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Real Inflation and Real Deflation

One of the more annoying aspects of economics is the importance placed on the CPI figures and how infuencial they are not only on the economics profession, but on life in general. So many aspects of our lives are effected by this number, HECS debts, pensions and any number of other parts of our lives where a number produced by the Australian Bureau of Statistics (ABS) determines how much we get and how much we pay in everyday life. For an excellent critique of the Australian CPI figures please read this post.

It is an ever changing and arbitrary measure of one organisations opinion on what a typical snapshot of prices are for a typical Australian. As products become more sophisticated and pricing methods more and more complex, the ABS is expected to keep up with the complexities of the market. In my opinion this is a pipe dream. As each year passes the CPI figures become more and more irrelevant.  Business is too clever by half these days and they have many ways of increasing prices without actually increasing prices.

The CPI is an old fashioned and out of date concept.

The worrying thing though is the importance placed upon it by the business, economic and political communities.

I do not agree with the vast majority of the theories of the Austrian school of economics. Far too Laissez-Faire for my liking. There is however one aspect of their thinking that I do agree with, up to a point. The Austrians theorise that inflation is represented purely and simply via the change in money supply. Money supply goes up, there are more dollars, this devalues the existing stock of dollars, effectively an inflationary impact.

I happen to think this is a much more accurate representation of inflation than the CPI figures all countries rely upon. However, I would add one more qualification. If the money supply is rising 10% a year this does not mean a 10% inflation rate. My simple reasoning is that if short term interest rates are 6% over the year then in theory the money stock could have earnt itself that 6%, therefore making the real inflation (M3 growth – Short term interest rates) 10% -6% = 4%.

I fully realise this is not a perfect measure of inflation, there in all likelihood is no perfect measure.

This measure is a much more realistic representation of what is actually happening in an economy and how the average person is ‘feeling’ inflation in an economy than CPI.

So we should begin by having a look at how this particular measure of inflation has behaved in Australia historically.

For the purposes of this study I will be using the M3 figure as a measure of the money supply and the monthly average 90 day bank bill rate as the measure of short term interest rates.

The chart below shows the annualised growth rate of M3 and the monthly average of 90 day bank bills from the period 1970 to 2010 for Australia. What quickly becomes apparent from the chart is that these two measure historically tracked each other in the sense that they would diverge only for two or three years at the most before reversing anf diverging in the opposite direction. A constant dance of correction, suggesting each measure attempts to balance the other one out. This was true up until the turn of the milleneum when the 90 bank bill rate has been below the M3 growth rate for an unprecedented 9 years in a row. If not for the very brief period of parity during the dotcom bust in 2001 the unbroken run would have stretched for an incredible fifteen years in a row. Essentially that means fifteen years in a row of inflation after a period where inflation and deflation were working to balance each other out. Notice the spikes in the 1970s, in this period inflation did manifest itself in the CPI. However, in the 2000s the CPI has never shown the rate of inflation indicated by this chart. The explanation for this is that the inflation of the 2000s has primarily been asset price inflation, mostly in asset classes that are not represented adequately in the CPI figures.

Data sources from: http://www.rba.gov.au/statistics/tables/index.html

If the difference is taken from the growth in M3 and the 90 day bank bill figures the resulting number is a new measure of inflation for the country. The chart below shows clearly that inflation has been on the rise for 15 years. Before that there were short sharp bouts of inflation followed by short sharp bouts of deflation. As the chart demonstrates into 2010 the inflation rate is dramatically falling. In my opinion what will happen is that the country will now enter an extended period of deflation to counteract the previous extended period of inflation.

Date Source: http://www.rba.gov.au/statistics/tables/index.html

In this final chart I simply show the accumulation of the difference between M3 and 90 bank bills (inflation). What this chart reveals is the build up of inflation in the 1970s and then an extraordinary period of stability over 20 years from 1978 to 1998 where the inflation rate was in balance. The of course the rise of inflation again in the 2000s. Interesting that the rise in the 2000s and the 1970s are very similar.

Source Data: http://www.rba.gov.au/statistics/tables/index.html

It is my argument that the data represented above is a true representation of inflation in Australia. Just ask yourself, how have you personally felt the cost of living over the last 10 years? Do you think the cost of living has only marginally risen in that time or do you think it has been accelerating, eating into the value of each dollar you earn? The hope is that the economics profession looks outside the square and maybe investigates ideas that challenge the orthodoxy.

  • http://www.talkfinance.net/f3/inflation-data-not-representative-1900/index2.html#post6807 Inflation data ‘not representative’ – Page 2

    [...] and the cost of living These are my own thoughts, I come up with a completely new measure. Real Inflation and Real Deflation « deflationite.com My version of inflation/deflation in Australia since [...]

  • PETER_W

    The disconnect between the 90 day bill rate & M3 growth during the past 15 years is likely due to the willingness of external creditors to fund our external deficit. The exponential rise in external debt to @ 100% GDP gross and @ 55% GDP net, has facilitated M3 growth independent of the bill rate, this was assisted by our interest rate yield spread which has been @ 2% over USD during the period so the carry trade has been profitable for external banks and Australian banks were able to lend in excess of the growth in deposits which has created a credit bubble in housing. My bet is the delusion of easy unearned income via currency carry trading will have a payback symmetry which will manifest with deflation in housing followed by a ZIRP from the RBA to protect the local banks which will cause a collapse in the AUD and 15 – 20 years of 2% carry trade will be wiped out by a permanent 50% capital loss on the AUD. Inflation can be measured in local or external currency but there is no permanent free lunch and as such Australian houses will be roughly the same price as US houses adjusted for currency over the long term, that implies a decent decline in house prices and a big decline in the AUD/USD.

  • http://www.irishtimes.com/money/pension-funds pension funds ireland

    Wow ! nice…..very nice post….well written… about pension fund ….thanks for share it… A defined benefit plan guarantees a certain payout at retirement,
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