It is not surprising that we are experiencing asset bubbles around the world due to the enormous growth in money supply (credit).
If you took a graph of RE prices in Canada, and overlay a graph of mortgage debt, you would find that they are highly corelated.
As Ron Paul says, inflation (rise in prices) is caused by excess growth in money supply. If the economy is growing in low single digits, and money supply is growing in double digits, this will cause inflation.
It's just that the gov't and some economists refuse to label a rise in asset prices as inflation. Those that do, often call it "good" inflation, as it causes peoples investments to rise in price.
Usually the bond market would correct this before it got to the bubble stage, as bond investors would take note of this increase in money supply, and bonds would sell off, causing interest rates to rise, slowing the increase in credit (which is how the money supply grows).
This would normally choke off the speculation before it became too rampant. This has not happened this time, as a lot of this extra money has made its way back into the bond market by way of foreign central banks recycling of their excess foreign currency reserves.
They do this so that their own currencies (Chinese yuan, Japanese yen) do not rise in value against the currencies of the countries that buy their products. This recycling has allowed the bubble to inflate much larger than would have otherwise been possible.
On top of all of this, because of the free flow of money, there are speculators who will borrow money in Japanese yen (at near zero interest rate), or some other currency where the cost of borrowing is low. They will then use that money to buy the bonds of a country whose interest rate is much higher (US, New Zealand, Canada,etc.)
This also adds fuel to the fire, as it keeps long term interest rates artificially low. This keeps the cost of long term debt (mortgage) low, and allows for more people to compete for a limited supply of houses. Demand goes up, and prices rise. This causes people to take on more debt, which causes the money supply to increase. A vicious cycle perpetuated by cheap credit.
Yes, you nicely connected the dots. I am not totally sure about the bond market. Can offshore buying really overpower domestic demand to the point that bonds are grossly mispriced?
And is CPI really misleading? It seems reasonable for most things I spend money on. I am totally opposed to the idea of including home price in CPI.
If you are right that inflation is higher than what CPI indicates, then debt is on sale. Borrow away and buy whatever you determine will outpace CPI.
"If you are right that inflation is higher than what CPI indicates, then debt is on sale. Borrow away and buy whatever you determine will outpace CPI."
And that's exactly what's happened in the past 5 years. Debt has been on sale, and folks have leveraged themselves up the wazoo for the biggest consumer item of all -- housing. Which in turn has itself become a vehicle for further borrowing for "wealth effect" consumer items, renos, second properties, borrowing for investments.
If risk premia ever return to lending (hello, subprime implosion!), then we'd be looking at deflation for most items in the CPI as supply baloons and demand from borrowed money shrinks. Ont the other hand, owner's equivalent rent would start to increase. So the schizoid CPI would be stood on its head, and probably remain balanced. Though the financial landscape would have changed dramatically.
Can offshore buying really overpower domestic demand to the point that bonds are grossly mispriced?
The bond market is somewhat like the RE market. Prices are set at the margins. Not everyone is selling their bonds all at once.
The last I heard, foreign reserves for Asian nations, led by China and Japan are over three trillion U.S. dollars. This is increasing very rapidly. The U.S. current account defecit is adding to this amount daily, approaching an annual figure of one trillion dollars.
Couple this with the yen carry trade, and you've got an awful lot of foreign capital being put to work in the bond market. I believe that this amount is sufficient enough to effect bond prices domestically.
If you are right that inflation is higher than what CPI indicates
I just posted on another blog regarding manipulations in the CPI.
"And that's exactly what's happened in the past 5 years. Debt has been on sale, and folks have leveraged themselves up the wazoo for the biggest consumer item of all -- housing."
Temporarily yes, but would you call it "inflation". Easy come easy go. Sticking on the topic of underreported inflation, if long term debt is on sale (less than inflation), what exactly would you buy to take advantage. And don't say "real estate".
"The bond market is somewhat like the RE market. Prices are set at the margins. Not everyone is selling their bonds all at once."
Of course it is set at the margin. But demand is not inelastic. When the risk/liquidity premia get squeezed out, any rational holder would unload for greener pastures.
For what you suggest to occur, there would have to be indiscriminate offshore buying, and oblivious domestic demand/supply. But not out of the question.
This sounds a lot like deploring one extreme (excess credit) to embracing another (no credit)....
The track record of the gold standard, as well as any fixed exchange rate standard is rather mixed. To hear the speaker talk about Argentina's success in employing a fixed exchange rate makes me wonder if we are discussing the same country. Runaway inflation is a real downer, but deflation is certainly not a huge improvement. I seem to recall that the Bank of Canada did pursue a zero inflation rate policy throughout the 1980s, and we very nearly got it, but we did also get a really bad recession.
Whenever I hear an argument for the return of the gold standard, I keep waiting for the following argument to be a call for a return to feudalism.
For what you suggest to occur, there would have to be indiscriminate offshore buying
I think buying by Asian Central Banks could almost be described as indiscriminate. They must do this to keep their currencies from rising in value.
The U.S. has been trying to put pressure on China to let the value of their currency drift upward relative to the U.S. dollar. The Chinese gov't has been very reluctant to let this happen.
Alan Greenspan once spoke about this bond market conundrum. He was raising short term interest rates, so that the long rates would follow (as would normally occur). This wasn't happening, in fact long rates were falling.
This was frustrating him. He was going out of his way to "warn" the bond market that interest rates were going to rise, hoping that long term bonds would sell off, causing the long rates to rise. His actions were being ignored.
He blamed the global liquidity/savings glut of the Asian economies. They were buying when he wanted them to be selling.
The Bank of Canada has kept rates lower than they would normally be, because they do not want to add any incentive for more foreign purchases of our debt. This would cause the C$ to appreciate even further than it has, which they would like to avoid.
Seems to me that foreign purchasers of our bonds are having an effect on our domestic interest rates.
Debt has been on sale, and folks have leveraged themselves up the wazoo for the biggest consumer item of all -- housing.
Well not quite. Housing is an investment. Shelter, or accommodation, is a consumer item. The latter is the yield on the former.
People are not borrowing money so they can have a place to live. They are borrowing money to take an equity position in the asset of housing. Big difference. And of course, this is why the yield on housing (rent/price) has dropped to an all-time low, which is another way of saying housing is in an asset bubble.
"I keep waiting for the following argument to be a call for a return to feudalism."
We are way beyond that. In "feudal times", the rent on one's land was 10%. Many might give another 10% to the church. That let the peasant family keep 80% of what was produced by them. The Land Lord, of course, lived in style.
Something that few realize is that your SIN is a chit for your share of the national debt. Most think only abstractly of that debt, but what happens when/if that debt is called? $16,752.50 for every man woman and child in Canada. Not to mention provincial and municipal debts. Add that to your mortgage.
