The Inflation and Deflation Balancing Act

inflation and deflation
These are your only two choices

“The test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function.” – F Scott Fitzgerald

The US has become a two choice society. We are consistently bombarded with the idea that our choices are binary. You have to vote republican or democrat, pro-life or pro-choice, for this idea or against it. Why is it that our choices in life are being limited to only two choices? Neither of which is chosen by us. Two positions in a debate are chosen and we have to choose from which one we like the best, or more commonly which one we dislike the least.

If you watch most news stations, they bring up two people to discuss an issue and usually both are extreme views, and you are supposed to pick a side. When did we become a binary choice society? During the next presidential election, we will most likely have to choose between two people. I cannot remember the last time that I spoke to anyone who “liked” either choice. The conversation always ends up with the phrase, “yes I know he isn’t great… but he is certainly better than the other guy.” I’m willing to bet that the majority of people in the US (whether they know it or not) vote for the lesser of two evils on election day. This means they are not voting for a candidate, they are voting against the other candidate. Really??? Our voting choices really come down to a dilemma? Our choices for the future of this country are based on who we can tolerate the most? It astounds me that more people don’t realize that they do this. But I digress…

The Inflation and Deflation Balance

The balance between inflation and deflation is much the same issue as many of our choices between two opposing ideas. It is a false dilemma. This is not a binary choice. Technically, if you subscribe to the theory that inflation or deflation are measured by the CPI, then actually inflation and deflation would be measured by degrees rather than a binary choice. Inflation is essentially the continued rise in prices while deflation is the continued falling of prices. Determining inflation or deflation should be as easy as looking at the aggregated price level of goods and services (CPI). However, this assumes that the CPI method of measurement is an accurate measurement.

What if inflation and deflation are not your only choices?

Is the CPI an accurate measurement of inflation?

The CPI, or consumer price index, is a measurement conducted by the Bureau of Labor Statistics, where it proposes to measure the changes in price level of a basket of goods and services purchased by households in the US economy. This is a generally accepted measurement of inflation in the economy. There is no other widely accepted measurement of inflation.

As with any government statistic, there is always the question of accuracy. This is partially due to a changing methodology of calculation over time, and partially due to a periodic adjustment (sometimes significantly) multiple times after its initial release.

This is how the US government formerly calculated the CPI.

I’m sure the CPI is eventually accurate (after all the revisions) based on what it is measuring, but is it measuring the correct things? The CPI numbers generally line up with some alternative indicators that we follow which measure a similar basket of goods, but the CPI also ignores a number of areas which are important to the economy and the overall assessment of inflation and deflation.

CPI methodology revisions

Since its creation during World War I, the CPI has been comprehensively revised 6 times. The stated goal of these revisions have been to more accurately reflect inflation, but does it? John Williams, an economist at ShadowStats, continues to measure inflation with the current and prior two revisions of the CPI in the 1980s and 1990s in order to put perspective on the CPI compared to the prior revisions. The differences are remarkable. Currently, depending on the version of CPI that you use, the CPI could range from its existing number of 1.7% to ~5.5% or even up to ~9.5%. This is a very large difference in the measurement of inflation. Which one is accurate?

Statistical reporting and revisions of government statistics

If Government statistics are accurate, then why revise them?

Statistics are initially provided on a regular basis by a predictable release date. Depending on what is being measured, these initial releases could be weekly, monthly, quarterly, or annually. Once they are released, you would think that the accuracy can be trusted. Otherwise, why would they release them? When I was working at Paine Webber back in 2000, I heard a presentation by Edward Kerschner, where he had a slide on government statistics. Ed is a very dynamic speaker. His whole presentation was great, but one slide stuck out to me. I even managed to find the slide online, although it has a big question mark in the middle. I thought it was important enough to share.

As you will notice the 1995 Q4 GDP number starts at 0.9% and is revised up to 3.0%. the 1985 Q1 GDP numbers start at 2.1% and rise up to 5.9% and settle down to 3.8%. You have to ask yourself… Does the US Bureau of Economic Analysis hire monkeys to throw darts at a board with numbers in hopes of hitting a number which is suitable for publishing, or do they draw revision numbers out of a hat and publish the winner? Obviously, I’m being a bit facetious, but these are large revisions. .01% or .03% might be reasonable for a margin of error? but 3% or even 5%?  5% of the 1985 Q1 GDP number comes out to a difference of $211,850,000,000. $211.85 Billion is not a small number. In 1985 it was even bigger due to inflation.

