Inflation is quite a tricky topic, since there are so many different views about the definition of it and depending on the definition, there are also multiple aspects that need to be considered. I previously wrote some general thoughts about inflation, which can be read here.

Originally, inflation was defined as an increase in the money supply.

In recent years, inflation is generally just used to describe the price increase in the cost of living. This encapsulates a far broader range of components and leaves far more room for interpretation, because there are multiple factors that can result in changing prices, whereas the old definition was very precise. It focused on the underlying unit that was actually (like a balloon) being inflated — which is money.

In essence, the increase in the money supply is the main ingredient for price increases over time, but there are many other factors that predominantly influence daily, weekly and monthly price swings. Erroneously, many economists jump to the conclusion, that monetary expansions have little effect on inflation.

It is actually pretty simple: On the one side of the equation is the economic output and on the other side is the monetary supply. If the money supply is increased, it follows that each unit can buy fewer of the produced goods. In today’s complex economy, there are numerous reasons why this adjustment doesn’t materialize and appear immediately, but it is still holds true in the long term.

This chart indicates how the two tend to be correlated over a longer stretched time frame. Note that the blue line (monetary expansion) tends to increase first before it gets manifested in higher prices.

When it comes to inflation as an economic indicator, which can be analyzed in comparison to other data sets and used to gauge market developments, most people look at the Consumer Price Index (CPI) that is published on a monthly basis by government agencies in most major countries. In the US that is the Bureau of Labor Statistics (BLS).

Other often referred inflation indices are the Wholesale Price Index (WPI), as well as the Producer Price Index (PPI).

Given the complexity of an economy and how differently people go about their lives, it is obviously quite a difficult task to perfectly measure the overall rate of inflation.

It is important to be aware that the CPI is just a number derived through a certain methodological process of measuring the prices for certain goods and services. It used to be a fixed basket of the same goods, but it has changed over time. Furthermore, many things people spend money on are not included at all. As I previously wrote:

What can be said is that the way of calculating has gone through various changes over the years. Prior to 1980, it used to be a fixed basket of goods which price was measured over time. Nowadays the calculation is much more complex. For instance, so called hedonic adjustments try to adjust for technological improvements of products. In addition, if a product increases a lot in price, it is presumed that consumers will shift to buy a cheaper substitute product. Thus, many argue that these changes have made it possible for government institutions to understate the real level of inflation.

For instance, while many price increases have been set off by assumed quality improvements, the opposite has not been the case. Arguably, the quality of air traveling has decreased immensely over the last 2.5 years, but this has not been appraised by the BLS.

Moreover, the CPI does’t include real rents or investment items. These are for most people important parts of their budget and have gone up way more than the CPI over recent years.

Therefore, it doesn’t represent any ‘true’ inflation number.

I personally believe that the CPI generally has the tendency to understate the real rate of inflation which the majority of the population experiences. This is for the simple reason that the incentive structure is such, that the agencies who are deciding on the methodology and publish the numbers are benefiting from a lower CPI. This is another topic, but in essence, inflation is a hidden tax and governments benefit in various ways from it. The perfect situation for governments is to have really high inflation, while the population believes that the inflation is low and under control. This is not a conspiracy theory and I do not believe that the responsible government employees go to office with the intention of ‘faking’ lower numbers in mind. I rather believe that there are underlying incentive structures. These incentives are integrated throughout the whole bureaucratic network apparatus, with small effects in every little decision that is made.

While having these flaws, the CPI still conveys some valuable information and its monthly changes and trends — in combination with other data — provides some insights of what is going on in the economy.

I actually like Michael Saylor’s take on inflation:

Inflation is a vector. Define a market basket of products, services, and assets that you desire, weight them subjectively, and you can have your own index. If you want a low number, place a bunch of abundant, low variable cost items in that basket. https://t.co/LBBvRRKCtO

— Michael Saylor⚡️ (@saylor) September 27, 2020

He sees the CPI number more as a vector, which gives a general idea where things are heading, but can subjectively be meddled with, depending on various individual life choices and should therefore not be seen as an ultimate arbitrator for everyone. Anyway, taken as a general vector it still provides useful clues.

So what does the CPI number tell us about the economy?

• A high CPI number might suggest that:
  • …the economy is overheating.
    • Companies are rapidly expanding their businesses.
    • Lots of hiring, there are more job offerings than people looking for work, putting upward pressure on wages.
    • Large amounts of capex.
    • Investors go higher on the risk curve, resulting for example in a surge in technology stocks.
  • …there is high monetary expansion going on.
    • Prices for everything are going up at a similar rate.
    • It might have the same characteristics as an overheating economy.
    • If caused mainly through debt monetization of government debts, then it might spiral out of control and even lead to a hyperinflation.
  • …there are supply shocks or supply chain constraints.
    • Some items experience high inflation, while other items prices stay comparatively stable.
  → All of these might cause the central bank to raise interest rates or other policies to tighten the money supply

On the other hand:

• A low CPI number might suggest that the economy is:
  • …healthy:
    • If prices come down as a result of increased productivity.
  • …sluggish:
    • Low growth numbers.
    • If companies are pessimistic and do not hire or invest in capital expenditures.
    • Consumers are not spending most of their income.
  • …in recession:
    • If GDP decreases for several quarters.
    • The stock market is in a bear market and most asset prices are falling.
    • People are losing their jobs, resulting in high unemployment and the overall demand sees substantial declines.
    • Investors seek safe heaven investments (e.g. Treasuries).
  → These scenarios might cause the central bank to lower interest rates to incentivize spending and investment and/or stimulate the economy by quantitative easing (QE).→ It also might trigger the government to engage in fiscal stimulus measures to boost the economy.

These are only some of the possible aspects that can be witnessed and often there is some combination of them. For instance, there are good reasons to believe that the current high inflation numbers stem from:

• The massive monetary expansion and stimulus packages in response to Covid.
• As well as supply chain restraints and shortages caused by the implemented Covid policies around the globe, as well as sanctions against Russia.

Furthermore, large swings in some items might have a huge contribution to the CPI number:

The chart shows that the price increases in energy and food made up almost half of the most recent 8.5% CPI rate. Further, both of them are also responsible that the YoY index number decreased from 9.1% in June to 8.5% in July. Most other contributors kept their upward trend throughout July.

Another indicative aspect is the trend. Is the CPI in a consistent upward trend month over month, did it peak, or is the general momentum downward. And, do all items move in the same direction, or are there distinctive differences:

• The consistent upward trend of most contributors since 2020 might be mainly caused by the massive monetary expansions in the form of stimulus packages.
• Whereas the swings of the contributor for “used cars and trucks” might be attributed to supply chain issues.
• And the energy price is probably highly affected by the war in the Ukraine and the accompanying sanctions.

I will end this post with a quote that is important to bear in mind when thinking about inflation:

The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy.

— Ludwig von Mises