"Well not quite. Housing is an investment. Shelter, or accommodation, is a consumer item. The latter is the yield on the former."
I get that , but if it's something consumers spend money on, it's a consumer item in my books. Much of the over investment in housing the past few years has been ladled out towards discretionary and non-equity aspects of the 'investment' -- renovated kitchens, the third bathroom, crown mouldings, landscaping etc. Replacement costs for maintaining the investment and the fickle nature of the market's appreciation of discretionary improvements are a unique feature of this particular asset class.
Housing is a better bellwether than consumer goods for inflation, or at least one that shouldn't be ignored because the standard measure marginalizes it. Why should inflation only measure consumer price increases? With many consumer items, substitution is possoble -- if prices increase, something else can take its place. Orange juice too expensive? Drink apple. Prices for sirloin are going to the moon? Consumers switch to pork chops. We all gotta live somewhere, and what we bid for a non-discretionary asset with a significant supply lag is far more indicative of oversupply of money than discretionary consumer items.
Increases in asset prices, housing in particular, have an impact that is far more 'corrosive' than inflation on flatscreen TVs, orange juice, Ipods and SUVs. Overinvestment in housing in the aggregate is ultimately deflationary -- as consumers spend more of their paycheques to the lenders hodling their mortgages. If this overinvestment has been spurred by cheap debt (cheaper than actual, if not measured, inflation) then the economy veers towards a liquidity trap as there's little room for easing, and stimulative policies meant to spur spending and the economy have little effect. If fiscal polcy ignores asset bubbles, it loses the power to deal with worse problems later.
CPI, not CPI, whatever. The housing bubble is a significant financial and economic issue which will have repercussions for years to come. It could have been avoided had policymakers decided to be more sanguine about how the effects of stimulative fiscal policies are measured. We'll look back and wonder how policymakers could have ignored the elephant in the room.
Policymakers aren't ignoring the elephant at all - they're enjoying the ride, or at least their friends are. There are way too many well-connected people making money hand over fist from this housing bubble for the powers that be to do anything about it. And to make things even worse, Joe6Pack thinks he's making money from it too.
So little wonder that nobody in power - or out of power - wants to do or say anything about it. Any politician who spoke out against the current crazy RE prices would be blamed by his opponents, and much of the public, for the inevitable future price declines. Just like the REIC south of the border is now blaming the media for the RE bust.
Just like VCR RE 1981, dot-com, etc. Same old, same old.
I tend to roll my eyes when people talk about the gold standard, history tells me that the potential for horrendous peaks and crashes is all together possible with that type of system. And isn't it credit that has allowed the massive investment and productivity we enjoyed in the 20th century?
That being said, the system definitely works towards the rich and powerful, at the expense of the middle class and the poor.
The best you can do (assuming you are in the last 2 categories) is understand what is going on, and not fall into the trap they set for you.
"Something that few realize is that your SIN is a chit for your share of the national debt. Most think only abstractly of that debt, but what happens when/if that debt is called? $16,752.50 for every man woman and child in Canada. Not to mention provincial and municipal debts. Add that to your mortgage."
Well, one difference over feudal times is that the bulk of government spending migrates back to taxpayers in the form of services, whereas in feudal systems the peasants really got nothing other than "protection". Fortunately, I think Canada is pretty safe from having a run on our government bonds, and it does not look like any government is going to embrace deficit spending anytime soon, so I think we are ok.
As a point to ponder, estimates suggest that three quarters of our national debt can be attributed to the high interest rates in the 80s when the BOC decided to aim for zero inflation.
estimates suggest that three quarters of our national debt can be attributed to the high interest rates in the 80s
Those high interest rates were a direct result of, and necessary to put an end to, the inflationary policies and outcomes of the late 1960's and 1970's. Let's put the blame where it belongs.
"Why should inflation only measure consumer price increases? With many consumer items, substitution is possoble -- if prices increase, something else can take its place"
We can define inflation any way we want. CPI stands for CONSUMER price index. It measures the cost of living. Rent or rent equivalent is a cost of living. Owning a property is an investment (price is forward looking and value is based on future expectations). A rise in house prices is not inflation in that sense, any more than a rise in the stock market is inflation.
You are right that people need to live, but that is covered in rent and rental equivalents.
Also, not the absurd variance that speculation would cause to our inflation measures if house prices were included. Imagine that housing is weighted at 30% of CPI. During 1980-1981, official inflation figures would been 20%. And in 1982 we would have had DEFLATION. It would be a madhouse, with indexed pensions going up and down.
Finally, note that the long term debt market doesn't care about how we officially define inflation.
"f fiscal polcy ignores asset bubbles, it loses the power to deal with worse problems later."
Agree wholeheartedly with the latter part of your post. The mandate of the Fed, IMHO, isn't to micromanage the economy. A discretionary Fed is way too influenced by short term pressures to keep us prosperous. It should look after the situations when the negative or positive feedback loops prevent the economy from balancing itself. In a depression, nobody is spending because times are bad, which causes hurts the economy and so on. During boom times, people are spending because the economy is strong, which overheats the economy and so on. IMHO, the Fed should butt out, until either EXTREME becomes a possibility. That may mean having to allow a recession or two once in a while without acting, so that the excesses can be worked out. Hear that, Greenspan?
Finally, note that the long term debt market doesn't care about how we officially define inflation.
I disagree. Every commentary that I've read from professional fixed income investors mentions the Gov't reported CPI inflation rate as the most important factor in determining a bond's value.
In other words, long term interest rates are hugely dependant on the stated CPI.
"I disagree. Every commentary that I've read from professional fixed income investors mentions the Gov't reported CPI inflation rate as the most important factor in determining a bond's value.
There is a logical disconnect.
I said that "the long term debt market doesn't care about how we officially define inflation."
You respond with "long term interest rates are hugely dependant on the stated CPI"
B does not follow A. Maybe they follow CPI because it accurately reflect what they are looking for. As opposed to blindly following arbitrary government statistics. Should the CPI be rejigged arbitrarily, you can rest assured that the bond market would see through it.
Second, realize that matter what we think of CPI in its present state, it gets inflation more right than it gets it wrong. Hence, one would expect a long term bond investor to keep closely watch it.
Third, I don't think that your statement that "professional fixed income investors mentions the Gov't reported CPI inflation rate as the most important factor in determining a bond's value" is above questioning. Do have anything to back that up? Viewing CPI as an important factor is not the same as blindly following.
"In other words, long term interest rates are hugely dependant on the stated CPI.""
As per my reasoning above, I don't think that conclusion necessarily follows. It is dependent on stated CPI, as long as bond holders see stated CPI as relevant. If the CPI was to become irrelevant, I think the bond market is sufficiently efficient to disregard the metric.
"...realize that matter what we think of CPI in its present state, it gets inflation more right than it gets it wrong."