The important point is that most people look at the initial number and not the revisions. This places a large amount of importance on the initial numbers, which statistically are inaccurate and in many cases outside a statistical margin of error. So is the CPI accurate? probably not initially, but maybe over time with many revisions it is… assuming they use the correct formula to assess inflation. The real issue comes down to what they are measuring. Are they measuring the correct basket of goods? Does this basket of goods epitomize the US economy enough to be the sole indicator?

IAG Inflation Monitor

This year we created the IAG Inflation Monitor as a way to more accurately measure inflation in the US economy. We feel the CPI does not characterize the US economy well enough to be the sole indicator of inflation or deflation. In our quest for finding the most accurate measurements of inflation and deflation, we realized that the question of how much inflation we have is much more complex that most people realize. The most common measure of inflation is the CPI. However, the CPI is an aggregated number. In order to find the answer to our question, we have disaggregated the inflation number into different components so we could analyze how inflation and deflation are affecting the US economy. After conducting this disaggregation, we have found that this method of measuring inflation shows us a very different conclusion than if we just looked at the CPI. It has also helped us answer the nagging question…

“If the Federal Reserve is printing all these Dollars, why is there very little inflation?”

Do we have inflation or deflation?

In watching the media and listening to intelligent people (who are selling their book) discuss inflation or deflation, many times they are at one extreme or the other. Either we will have hyper-inflation in the US, and we all need to buy gold, or we will have deflation and we all need to buy guns and gold and go live in a cave (I’m looking forward to the day when I turn on CNBC and see a commercial with someone selling caves to deflationists).This assumes that only one of these scenarios will come to pass. What if neither happens? What if both happen? Both? How is that possible?

Inflation and deflation are much more complex than just a simple number. They are also a matter of perspective. The CPI measures changes in the price of goods and services, but doesn’t give you detail. Asset prices may be rising, commodity prices may be falling along with wages, and the Federal Reserve may be printing money. Does this mean you have inflation or deflation? What does the CPI miss in its measurements?

inflation or deflation
Does this mean we have inflation or deflation?

Some of the items that are not measured by the CPI are inflationary or deflationary demographic trends, consumer psychology, or structural changes to the economy. These three all have a structural impact on the economy and are not easily changed with monetary policies. They require legislative changes or a more significant outside influence to change inflationary or deflationary trends. While these items will eventually show up in the CPI, who wants to know about deflation that happened 7 years ago? It certainly doesn’t help me to know that? I, like most people, want that information today.

Assessing Inflation and deflation with different metrics

The economy is a complex ecosystem made up of everyone in the US, as well as their individual and collective psychologies. Not everything can be measured in statistical numbers. Some economic indicators are lagging indicators, which show you what happened in the past. These are less useful. You need to know about the inflation and deflation balance today, so you can assess your financial planning for the future. Your actions will most likely be different if you know there is inflation vs if there is deflation in the economy. If there is deflation, you can put off that large purchase till later. If there is inflation, then you need to be more productive with your money so it doesn’t lose value tomorrow. The three things you need to know about the inflation and deflation balance that don’t show up in the CPI are: demographic shifts, consumer psychology, and structural changes to the economy.

Demographic trends

Japan has been in a deflationary trap for almost 25 years. There are a number of reasons for this, but one of the major reasons is that they have a large aging population and a small younger generation. This is putting a strong deflationary pressure on the economy since people are withdrawing money from their savings and being less productive members of the economy since they will be leaving the workforce. While this is fixable, it will require some major changes in legislation as well as the country’s culture. Their demographic trend is a well-known problem, and yet it is being addressed with monetary solutions to no avail. These “solutions” have not worked for the past 25 years and will probably never work. Until Japan figures out how to change these strong deflationary forces, they will continue to live in a deflationary economy. This is not necessarily a bad thing, but it will be if they continue to destroy the value if the Yen in an attempt to create inflation. Deflation is not the problem, their “solutions” are.

Consumer Psychology

Consumer psychology is not easy to measure, but it is one of the most important things when it comes to inflation or deflation. Inflation and deflation are states of the economic cycle, but they are also states of the consumer psyche. Consumer psychology means everything, since it is what determines prices, and it is not easy to change with simple measures. It typically requires more significant actions from an outside influence. The reason consumer psychology is important is because if the consumer thinks there is inflation, they will spend their money quickly because they assume that prices will be more expensive later. This is a self-reinforcing process. Deflation has the same reinforcing process by causing more deflation.

