Why Inflation Can Lead or Lag Economic Cycles

Wednesday, April 16, 2008 | 07:38 AM

Yesterday, we reviewed the PPI data. Today at 8:30, we get the Consumer Price Index (CPI).

There is a certain faction of folks who missed the early warning signs of inflation. These same folks are now telling us not to worry about inflation, since the threat of an economic slow down is more important. Yes, the same folks who told us there wouldn't be a recession, and are now saying its over, have brought the same wonderful approach to rising prices. They are not to be trusted.

Here's the way their arguments have run:

PPI is too hot?
Not to worry, its CPI that matters.

What? CPI is too strong?
Well, Ignore Food & Energy, and focus on Core inflation.

Huh? The Core is elevated?
Ya know, it doesn't really matter, because Inflation is a lagging indicator.

How's that for an utterly intellectually dishonest approach? And factually wrong to boot.

Mich_max_630_378 Let's start with Federal Reserve: They look to future inflation expectations via University of Michigan (chart at right) as their leading inflation indicator. This is why there is an ongoing attempt by some to convince the public that -- beyond what their own lying eyes are telling them about price increases -- there is no inflation. 

Beyond the usual inflation denialists, however, this morning I want to discuss why inflation isn't properly described as a lagging indicator, and shouldn't be dismissed as just so much history. Those who do so do at the risk of their own financial peril.

First off, the technical definition: Only the services portion of CPI goes into the Conference Board's lagging indicators. Hence, everything from crude to food to manufactured goods is not technically part of the lagging indicators basket.   

However, that fails to capture the gestalt of what it means to be a lagging economic indicator. A quick review: A lagging indicator changes its direction after the business cycle changes. Lagging does not mean it is reported after the fact (all indicators are reported that way). Rather, what it lags is the cycle, and not real time.

For example, Unemployment tends to tick up for months after a recovery has began. Hence, it is said to lag the cycle. Temp help, on the other hand, leads the cycle, but is not one of the 10 Conference Board LEIs (but average manufacturing-worker workweek is). The Stock market tends to lead the cycle turns,  falling before a recession starts, and rising before the recovery is apparent (there are many exceptions to this). Thats why its part of the LEIs.

Hence, PPI, reported yesterday, is not a lagging indicator. And properly understood, it provides lots of insight into future inflation.

How? We can track inflation as it moves through the manufacturing pipeline, from "crude" (raw materials) goods to "finished goods." What has been taking place over the past few years has been the price of "crude goods" have been escalating a whole lot faster than the finished products. This is evidence of future inflation, as it eventually shows up in the form of higher prices for finished products.

For a long while, manufacturers and retailers were eating these price pressures, making up for them via a combination of increased efficiency,  outsourcing to the lowest price producer overseas, and absorbing a hit to their margins.

But that can only go on for so long, and it seems to have reached a peak several quarters ago.

How do we know this? The "inflation spread" between the crude goods and finished goods. Its now at record levels. This spread is even greater than it was in the late 1970s/early '80s.

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Producer Price Inflation Spread

Inflation_spread
Chart courtesy of Bill King, Bloomberg

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This is why I took no quarter yesterday from the usual claim that inflation is a lagging indicator. Its not;  a portion of the CPI however, is.

I hope this clarifies your understanding of inflation.

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UPDATE: April 16, 2008 3:15pm

A friend sends along the following comments:

"Inflation is a lagging indicator which peaks long after an expansion in economic activity has ended. The expectation is that a moderation in inflation will emerge as the economy slows in the next few months."

For the most part, that's true.

Except when its not.

Like in the 1970s. Or, over the past few months. Recall Q1 2008 saw GDP at 0.6%, and inflation accelerated. So either inflation is greatly lagging -- or perhaps, in the current instance its not quite the lagging indicator everyone thinks . . .

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Sources:
University of Michigan Inflation Expectation   
http://research.stlouisfed.org/fred2/series/MICH/

Global Business Cycle Indicators   
The Conference Board, March 20, 2008
http://www.conference-board.org/economics/bci/pressRelease_output.cfm?cid=1

Wednesday, April 16, 2008 | 07:38 AM | Permalink | Comments (22) | TrackBack (0)
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Comments

On a personal note, our company (printing) has been hit with three price increases just last week. A 6% increase in our UPS rates, a 9% increase in our packing material and 3% on paper and chemicals.

And yes, we have eaten these increases before - but not anymore. We are increasing our retail prices 5% on May 1st. So, the idea that companies like mine have been a temporary "plug" in the dike are true, but not anymore...

Posted by: austincompany | Apr 16, 2008 7:55:39 AM

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