What is the basis of your conclusion? If we define inflation as a general rise in prices, or a decline in the purchasing power of money, then I would argue that the CPI does not accurately reflect reality.
Just look at the recent price history of : housing, commodities, food, energy, gasoline, insurance, education, phone bills, cable bills, etc. In my opinion, the only way that CPI reflects true inflation is if you don't buy anything.
I had a laugh when I looked at the Bank of Canada's website and noted what they exclude from their core inflation calculation. From the BOC's website quote: " 1. Core CPI: The CPI excluding eight of the most volatile components (fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, inter-city transportation and tobacco products) as well as the effect of changes in indirect taxes on the remaining components."
Don't eat, don't drive, don't buy a house, don't heat that house, don't take out a mortgage, don't use the bus, and above all, don't smoke. Then you'll be OK.
By excluding the "most volatile" items, that usually means the ones that are consistently rising in price.
"We can define inflation any way we want. CPI stands for CONSUMER price index. It measures the cost of living."
From Statistics Canada's publication, "Your Guide to the CPI" - Misconceptions About the CPI - pg. 3 quote "The CPI is not a cost-of-living index, though people frequently call it this."
Many people still think that it reflects cost of living. According to the people that collect the data and compile the index (Statscan), it does not.
"Third, I don't think that your statement that "professional fixed income investors mentions the Gov't reported CPI inflation rate as the most important factor in determining a bond's value" is above questioning. Do have anything to back that up?"
Exerpts from PIMCO's website (world's largest professional fixed income investment manager - $687 billion U.S. under management)
Bond Basics - June 2006
"Understanding inflation is crucial to investing because inflation can reduce the value of investment returns."
"In the U.S., the two most widely monitored indicators are the Producer Price Index (PPI) and the Consumer Price Index (CPI)."
"The more widely followed CPI reflects retail prices of goods and services, including housing costs, transportation, and healthcare. Many private and government contracts, such as social security payments or labor contracts, are explicitly linked to changes in the CPI."
"...rising inflation erodes the value of the principal on fixed-income securities."
"What is the basis of your conclusion? If we define inflation as a general rise in prices, or a decline in the purchasing power of money, then I would argue that the CPI does not accurately reflect reality. "
I said that it gets it more right than wrong. You seem hung up the fact that it is not perfect. If you needed inflation data, would you prefer CPI or a no number at all?
"By excluding the "most volatile" items, that usually means the ones that are consistently rising in price. "
No, volatile means just that. If you data which shows that the volatiles have outpaced CPI over time, I am all ears.
"Many people still think that it reflects cost of living. According to the people that collect the data and compile the index (Statscan), it does not. "
You make that sound so authoritative. However, it is selective quoting and nitpicking. Here is some more detail from the very document you referenced:
"We could compute a cost-of-living index for an individual if we had complete information about that person’s taste and consuming habits. To do this for a large number of people, let alone the total population of Canada, is impossible. For this reason, regularly published price indexes are based on the fixed basket concept rather than the costof- living concept."
Translation: CPI is not a TRUE cost of living measure, because that would be expensive and complicated to calculate. Instead we use a proxy, a fixed basket of goods. For all practical purposes it serves as a measure of cost of living. The more "typical" you are, the better it tracks YOUR cost of living.
Me thinks you arbitrarily seized on this fact to poke a "phantom" hole in my argument, but I don't think it is relevant.
"Understanding inflation is crucial to investing because inflation can reduce the value of investment returns."
No argument there.
"In the U.S., the two most widely monitored indicators are the Producer Price Index (PPI) and the Consumer Price Index (CPI)."
Again, no argument. But how do you get "the most important factor in determining a bond's value" out of "monitored indicator"?
"...rising inflation erodes the value of the principal on fixed-income securities."
Again, no argument. You are playing bait and switch here. The fact that inflation affects bond prices is not in dispuute. What is in dispute is:
a) Accuracy of CPI as a measure of inflation
b) Valuation methodology of long term bond investors.
"I said that it gets it more right than wrong. You seem hung up the fact that it is not perfect. If you needed inflation data, would you prefer CPI or a no number at all?"
Freako, sorry to beat a dead horse, but here goes.
I agree that the stated CPI is better than nothing, but since many people and governments make important decisions based on this data, it should be accurate.
Keep in mind that the gov't has a financial interest in keeping this number low. Much of their costs are tied to CPI. It affects the interest they pay on their debt, the wages they pay to public servants, and CPP, OAS, etc. are indexed to this number.
Why is it so far fetched that the number would be biased to the low side?
I posted a link on Solipsist's site to John Williams' Shadow Government Statistics websitehttp://www.shadowstats.com/cgi-bin/sgs/article/id=343. He has recalculated CPI the way it used to be done, before all of the manipulation. He says, "Inflation, as reported by the Consumer Price Index (CPI) is understated by roughly 7% per year." He makes a very good case.
"However, it is selective quoting and nitpicking. Here is some more detail from the very document you referenced..."
Agreed, I was looking through that document for something else when I came across that statement. I haven't read the whole thing.
"CPI is not a TRUE cost of living measure, because that would be expensive and complicated to calculate. Instead we use a proxy, a fixed basket of goods."
Here's my point, it is not a fixed basket. It has been rejigged quite a bit since the 70's. Substitutions and hedonic adjustments render it a politically correct basket.
It is supposed to be an index for a fixed standard of living. Wouldn't home ownership be part of one's standard of living? It used to be.
"Again, no argument. But how do you get "the most important factor in determining a bond's value" out of "monitored indicator"?"
I didn't get it from "monitored indicator". It came from the statement "Understanding inflation is crucial....The more widely followed CPI". My point was that the CPI is widely followed as an inflation indicator, and that inflation was a crucial factor in fixed income investing.
Again, no argument. You are playing bait and switch here. The fact that inflation affects bond prices is not in dispuute. What is in dispute is:
a) Accuracy of CPI as a measure of inflation
b) Valuation methodology of long term bond investors."
I believe point a) is addressed above. See shadowstats link.
Point b) - The bond market is susceptible to "irrational exuberance" just like any market. Bond investors are for the most part a saavy bunch, but they are relying on imperfect data, IMHO.
It is probably not surprising that they follow CPI, because this is what the Central Bank follows to determine interest rate policy, which greatly affects bonds.
I think a more accurate reflection of inflation can be had by looking at the growth in money supply. If the number of dollars grows at a faster rate than GDP, inflation will follow.
Every extra dollar that is created causes all dollars to lose purchasing power. This shows up as a rise in prices. Money supply in Canada, U.S., U.K., etc. has been growing in double digit percentages for the last few years, GDP has been growing in low single digits.
Because of this, my dollars have lost purchasing power. I can no longer buy as much house, food, gas, insurance, energy, vacation enjoyment, etcetera.
Freako, I respect and appreciate your commentary, and I usually agree with most of what you say. However, on this CPI issue, we may have to agree to disagree. Which is fine. If we all had the same opinions, how boring would that be?