Structural changes

Structural changes are things which cause people to completely rethink how they do things. The invention of the internet and email has allowed people to communicate via email instead of letters, the invention of the printing press reduced the need for people to hand write books, since they could mass-produce them, and long-term structural unemployment causes people to re-purpose themselves by learning a new profession or face permanent or long periods of unemployment. These changes are long term shifts, which are not easily redirected. It would take a major structural adjustment to adjust the trend of another structural change. Solutions like tax cuts, changing immigration policies, government programs stimulating areas of the economy, or reducing regulatory burdens are examples of structural solutions.

For example, a major structural problem would be having persistently high unemployment, similar to what European countries such as Greece or Spain are experiencing. This problem cannot be fixed by changing interest rates or printing money, which are primarily tools of the central bank. Oddly enough, keeping low unemployment is one of the mandates of the Federal Reserve, yet they don’t have the tools to make the necessary changes. Changing this structural problem could be fixed with legislative changes such as incentives for companies to hire more employees, in the case of Spain, remove the burden of paying ex-employees a high severance for extended periods of time. Other examples would be providing tax incentives for people to start new businesses, lowering tax rates, removing regulatory burdens, and more.

How can we have both Inflation and Deflation at the same time?

Think of inflation and deflation as a tug-a-war. Both are pulling on the rope, and eventually one of them will win. They both can be active in different ways, but they don’t always reflect the nature of these forces in the CPI number.

You can breakdown Inflationary and deflationary forces into 2 categories: cyclical and structural.

Cyclical forces – These are inflationary or deflationary forces which have small effects on the economy. An example of this would be the rising value of the US Dollar. A rising US Dollar compared to other global currencies would potentially cause a slowdown or recession in the US due to a reduction of exports. This can be fixed by allowing the value of the US Dollar to decline. In general cyclical inflation or deflation can be manipulated by monetary policy.Cyclical inflation or deflation operate independently of structural inflation or deflation.

Structural forces – These are major inflationary or deflationary forces which will inevitably have a large effect on the economy. An example of this is Japan’s aging population. They have a large percentage of the population which is retiring and a lot fewer workers to take their place in the workforce. This puts a strong deflationary force on the economy. Another example is the invention of new technologies which reduce the costs of goods and increase productivity. In general, structurally caused inflation or deflation can only be “fixed” or manipulated by legislative or structural changes. Structural inflation or deflation operate independently of cyclical inflation or deflation.

These two categories, cyclical and structural, can both be active at the same time and not necessarily have the same effect on the economy. Ray Dalio of Bridgewater Associates, the world’s largest hedge fund, put together this 30-minute video called “How the economic machine works”. This video gives a very clear description of the economic cycles.

What does this mean for you?

The first thing you should do is ignore all the people use hyperbole to explain what will happen in the world. It is primarily used to motivate you into action with whatever they are selling. Many times their arguments are interesting and thought-provoking, but the probabilities are very low that the extreme scenarios being proposed will actually come to pass.

The next thing you should do is learn as much about inflation and deflation as you can. If you understand how they affect your investments and capital, you will be in a much better place once the tug-of-war results in a winner. Without a clear trend of whether inflation or deflation will win the tug-of-war, investors and consumers need to be ever vigilant about understanding what the trends are and where they are going. That means until it is clear that inflation is back in a solid uptrend, consumers need to lower their amount of debt outstanding, retain a portion of their capital in cash, and not take excessive risks.

You can use our IAG Inflation Monitor as a way to stay on top of inflation and deflation trends. This is still a new service and we are continually making adjustments to improve its usefulness and accuracy. Feel free to contact us with any questions or to learn more about Inflation Monitor or our wealth management services.

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About Innovative Advisory Group: Innovative Advisory Group, LLC (IAG), an independent Registered Investment Advisory Firm, is bringing innovation to the wealth management industry by combining both traditional and alternative investments. IAG is unique in that they have an extensive understanding of the regulatory and financial considerations involved with self-directed IRAs and other retirement accounts. IAG advises clients on traditional investments, such as stocks, bonds, and mutual funds, as well as advising clients on alternative investments. IAG has a value-oriented approach to investing, which integrates specialized investment experience with extensive resources. 

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About the author: Kirk Chisholm is a Wealth Manager and Principal at Innovative Advisory Group. His roles at IAG are co-chair of the Investment Committee and Head of the Traditional Investment Risk Management Group. His background and areas of focus are portfolio management and investment analysis in both the traditional and non-traditional investment markets. He received a BA degree in Economics from Trinity College in Hartford, CT.

Disclaimer: This article is intended solely for informational purposes only, and in no manner intended to solicit any product or service. The opinions in this article are exclusively of the author(s) and may or may not reflect all those who are employed, either directly or indirectly or affiliated with Innovative Advisory Group, LLC.

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