Tuesday, December 15, 2015

The data says otherwise

A very interesting article, The Mystery of Missing Inflation Weighs on Fed Rate Move by Josh Zumbrun.

For years now, I have been arguing with my financial advisor, when looking how to direct my retirement investments, that inflation is likely to pick up soon. And every year I am wrong. The basis for my anticipation of inflation has been at least two-fold. Governments in the US and Europe have been printing money for most of the past decade. Printing money is almost always a prelude to inflation. Second, there has been a massive increase in the middle class around the world. The middle class are big consumers and inflation is in part a function of too much demand chasing too little supply. There were a few other reasons for my anticipating inflation but those were the biggest pillars.

But no inflation to be seen. This affects more than the performance of my retirement accounts as the article outlines.

Why no inflation. The article outlines most of the major theories. Once I was wrong more than three years in a row, I spent some time trying to understand why the forecast was so wrong. Among my theories, some of which are covered in the article and some which are not.
1) Our supply chains and manufacturing processes have gotten so sophisticated that it is rare for there to be real instances where there is too much demand versus an unresponsive supply.

2) That the US government has been sotto voce redefining how inflation is measured so that the items with biggest increases are not included in the indices. There is some fair amount of evidence to support this.

3) Perhaps the increasing size of the global middle-class has contextual attributes which perhaps dampens the size and impact of their increasing demand. Specifically, the largest increases in the middle class have been in India and China. The first is notable for its endemic corruption and the second for the dominance of the central planners (ad their whims). Perhaps concern about the detrimental impact of corruption and uncertainty about the direction of a corrupt and unaccountable central party might reduce the willingness to consume by the newly middle class. Perhaps they are salting away the surplus for an anticipated rainy day but with the additional unplanned effect of reducing inflation.

4) Since much of developed nation increase in productivity appears to be as a result of reduced costs rather than increased output, perhaps that dynamic is suppressing inflation.

5) While unemployment is down at levels where inflation is an important concern, perhaps governmental redefinitions of inflation are giving us a false reading. Even more likely is that the large bench of warehoused workers (visible through the labor force participation rate) likely means that the low unemployment levels are less consequential than in the past.

6) Is there something going on with technology labor substitution that might be at the root of low inflation?
The real answer is that no one understands why we have not experienced material inflation rates. Our models and theory say there should be.

It reminds me of the state of the art in climatology. The theory says one thing and the data say another.

I did like this allusion to confusing correlation with causation. These are big complex systems with relative few data points and a lot of noise.
The Fed’s preferred measure of inflation rose an average of 2.038% a year between 1992 and 2007, bolstering confidence that economists understood how inflation worked. The price of a Fourth of July barbecue, for example, closely tracked the 2% annual target over that period: Average prices for a pound of ground beef went to $2.70 from $1.91; American cheese climbed to $3.91 a pound from $3.01; a 16-oz bag of potato chips rose to $3.65 from $2.84. Wages also rose modestly so workers kept pace.

Central bankers “thought that it must be their own doing,” said Jon Faust, the director of the Center for Financial Economics at Johns Hopkins University, who served two stints at the Fed during that period. “We thought we figured out macro policy, and we could deliver low, stable inflation and stable output and low unemployment and all things good.”
It is also, along with climate science, a suitable reminder that the appeal to authority is a logical fallacy. The experts honestly think they know what they are talking about but the data makes clear that that is not true.

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