"Why is it so far fetched that the number would be biased to the low side?"
It may be. My opinion, in the end, is that the bond market is fairly efficient. If CPI is not accurate, the bond market will see through that.
Hence, a low inflation environment is likely. Expectations are an aggregate of probabilities. It could be that risk deflation is priced in. Why would we have a low inflation/deflationary environment? Because either:
a) There are expectations of high productivity growth
b) Recession
"Inflation, as reported by the Consumer Price Index (CPI) is understated by roughly 7% per year." He makes a very good case."
I don't have reason to doubt the 7% difference. If inflation was 3% with current methodology, it would be 3.21% with old one. Not trivial, but definitely not the cause of inverted yield curve.
But which measure is "true" inflation? This gets complicated, and we can easily fall into semantical traps. As the nature of society and life in general changes, the notion of holding CPI apples to apples loses its relevance. Hedonics may be subjective, and maybe there are some flaws, but we need to capture these changes.
IMHO, the inflation I am concerned about is related to the loss of purchasing power resulting from excessive growth in the money supply. Things get a little muddled due to an every increasing money supply offset by increased productivity. It is a dynamic world, so attempts at static yardsticks is an imperfect science.
I agree that there are problems with CPI. I read UBC prof Maurice Levy's book on macroeconomis a few years ago. If I recall correctly, he argued that rising oil prices (due to supply issues) is not inflationary. If people have to spend more on gas, they will spend less on other things. Yet, central bankers are pore over every tick of a CPI datapoint, as if inflation was a small raft navigating whitewater rapids. The boat gets tossed here and there, and the bankers try to navigate with their paddles. But the raft isn't inflation, but CPI. Inflation? It is the river itself.
"Here's my point, it is not a fixed basket. It has been rejigged quite a bit since the 70's. Substitutions and hedonic adjustments render it a politically correct basket."
As per my comments above, things change. Would you even try to apply CPI figures to a basket from 100 years ago? Who cares what the cost of candlewax and horseshoes is today?
How do you account for the fact that a 27 inch black and white TV has been replaced by a 50 inch 1080P Aquos LCD panel? How do you account for laser eye surgery, or life saving drugs? Hedonics are not perfect, do capture things. I agree that the subjective nature of some items opens to door to incompetence or manipulation. Gotta take the good with the bad.
"Agreed, I was looking through that document for something else when I came across that statement. I haven't read the whole thing."
That acknowledgement shows that you debate in good faith. I appreciate that.
"It is supposed to be an index for a fixed standard of living. Wouldn't home ownership be part of one's standard of living? It used to be."
Now it is my turn to beat the dead horse. Yes, ownership as measured by rent or rental equivalent. Prices are forward looking, and in that sense an investment whose price fluctuates signficantly due to changing expectations of FUTURE consumption of housing. Including house prices (actually, land prices) in CPI makes as much sense as including stock prices in CPI. If we included house prices, inflation as measured by CPI would be unnecessarily volatile (imagine 1980 to 1983).
"My point was that the CPI is widely followed as an inflation indicator, and that inflation was a crucial factor in fixed income investing."
Yes, but doesn't disprove the idea that bond investors can think outside the CPI box. I think CPI is a good starting point, but as mentioned, I think bond investors can and will tweak their models for bias. I presume we will have to agree to disagree on this point.
""- The bond market is susceptible to "irrational exuberance" just like any market."
No market is perfectly rational, but I'd put the bond market at the top of the list. It will run circles around RE in terms of efficiency, that is for sure. Market actors are almost entirely professionals. Unlike stocks, not susceptible too speculation and extrapolation. It may help that bonds are quoted in yield. It is hard to extrapolate something which quotes a lower number as prices rise. Imagine if RE was quote in rental yield? " "If the number of dollars grows at a faster rate than GDP, inflation will follow."
That is exactly how I view it. But do you mean real or nominal GDP (I presume real), and do you mean absolute GDP, or per capita? Don't forget that velocity is part of the equation too. It has been increasing about a percent a year for half a century.
"Money supply in Canada, U.S., U.K., etc. has been growing in double digit percentages for the last few years, GDP has been growing in low single digits."
M1, M2 or M3? Also, not the sizeable absolute difference between the money supply and GDP. As per wikipedia, the amount of M2 per capita in the U.S. was $4500 as of December 2006. That is only a fraction of GDP.
And how much of the recent increase in money supply is related to housing boom related borrowing? If large, is that really inflation? What if the bubble bursts and all the borrowing and what have you undwinds itself? Should that be considered inflation followed by deflation? Or should we just exclude this detour altogether? My vote is with the latter.
"It is probably not surprising that they follow CPI, because this is what the Central Bank follows to determine interest rate policy, which greatly affects bonds."
Yes, in a sense, bond investors are not merely forecasting inflation, but also predicting the Fed response to inflation. And then the impact on the economy of that response. That includes estimates of future productivity growth among many other things. Not easy stuff.
"Because of this, my dollars have lost purchasing power. I can no longer buy as much house, food, gas, insurance, energy, vacation enjoyment, etcetera."
Anecdotally, I'd argue that over say the last 20 years, CPI has accurately tracked price changes in everything but house prices. But house prices are not part of CPI, and as argued above shouldn't be. As you probably know, Sauder data has real rents DOWN over the past 35 years. I vaguely remember gasoline costing 39 cents in 1985. Plugging that into the BoC inflation calculator, I get 79 cents, so definitely up. But I believe that includes increases in gasoline taxes. A few short years ago, gasoline was DOWN in real terms. That is why it is labelled "volatile". Oil, for example is still down since 1980.
"I don't have reason to doubt the 7% difference. If inflation was 3% with current methodology, it would be 3.21% with old one. Not trivial, but definitely not the cause of inverted yield curve."
I believe that the old method would produce a 10% (3% + 7%) result rather that a 3.21% result. That is significant.
"M1, M2 or M3? Also, not the sizeable absolute difference between the money supply and GDP. As per wikipedia, the amount of M2 per capita in the U.S. was $4500 as of December 2006. That is only a fraction of GDP"
M3. That $ 4500 figure from wikipedia was for M1. The figure for M2 is $ 23,320. There are no official figures for M3, since the U.S. stopped reporting it in 2006, however there are other sources that have continued computing the figure.
Currently, M3 in the U.S. is about 10 Trillion. Using the same pop. base, that would come out to about $ 33,220 per capita.
27 comments:
It is not surprising that we are experiencing asset bubbles around the world due to the enormous growth in money supply (credit).
If you took a graph of RE prices in Canada, and overlay a graph of mortgage debt, you would find that they are highly corelated.
As Ron Paul says, inflation (rise in prices) is caused by excess growth in money supply. If the economy is growing in low single digits, and money supply is growing in double digits, this will cause inflation.
