Below is an extract from a commentary originally posted at www.speculative-investor.com on 16th October 2005.
Inflation
One of our pet peeves is the way the inflation issue is constantly being muddied by a failure to define the term correctly and by misguided attempts to provide clarity by distinguishing between the so-called different types of inflation (monetary inflation, price inflation, asset inflation, etc.). Apart from the minor problem of being a poor use of the English language -- price inflation literally means more prices, not higher prices, and asset inflation literally means more assets, not higher prices for assets -- there is the major problem that any attempt to portray rising prices and inflation as one and the same will obscure the cause of inflation. Such attempts will, therefore, play into the hands of those whose job it is to perpetuate the inflation whilst managing inflation expectations (central bankers).
A good way to explain what we are trying to get at is by using the topical example of oil. Whenever there's a large rise in the oil price, as has been the case over the past year, the price rise is typically portrayed by the press as having inflationary consequences. In other words, mainstream thinking has it that a rise in the oil price will flow through to other prices, thus causing an increase in the general price level (what most people incorrectly think of as inflation). Therefore, if the general price level does, in fact, rise following a rise in the oil price then central bankers will be able to point to whatever caused the oil price spike -- things that are clearly outside their control, such as OPEC, hurricanes, conflict in the Middle East, strikes/rioting in Nigeria, insufficient refining capacity, etc. -- as being the CAUSE of the inflation. They will then be able to position themselves as inflation-fighters -- white knights that ride to the rescue to kill-off the inflation beast before it inflicts too much damage on the economy. The truth, however, is that a rise in the oil price or any other price cannot possibly lead to an increase in the general price level unless the total supply of money increases by a sufficient amount. By the same token, if the supply of money remains constant or increases at a slow rate then price gains in some sectors of the economy will have to be offset by price reductions in other sectors of the economy.
The bottom line is that individual prices move up and down for many reasons, but the ONLY way a sustained increase in the GENERAL price level can occur is for there to be a reduction in the relative value of the common medium of exchange (money), and the cause of a reduction in the relative value of money is almost always a central bank-sponsored increase in the supply of money (inflation). Putting it more simply, an increase in the general price level cannot occur without the help of the central bank. However, we run the risk of obscuring this fact if we do anything other than define inflation in terms of money supply growth.
The Dollar and Inflation Expectations
The real short-term interest rate in the US is one of the most important determinants of the dollar's exchange rate. This interest rate is, in turn, determined by the nominal short-term interest rate controlled by the Fed and by inflation expectations (the expected effects of inflation on the dollar's purchasing power). We emphasise that the real interest rate is not determined by how fast the dollar has lost purchasing power in the past or how fast it is currently losing purchasing power, but how fast the market EXPECTS it to lose purchasing power in the future.
In a world where the Fed goes to great lengths to make sure the markets are never surprised by changes in the Fed Funds rate (the nominal short-term interest rate), it stands to reason that changes in inflation expectations will tend to have a greater influence on the dollar's exchange value than will changes in short-term interest rates (since the interest rate changes are generally telegraphed well in advance). By comparing charts of the VIPSX/USB ratio (a measure of inflation expectations) and the Dollar Index, which is exactly what we've done below, we can see that this has, in fact, been the case over the past year. VIPSX, by the way, is the Vanguard Inflation-Protected Securities Fund, so the VIPSX/USB ratio tells us how inflation-protected securities are performing relative to non-inflation-protected securities. Regardless of what is happening with absolute prices, when the inflation-protected securities are rising relative to the non-inflation-protected bonds it means that the market's expectations regarding future dollar depreciation are ramping upward.
By the final quarter of last year the Fed was well into its rate-hiking campaign and yet the dollar was plunging. The above charts suggest that this had a lot to do with rising inflation expectations. Notice, though, that the dollar bottomed and began to rally very soon after inflation expectations began to fall. Since then, each short-term trend change in inflation expectations has been accompanied by an opposite short-term trend change in the Dollar Index with a big dollar rally occurring during April-June in parallel with a sharp fall in inflation expectations.
There has, however, been something of a divergence over the past 4-6 weeks in that the dollar has moved higher concurrently with rising inflation expectations. This divergence can be explained in two ways. First, an increase in US$ inflation expectations won't cause the US$ to fall against the euro if euro inflation expectations are rising even faster. In general, an environment in which inflation expectations are ramping higher throughout the world is an environment in which gold is likely to rise in terms of all currencies. Second, for the first time in a long time there were large shifts, during August and September, in what the market expected the Fed to do. Specifically, within the space of about 6 weeks the market went from expecting the Fed Funds rate to be 4.25% by year-end, to expecting it to be 3.75% by year-end (in early September in response to the New Orleans disaster), to once again expecting it to be 4.25% by year-end.
Looking ahead, a 4.25% Fed Funds rate by year-end is presently factored into the currency market so unless the Fed decides to get more aggressive (unlikely) the dollar won't get any more help from changes in nominal short-term interest rates over the next few months. It could, however, get pushed sharply higher or lower by changes in inflation expectations. For example, if President Bush keeps saying things like "we'll spend whatever it takes" and/or the US monetary aggregates begin to increase at a significantly faster pace then the dollar will probably weaken. On the other hand, if something were to happen to cause inflation expectations to plunge -- a deflation scare associated with severe declines in the prices of equities and/or industrial commodities, for instance -- then the dollar would probably become much stronger even if the Fed were to react to the 'crisis' by putting their rate-hiking program on hold.
As discussed in recent commentaries, we think the odds are in favour of the dollar pulling back over the next few weeks. We aren't, therefore, anticipating a near-term deflation scare. We do, however, think there's a good chance of something happening within the next several months that causes inflation expectations to plunge and pushes the dollar sharply higher. In order to set the scene for the next wave of central bank-sponsored inflation it is, after all, important that the deflationists be given some time in the sun every couple of years.
