How bad is this inflation relative to history?
And is it likely to be sticky?
Today I’m going to do something simple with the inflation numbers which I haven’t seen anyone else do.
Various theories of inflation emphasise how inflation tends to build on itself. The mainstream models show this through their idea of ‘inflation expectations’. Consumers, businesses and investors believe that the rate of inflation in the future will be x% and then, lo and behold, they set prices in such a way that inflation turns out to be x%.
The more Keynesian view of inflation, which I think is more realistic, is of the ‘wage-price spiral’. In this framework, prices rise due to an exogenous shock — say, an energy market shock or a supply-side shock (lockdowns, anyone?) — and then workers demand nominal wage increases to keep their purchasing power. Companies then see their profit margins threatened and respond by raising prices to hold these margins intact — this builds on itself over and over again and inflation becomes ingrained. The popular practice of CPI indexation exacerbates this tendency in many markets too.
The two theories are distinct. They do not always make the same predictions. What they do share in common is that inflation does tend to build on itself. So, if the initial inflationary shock is larger, this could mean bad news moving forward. With this in mind, let’s look at the recent shock in comparison to previous shocks. We will take 12 months worth of data of each major inflation since 1945. (I’m counting the 1970s episode as having started in 1972 and carrying on until the Volcker shock).
A few things stand out.
The present shock looks more like the ‘sticky’ inflations than like the Korean war inflation in the early 1950s.
The present inflation starts quicker than any of the previous sticky inflations.
12 months in, we are roughly in line with where we were 12 months into the inflation of the 1970s.
None of that is great news. It seems to suggest that, on this very simplistic basis, we are entering into a sticky inflation with levels potentially like those of the 1970s.
But looking at the data raw can fool the eye a little. Recall that we are assuming that inflation might build on itself. So, what really matter is not the rate of change per se, but the accelaration. We should not be so focused on how many miles per hour the car is travelling, but rather on the RPM. The best way to do this is to take the acceleration of inflation — that is, the rate of change of the rate of change — and construct an index. I call this the ‘CPI acceleration index’.
This doesn’t look good. The acceleration in inflation we have seen this past year has been substantially worse than the acceleration we have seen in any other inflation in its first 12 months except 1950-51. But 1950-51 wasn’t sticky. We can see that in the curve in the acceleration index.
For Europe let’s look at Germany. It is likely that the recent inflation is going to give the hawks — that is, the Germans — the upper-hand in the ECB, so it’s probably best to view it through German eyes.
This is straightforward enough: relative to history, today’s inflation in Germany looks pretty much like every other sticky inflation the country has experienced since 1960. We might even argue that it is slightly worse given that the inflation this time started at a much lower level.
Now let’s look at our acceleration index.
Uh oh. This recent inflation looks like the worst on record if we view it through the lens of acceleration.
What do we make of all this? Well, such exercises need to be taken with a grain of salt. I have no issue with the statement that “historically the rate of inflation has showed a tendency to build on itself and there are good theoretical reasons for believing that this is due to specific structures in the economy”. But I do not think inflation feeding on itself is a sufficient condition for future inflation.
In short, this data does not prove that the present inflation is set to be worse than previous inflations. Nor does it tell us that it will definitely be sticky. But it certainly gives us an indication that it may be both these things.
If I remember, I will revisit this in six months and see where we are.