It's just that the gov't and some economists refuse to label a rise in asset prices as inflation. Those that do, often call it "good" inflation, as it causes peoples investments to rise in price.
Usually the bond market would correct this before it got to the bubble stage, as bond investors would take note of this increase in money supply, and bonds would sell off, causing interest rates to rise, slowing the increase in credit (which is how the money supply grows).
This would normally choke off the speculation before it became too rampant. This has not happened this time, as a lot of this extra money has made its way back into the bond market by way of foreign central banks recycling of their excess foreign currency reserves.
They do this so that their own currencies (Chinese yuan, Japanese yen) do not rise in value against the currencies of the countries that buy their products. This recycling has allowed the bubble to inflate much larger than would have otherwise been possible.
On top of all of this, because of the free flow of money, there are speculators who will borrow money in Japanese yen (at near zero interest rate), or some other currency where the cost of borrowing is low. They will then use that money to buy the bonds of a country whose interest rate is much higher (US, New Zealand, Canada,etc.)
This also adds fuel to the fire, as it keeps long term interest rates artificially low. This keeps the cost of long term debt (mortgage) low, and allows for more people to compete for a limited supply of houses. Demand goes up, and prices rise. This causes people to take on more debt, which causes the money supply to increase. A vicious cycle perpetuated by cheap credit.
nice synopsis casual
I think most people fail to connect the dots as you have - good on you.
Yes, you nicely connected the dots. I am not totally sure about the bond market. Can offshore buying really overpower domestic demand to the point that bonds are grossly mispriced?
And is CPI really misleading? It seems reasonable for most things I spend money on. I am totally opposed to the idea of including home price in CPI.
If you are right that inflation is higher than what CPI indicates, then debt is on sale. Borrow away and buy whatever you determine will outpace CPI.
"If you are right that inflation is higher than what CPI indicates, then debt is on sale. Borrow away and buy whatever you determine will outpace CPI."
And that's exactly what's happened in the past 5 years. Debt has been on sale, and folks have leveraged themselves up the wazoo for the biggest consumer item of all -- housing. Which in turn has itself become a vehicle for further borrowing for "wealth effect" consumer items, renos, second properties, borrowing for investments.
If risk premia ever return to lending (hello, subprime implosion!), then we'd be looking at deflation for most items in the CPI as supply baloons and demand from borrowed money shrinks. Ont the other hand, owner's equivalent rent would start to increase. So the schizoid CPI would be stood on its head, and probably remain balanced. Though the financial landscape would have changed dramatically.
Can offshore buying really overpower domestic demand to the point that bonds are grossly mispriced?
The bond market is somewhat like the RE market. Prices are set at the margins. Not everyone is selling their bonds all at once.
The last I heard, foreign reserves for Asian nations, led by China and Japan are over three trillion U.S. dollars. This is increasing very rapidly. The U.S. current account defecit is adding to this amount daily, approaching an annual figure of one trillion dollars.
Couple this with the yen carry trade, and you've got an awful lot of foreign capital being put to work in the bond market. I believe that this amount is sufficient enough to effect bond prices domestically.
If you are right that inflation is higher than what CPI indicates
I just posted on another blog regarding manipulations in the CPI.
Here's a link to a good article on the way it is manipulated.
http://www.shadowstats.com/cgi-bin/sgs/article/id=343
"And that's exactly what's happened in the past 5 years. Debt has been on sale, and folks have leveraged themselves up the wazoo for the biggest consumer item of all -- housing."
Temporarily yes, but would you call it "inflation". Easy come easy go. Sticking on the topic of underreported inflation, if long term debt is on sale (less than inflation), what exactly would you buy to take advantage. And don't say "real estate".
"The bond market is somewhat like the RE market. Prices are set at the margins. Not everyone is selling their bonds all at once."
Of course it is set at the margin. But demand is not inelastic. When the risk/liquidity premia get squeezed out, any rational holder would unload for greener pastures.
For what you suggest to occur, there would have to be indiscriminate offshore buying, and oblivious domestic demand/supply. But not out of the question.
This sounds a lot like deploring one extreme (excess credit) to embracing another (no credit)....
The track record of the gold standard, as well as any fixed exchange rate standard is rather mixed. To hear the speaker talk about Argentina's success in employing a fixed exchange rate makes me wonder if we are discussing the same country. Runaway inflation is a real downer, but deflation is certainly not a huge improvement. I seem to recall that the Bank of Canada did pursue a zero inflation rate policy throughout the 1980s, and we very nearly got it, but we did also get a really bad recession.
Whenever I hear an argument for the return of the gold standard, I keep waiting for the following argument to be a call for a return to feudalism.
For what you suggest to occur, there would have to be indiscriminate offshore buying
I think buying by Asian Central Banks could almost be described as indiscriminate. They must do this to keep their currencies from rising in value.
The U.S. has been trying to put pressure on China to let the value of their currency drift upward relative to the U.S. dollar. The Chinese gov't has been very reluctant to let this happen.
Alan Greenspan once spoke about this bond market conundrum. He was raising short term interest rates, so that the long rates would follow (as would normally occur). This wasn't happening, in fact long rates were falling.
This was frustrating him. He was going out of his way to "warn" the bond market that interest rates were going to rise, hoping that long term bonds would sell off, causing the long rates to rise. His actions were being ignored.
He blamed the global liquidity/savings glut of the Asian economies. They were buying when he wanted them to be selling.
The Bank of Canada has kept rates lower than they would normally be, because they do not want to add any incentive for more foreign purchases of our debt. This would cause the C$ to appreciate even further than it has, which they would like to avoid.
Seems to me that foreign purchasers of our bonds are having an effect on our domestic interest rates.
Debt has been on sale, and folks have leveraged themselves up the wazoo for the biggest consumer item of all -- housing.
Well not quite. Housing is an investment. Shelter, or accommodation, is a consumer item. The latter is the yield on the former.
People are not borrowing money so they can have a place to live. They are borrowing money to take an equity position in the asset of housing. Big difference. And of course, this is why the yield on housing (rent/price) has dropped to an all-time low, which is another way of saying housing is in an asset bubble.
"I keep waiting for the following argument to be a call for a return to feudalism."
We are way beyond that. In "feudal times", the rent on one's land was 10%. Many might give another 10% to the church. That let the peasant family keep 80% of what was produced by them. The Land Lord, of course, lived in style.
Something that few realize is that your SIN is a chit for your share of the national debt. Most think only abstractly of that debt, but what happens when/if that debt is called? $16,752.50 for every man woman and child in Canada. Not to mention provincial and municipal debts. Add that to your mortgage.
Servitude has just gone stealth.
"Well not quite. Housing is an investment. Shelter, or accommodation, is a consumer item. The latter is the yield on the former."
