectations are high. But they key reason why price increases tended to stick in the 1970s is that wages tended to keep pace with price increases. The data shows this and from what I have read, there was a lot of unionization and collective bargaining at the time that allowed wages to remain high despite a slump in economic activity. What is most striking during that time is if you look at the SPX or DOW on a nominal chart the low takes place in 1975, but if you look at in on a real (inflation adjusted) chart, 1982 is a clear lower low. Inflation was rampant but economic activity was slow.

That is similar is some respects but also very different to the situation we have now. Right now we have the private sector in a balance sheet recession. We still have extremely high debt (off the peak but still historically very high) and the main asset on the balance sheet (housing) is down by 30-50% in many cases. At the same time, unemployment is high and wage growth has been practically non-existant for the past several years. So those are the differences. The similarites are the commodity prices spikes. But the reason they are not sticking is because the consumer literally can't afford them. Energy affects gas prices (obviously) and it affect producer input costs. If consumers cut back at the gas station (like in 2008) and they forgo big ticket and discretionary purchases, then these price increases can't get passed along. We saw oil rise to $147, then down to $30. Now its back up to $100. I don't think this oil spike will persist. I think it will reach a climax (like in 2008) and consumers shift habits again and prices won't stick. As Jim Rogers would say: 'the cure for high commodity prices is high commodity prices'. That is not always true, but I think it is very true in this environment.

TPC has a good post out right now that talks about the trends in 'sticky prices'. It is a very good read and I would highly recommend it

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STICKY PRICES VS FLEXIBLE PRICES
3 March 2011 by Cullen Roche

http://pragcap.com/sticky-prices-vs-flexible-prices

There are multiple problems when debates over inflation and deflation break out.  The primary problem is that humans tend to be extreme in their beliefs.  There is too often no room for middle ground.  For instance, I am often taken out of context as a deflationist even though I maintained for the entirety of 2010 that we were likely to suffer disinflation and then earlier this year forecast low levels of inflation in 2011.  Nonetheless, because I reject the notion of hyperinflation or even high inflation I am pegged as the extreme opposite – a deflationist.  This extremism results in losing sight of the highest probability outcomes (which is likely to be neither deflation nor hyperinflation).  It’s great to have conviction in a belief, but it must be tempered by reality and probability.

In addition, humans tend to have very short memories resulting in attentional biases. In the case of inflation we tend to focus on what has happened only just recently as opposed to what has happened around us over the course of several days or months.  For most of us, this involves seeing gasoline signs, stock prices, gold prices or other noticeable prices.  These biases combine to lead most of us to constantly fret about near-term price changes in highly visible prices.  Gasoline prices are rising in the last few months so it must mean that we are on the verge of hyperinflation, right?  Not so fast.

The Cleveland Fed recently devised an inflation index that most readers can likely relate to.  It is called the Flexible CPI.  This index prices the more volatile measures of CPI and if you look at the chart below you’ll likely relate to the price changes better.  Yes, inflation really did feel high in 2007 & 2008 despite the low readings in the core CPI.  But the story was not complete just because flexible prices were surging.  When many were fretting about inflation their concerns were not without merit, however, they weren’t entirely accurate when one pulls back and looks at prices as a whole.

This is where the sticky prices index comes in.  While gasoline prices may be gyrating on a daily basis the price of many other goods and services (such as your rent or mortgage cost) remains relatively constant.  The Cleveland Fed elaborates on these indices:


4 Comments – Post Your Own

#1) On March 03, 2011 at 3:33 PM, ChrisGraley (29.76) wrote:

This fits my model a little more.

I do think that we are in stagflation right now (inflation + high unemployment)

I don't think that wage growth is as important as job growth right now. If hiring picked up suddenly, all bets are off the table and get ready for some high inflation. I don't forsee a sudden surge in jobs though.

I think that we'll plod along the way we've been going until retailers are forced to raise prices that the consumer is unable to swallow. That's when we will have what I call a deflationary moment.  

I call it a moment because I think that once it hits, government will be forced to react. I can't see us throwing more money at the system without trying to create jobs.

If we create jobs, we'll either have high inflation or stagflation.

If we don't create jobs, that moment may last a year or so, but I still see a government determined to keep throwing money at the problem, so I just can't see a long deflationary period.

 

 

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#2) On March 03, 2011 at 4:00 PM, binve (< 20) wrote:

ChrisGraley,

I agree, a large change in employment (mass hirings) would definitely change things and drastically alter the inflation / deflation dynamics. And like you, I am not seeing a catalyst right now for a massive surge in hiring..

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#3) On March 04, 2011 at 11:04 AM, leohaas (32.57) wrote:

The first lines of the article are dead-on:

"There are multiple problems when debates over inflation and deflation break out.  The primary problem is that humans tend to be extreme in their beliefs."

This statement is not only true for debates about inflation and deflation. It is true for most debates about the economy and how society ought to be in general. Its the extremist on both side of any issue who are most vocal. The middle ground is lost. And that is the biggest problem facing us today.

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#4) On March 04, 2011 at 11:20 AM, binve (< 20) wrote:

leohaas,

Completely agreed.

The past several months I have been challenging my own extreme beliefs in the markets and the extreme rhetoric that I would use on occasion. I have since toned down my rhetoric and hyperbole and I try to communicate ideas that are much more on point. Reality usually ends up being in the middle of extreme beliefs and I am trying to find that balance.

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