I get that , but if it's something consumers spend money on, it's a consumer item in my books. Much of the over investment in housing the past few years has been ladled out towards discretionary and non-equity aspects of the 'investment' -- renovated kitchens, the third bathroom, crown mouldings, landscaping etc. Replacement costs for maintaining the investment and the fickle nature of the market's appreciation of discretionary improvements are a unique feature of this particular asset class.
Housing is a better bellwether than consumer goods for inflation, or at least one that shouldn't be ignored because the standard measure marginalizes it.
Why should inflation only measure consumer price increases? With many consumer items, substitution is possoble -- if prices increase, something else can take its place. Orange juice too expensive? Drink apple. Prices for sirloin are going to the moon? Consumers switch to pork chops. We all gotta live somewhere, and what we bid for a non-discretionary asset with a significant supply lag is far more indicative of oversupply of money than discretionary consumer items.
Increases in asset prices, housing in particular, have an impact that is far more 'corrosive' than inflation on flatscreen TVs, orange juice, Ipods and SUVs. Overinvestment in housing in the aggregate is ultimately deflationary -- as consumers spend more of their paycheques to the lenders hodling their mortgages. If this overinvestment has been spurred by cheap debt (cheaper than actual, if not measured, inflation) then the economy veers towards a liquidity trap as there's little room for easing, and stimulative policies meant to spur spending and the economy have little effect. If fiscal polcy ignores asset bubbles, it loses the power to deal with worse problems later.
CPI, not CPI, whatever. The housing bubble is a significant financial and economic issue which will have repercussions for years to come. It could have been avoided had policymakers decided to be more sanguine about how the effects of stimulative fiscal policies are measured. We'll look back and wonder how policymakers could have ignored the elephant in the room.
Policymakers aren't ignoring the elephant at all - they're enjoying the ride, or at least their friends are. There are way too many well-connected people making money hand over fist from this housing bubble for the powers that be to do anything about it. And to make things even worse, Joe6Pack thinks he's making money from it too.
So little wonder that nobody in power - or out of power - wants to do or say anything about it. Any politician who spoke out against the current crazy RE prices would be blamed by his opponents, and much of the public, for the inevitable future price declines. Just like the REIC south of the border is now blaming the media for the RE bust.
Just like VCR RE 1981, dot-com, etc. Same old, same old.
Excellent analysis casual observer.
I tend to roll my eyes when people talk about the gold standard, history tells me that the potential for horrendous peaks and crashes is all together possible with that type of system. And isn't it credit that has allowed the massive investment and productivity we enjoyed in the 20th century?
That being said, the system definitely works towards the rich and powerful, at the expense of the middle class and the poor.
The best you can do (assuming you are in the last 2 categories) is understand what is going on, and not fall into the trap they set for you.
"Something that few realize is that your SIN is a chit for your share of the national debt. Most think only abstractly of that debt, but what happens when/if that debt is called? $16,752.50 for every man woman and child in Canada. Not to mention provincial and municipal debts. Add that to your mortgage."
Well, one difference over feudal times is that the bulk of government spending migrates back to taxpayers in the form of services, whereas in feudal systems the peasants really got nothing other than "protection". Fortunately, I think Canada is pretty safe from having a run on our government bonds, and it does not look like any government is going to embrace deficit spending anytime soon, so I think we are ok.
As a point to ponder, estimates suggest that three quarters of our national debt can be attributed to the high interest rates in the 80s when the BOC decided to aim for zero inflation.
estimates suggest that three quarters of our national debt can be attributed to the high interest rates in the 80s
Those high interest rates were a direct result of, and necessary to put an end to, the inflationary policies and outcomes of the late 1960's and 1970's. Let's put the blame where it belongs.
"Why should inflation only measure consumer price increases? With many consumer items, substitution is possoble -- if prices increase, something else can take its place"
We can define inflation any way we want. CPI stands for CONSUMER price index. It measures the cost of living. Rent or rent equivalent is a cost of living. Owning a property is an investment (price is forward looking and value is based on future expectations). A rise in house prices is not inflation in that sense, any more than a rise in the stock market is inflation.
You are right that people need to live, but that is covered in rent and rental equivalents.
Also, not the absurd variance that speculation would cause to our inflation measures if house prices were included. Imagine that housing is weighted at 30% of CPI. During 1980-1981, official inflation figures would been 20%. And in 1982 we would have had DEFLATION. It would be a madhouse, with indexed pensions going up and down.
Finally, note that the long term debt market doesn't care about how we officially define inflation.
"f fiscal polcy ignores asset bubbles, it loses the power to deal with worse problems later."
Agree wholeheartedly with the latter part of your post. The mandate of the Fed, IMHO, isn't to micromanage the economy. A discretionary Fed is way too influenced by short term pressures to keep us prosperous. It should look after the situations when the negative or positive feedback loops prevent the economy from balancing itself. In a depression, nobody is spending because times are bad, which causes hurts the economy and so on. During boom times, people are spending because the economy is strong, which overheats the economy and so on. IMHO, the Fed should butt out, until either EXTREME becomes a possibility. That may mean having to allow a recession or two once in a while without acting, so that the excesses can be worked out. Hear that, Greenspan?
Finally, note that the long term debt market doesn't care about how we officially define inflation.
I disagree. Every commentary that I've read from professional fixed income investors mentions the Gov't reported CPI inflation rate as the most important factor in determining a bond's value.
In other words, long term interest rates are hugely dependant on the stated CPI.
"I disagree. Every commentary that I've read from professional fixed income investors mentions the Gov't reported CPI inflation rate as the most important factor in determining a bond's value.
There is a logical disconnect.
I said that "the long term debt market doesn't care about how we officially define inflation."
You respond with "long term interest rates are hugely dependant on the stated CPI"
B does not follow A. Maybe they follow CPI because it accurately reflect what they are looking for. As opposed to blindly following arbitrary government statistics. Should the CPI be rejigged arbitrarily, you can rest assured that the bond market would see through it.
Second, realize that matter what we think of CPI in its present state, it gets inflation more right than it gets it wrong. Hence, one would expect a long term bond investor to keep closely watch it.
Third, I don't think that your statement that "professional fixed income investors mentions the Gov't reported CPI inflation rate as the most important factor in determining a bond's value" is above questioning. Do have anything to back that up? Viewing CPI as an important factor is not the same as blindly following.
"In other words, long term interest rates are hugely dependant on the stated CPI.""
As per my reasoning above, I don't think that conclusion necessarily follows. It is dependent on stated CPI, as long as bond holders see stated CPI as relevant. If the CPI was to become irrelevant, I think the bond market is sufficiently efficient to disregard the metric.
"...realize that matter what we think of CPI in its present state, it gets inflation more right than it gets it wrong."
What is the basis of your conclusion? If we define inflation as a general rise in prices, or a decline in the purchasing power of money, then I would argue that the CPI does not accurately reflect reality.
Just look at the recent price history of : housing, commodities, food, energy, gasoline, insurance, education, phone bills, cable bills, etc. In my opinion, the only way that CPI reflects true inflation is if you don't buy anything.
I had a laugh when I looked at the Bank of Canada's website and noted what they exclude from their core inflation calculation. From the BOC's website quote: " 1. Core CPI: The CPI excluding eight of the most volatile components (fruit, vegetables, gasoline, fuel oil, natural gas, mortgage interest, inter-city transportation and tobacco products) as well as the effect of changes in indirect taxes on the remaining components."
Don't eat, don't drive, don't buy a house, don't heat that house, don't take out a mortgage, don't use the bus, and above all, don't smoke. Then you'll be OK.
By excluding the "most volatile" items, that usually means the ones that are consistently rising in price.
"We can define inflation any way we want. CPI stands for CONSUMER price index. It measures the cost of living."
From Statistics Canada's publication, "Your Guide to the CPI" - Misconceptions About the CPI - pg. 3 quote "The CPI is not a cost-of-living index, though people frequently call it this."
Many people still think that it reflects cost of living. According to the people that collect the data and compile the index (Statscan), it does not.
"Third, I don't think that your statement that "professional fixed income investors mentions the Gov't reported CPI inflation rate as the most important factor in determining a bond's value" is above questioning. Do have anything to back that up?"
Exerpts from PIMCO's website (world's largest professional fixed income investment manager - $687 billion U.S. under management)
Bond Basics - June 2006
"Understanding inflation is crucial to investing because inflation can reduce the value of investment returns."
"In the U.S., the two most widely monitored indicators are the Producer Price Index (PPI) and the Consumer Price Index (CPI)."
"The more widely followed CPI reflects retail prices of goods and services, including housing costs, transportation, and healthcare. Many private and government contracts, such as social security payments or labor contracts, are explicitly linked to changes in the CPI."
"...rising inflation erodes the value of the principal on fixed-income securities."
CO, where to begin?
"What is the basis of your conclusion? If we define inflation as a general rise in prices, or a decline in the purchasing power of money, then I would argue that the CPI does not accurately reflect reality.
"
I said that it gets it more right than wrong. You seem hung up the fact that it is not perfect. If you needed inflation data, would you prefer CPI or a no number at all?
"By excluding the "most volatile" items, that usually means the ones that are consistently rising in price. "
No, volatile means just that. If you data which shows that the volatiles have outpaced CPI over time, I am all ears.
"Many people still think that it reflects cost of living. According to the people that collect the data and compile the index (Statscan), it does not. "
You make that sound so authoritative. However, it is selective quoting and nitpicking. Here is some more detail from the very document you referenced:
"We could compute a cost-of-living index for an
individual if we had complete information about that
person’s taste and consuming habits. To do this
for a large number of people, let alone the total
population of Canada, is impossible. For this reason,
regularly published price indexes are based on the fixed basket concept rather than the costof-
living concept."
Translation: CPI is not a TRUE cost of living measure, because that would be expensive and complicated to calculate. Instead we use a proxy, a fixed basket of goods. For all practical purposes it serves as a measure of cost of living. The more "typical" you are, the better it tracks YOUR cost of living.
Me thinks you arbitrarily seized on this fact to poke a "phantom" hole in my argument, but I don't think it is relevant.
"Understanding inflation is crucial to investing because inflation can reduce the value of investment returns."
No argument there.
"In the U.S., the two most widely monitored indicators are the Producer Price Index (PPI) and the Consumer Price Index (CPI)."
Again, no argument. But how do you get "the most important factor in determining a bond's value" out of "monitored indicator"?
"...rising inflation erodes the value of the principal on fixed-income securities."
Again, no argument. You are playing bait and switch here. The fact that inflation affects bond prices is not in dispuute. What is in dispute is:
a) Accuracy of CPI as a measure of inflation
b) Valuation methodology of long term bond investors.
"I said that it gets it more right than wrong. You seem hung up the fact that it is not perfect. If you needed inflation data, would you prefer CPI or a no number at all?"
Freako, sorry to beat a dead horse, but here goes.
I agree that the stated CPI is better than nothing, but since many people and governments make important decisions based on this data, it should be accurate.
Keep in mind that the gov't has a financial interest in keeping this number low. Much of their costs are tied to CPI. It affects the interest they pay on their debt, the wages they pay to public servants, and CPP, OAS, etc. are indexed to this number.
Why is it so far fetched that the number would be biased to the low side?
I posted a link on Solipsist's site to John Williams' Shadow Government Statistics websitehttp://www.shadowstats.com/cgi-bin/sgs/article/id=343.
He has recalculated CPI the way it used to be done, before all of the manipulation. He says, "Inflation, as reported by the Consumer Price Index (CPI) is understated by roughly 7% per year." He makes a very good case.
"However, it is selective quoting and nitpicking. Here is some more detail from the very document you referenced..."
Agreed, I was looking through that document for something else when I came across that statement. I haven't read the whole thing.
"CPI is not a TRUE cost of living measure, because that would be expensive and complicated to calculate. Instead we use a proxy, a fixed basket of goods."
Here's my point, it is not a fixed basket. It has been rejigged quite a bit since the 70's. Substitutions and hedonic adjustments render it a politically correct basket.
It is supposed to be an index for a fixed standard of living. Wouldn't home ownership be part of one's standard of living? It used to be.
"Again, no argument. But how do you get "the most important factor in determining a bond's value" out of "monitored indicator"?"
I didn't get it from "monitored indicator". It came from the statement "Understanding inflation is crucial....The more widely followed CPI". My point was that the CPI is widely followed as an inflation indicator, and that inflation was a crucial factor in fixed income investing.
Again, no argument. You are playing bait and switch here. The fact that inflation affects bond prices is not in dispuute. What is in dispute is:
a) Accuracy of CPI as a measure of inflation
b) Valuation methodology of long term bond investors."
I believe point a) is addressed above. See shadowstats link.
Point b) - The bond market is susceptible to "irrational exuberance" just like any market. Bond investors are for the most part a saavy bunch, but they are relying on imperfect data, IMHO.
It is probably not surprising that they follow CPI, because this is what the Central Bank follows to determine interest rate policy, which greatly affects bonds.
I think a more accurate reflection of inflation can be had by looking at the growth in money supply. If the number of dollars grows at a faster rate than GDP, inflation will follow.
Every extra dollar that is created causes all dollars to lose purchasing power. This shows up as a rise in prices. Money supply in Canada, U.S., U.K., etc. has been growing in double digit percentages for the last few years, GDP has been growing in low single digits.
Because of this, my dollars have lost purchasing power. I can no longer buy as much house, food, gas, insurance, energy, vacation enjoyment, etcetera.
Freako, I respect and appreciate your commentary, and I usually agree with most of what you say. However, on this CPI issue, we may have to agree to disagree. Which is fine. If we all had the same opinions, how boring would that be?
Cheers, mate.
"Why is it so far fetched that the number would be biased to the low side?"
It may be. My opinion, in the end, is that the bond market is fairly efficient. If CPI is not accurate, the bond market will see through that.
Hence, a low inflation environment is likely. Expectations are an aggregate of probabilities. It could be that risk deflation is priced in. Why would we have a low inflation/deflationary environment? Because either:
a) There are expectations of high productivity growth
b) Recession
"Inflation, as reported by the Consumer Price Index (CPI) is understated by roughly 7% per year." He makes a very good case."
I don't have reason to doubt the 7% difference. If inflation was 3% with current methodology, it would be 3.21% with old one. Not trivial, but definitely not the cause of inverted yield curve.
But which measure is "true" inflation? This gets complicated, and we can easily fall into semantical traps. As the nature of society and life in general changes, the notion of holding CPI apples to apples loses its relevance. Hedonics may be subjective, and maybe there are some flaws, but we need to capture these changes.
IMHO, the inflation I am concerned about is related to the loss of purchasing power resulting from excessive growth in the money supply. Things get a little muddled due to an every increasing money supply offset by increased productivity. It is a dynamic world, so attempts at static yardsticks is an imperfect science.
I agree that there are problems with CPI. I read UBC prof Maurice Levy's book on macroeconomis a few years ago. If I recall correctly, he argued that rising oil prices (due to supply issues) is not inflationary. If people have to spend more on gas, they will spend less on other things. Yet, central bankers are pore over every tick of a CPI datapoint, as if inflation was a small raft navigating whitewater rapids. The boat gets tossed here and there, and the bankers try to navigate with their paddles. But the raft isn't inflation, but CPI. Inflation? It is the river itself.
"Here's my point, it is not a fixed basket. It has been rejigged quite a bit since the 70's. Substitutions and hedonic adjustments render it a politically correct basket."
As per my comments above, things change. Would you even try to apply CPI figures to a basket from 100 years ago? Who cares what the cost of candlewax and horseshoes is today?
How do you account for the fact that a 27 inch black and white TV has been replaced by a 50 inch 1080P Aquos LCD panel? How do you account for laser eye surgery, or life saving drugs? Hedonics are not perfect, do capture things. I agree that the subjective nature of some items opens to door to incompetence or manipulation. Gotta take the good with the bad.
"Agreed, I was looking through that document for something else when I came across that statement. I haven't read the whole thing."
That acknowledgement shows that you debate in good faith. I appreciate that.
"It is supposed to be an index for a fixed standard of living. Wouldn't home ownership be part of one's standard of living? It used to be."
Now it is my turn to beat the dead horse. Yes, ownership as measured by rent or rental equivalent. Prices are forward looking, and in that sense an investment whose price fluctuates signficantly due to changing expectations of FUTURE consumption of housing. Including house prices (actually, land prices) in CPI makes as much sense as including stock prices in CPI. If we included house prices, inflation as measured by CPI would be unnecessarily volatile (imagine 1980 to 1983).
"My point was that the CPI is widely followed as an inflation indicator, and that inflation was a crucial factor in fixed income investing."
Yes, but doesn't disprove the idea that bond investors can think outside the CPI box. I think CPI is a good starting point, but as mentioned, I think bond investors can and will tweak their models for bias. I presume we will have to agree to disagree on this point.
""- The bond market is susceptible to "irrational exuberance" just like any market."
No market is perfectly rational, but I'd put the bond market at the top of the list. It will run circles around RE in terms of efficiency, that is for sure. Market actors are almost entirely professionals. Unlike stocks, not susceptible too speculation and extrapolation. It may help that bonds are quoted in yield. It is hard to extrapolate something which quotes a lower number as prices rise. Imagine if RE was quote in rental yield?
"
"If the number of dollars grows at a faster rate than GDP, inflation will follow."
That is exactly how I view it. But do you mean real or nominal GDP (I presume real), and do you mean absolute GDP, or per capita? Don't forget that velocity is part of the equation too. It has been increasing about a percent a year for half a century.
"Money supply in Canada, U.S., U.K., etc. has been growing in double digit percentages for the last few years, GDP has been growing in low single digits."
M1, M2 or M3? Also, not the sizeable absolute difference between the money supply and GDP. As per wikipedia, the amount of M2 per capita in the U.S. was $4500 as of December 2006. That is only a fraction of GDP.
And how much of the recent increase in money supply is related to housing boom related borrowing? If large, is that really inflation? What if the bubble bursts and all the borrowing and what have you undwinds itself? Should that be considered inflation followed by deflation? Or should we just exclude this detour altogether? My vote is with the latter.
"It is probably not surprising that they follow CPI, because this is what the Central Bank follows to determine interest rate policy, which greatly affects bonds."
Yes, in a sense, bond investors are not merely forecasting inflation, but also predicting the Fed response to inflation. And then the impact on the economy of that response. That includes estimates of future productivity growth among many other things. Not easy stuff.
"Because of this, my dollars have lost purchasing power. I can no longer buy as much house, food, gas, insurance, energy, vacation enjoyment, etcetera."
Anecdotally, I'd argue that over say the last 20 years, CPI has accurately tracked price changes in everything but house prices. But house prices are not part of CPI, and as argued above shouldn't be. As you probably know, Sauder data has real rents DOWN over the past 35 years. I vaguely remember gasoline costing 39 cents in 1985. Plugging that into the BoC inflation calculator, I get 79 cents, so definitely up. But I believe that includes increases in gasoline taxes. A few short years ago, gasoline was DOWN in real terms. That is why it is labelled "volatile". Oil, for example is still down since 1980.
Peace out.
"I don't have reason to doubt the 7% difference. If inflation was 3% with current methodology, it would be 3.21% with old one. Not trivial, but definitely not the cause of inverted yield curve."
I believe that the old method would produce a 10% (3% + 7%) result rather that a 3.21% result. That is significant.
"M1, M2 or M3? Also, not the sizeable absolute difference between the money supply and GDP. As per wikipedia, the amount of M2 per capita in the U.S. was $4500 as of December 2006. That is only a fraction of GDP"
M3. That $ 4500 figure from wikipedia was for M1. The figure for M2 is $ 23,320. There are no official figures for M3, since the U.S. stopped reporting it in 2006, however there are other sources that have continued computing the figure.
Currently, M3 in the U.S. is about 10 Trillion. Using the same pop. base, that would come out to about $ 33,220 per capita.
Correction on U.S. M3 statistic. As of early 2007, it was approx. $ 11.5 Trillion. (approx. $ 38,205 per capita)
"I believe that the old method would produce a 10% (3% + 7%) result rather that a 3.21% result. That is significant."
Now that I highly doubt.
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