HardAssetsInvestor

Written by Brad Zigler  |

July 15, 2009

Laying Odds On Inflation

Details

Dollars and deflation and despair? Or inflation gone wild?

• The Real-Time Monetary Inflation indicator
• The CPI
• A few probabilities

 

We get lots of questions from newer HAI (HardAssetsInvestor.com) readers about the Real-time Monetary Inflation indicator that appears at the top of each daily Desktop column. The difference between our monetary inflation rate and most people's concept of inflation, manifested by the Consumer Price Index (CPI), can sometimes be shocking.

So, why the big disparity? Perhaps an explanation is in order.

Two reasons, really. First of all, the daily update represents an average annual rate of inflation from the base year, 2006, to the present. When CPI numbers are presented, they're typically quoted for short, discrete periods such as a month or a year.  For example, the 12-month change in CPI clocked by the U.S. Bureau of Labor Statistics (BLS) through May 2009 was -1.3%. However, the Desktop daily update shows the current average annual inflation rate was 3.7% as of the last trading day in May.

The second - and perhaps most important - distinction is that these two statistics are really measuring two entirely different things. The CPI represents changes in the prices paid by domestic urban consumers for a small but hopefully representative basket of goods and services. The HAI monetary inflation indicator describes changes in the global purchasing power of the U.S. dollar measured against gold and the second-most widely held reserve currency, the euro.

The velocity of price changes for domestic purchases of goods and services can, at times, differ widely from the rate at which the dollar's value fluctuates in the foreign exchange market. For example, the rate of change in the HAI indicator for the 12 months ending in May was -2.6%, twice the contemporaneous CPI reading.

Over the long run, though, the two inflation rates can be (and one might expect should be) quite similar.

The HAI monetary inflation index is derived by calculating the difference between gold's appreciation rate in dollars versus its euro-denominated gains. Using a January 1999 base of 100, the current index of 151.88 implies a compound average annual inflation rate of 4.0%. Over that same 10-year period, CPI's annual growth rate can also be pegged at 4.0%.

 

U.S. Real-time Monetary Inflation (1999-2009)

 

Gold: Dollars Vs. Euros

Over the past decade, gold has appreciated at an average annual rate of 9.9% when metered in euros. Measured in dollars, gold's risen at an average annual rate of 11.8%. Simply put, the dollar has depreciated in gold purchasing power at a faster overall rate than the euro. There have been plenty of fits and starts along the way, however.  At times, the dollar's gold purchasing power was greater than the euro's; at other times, euros could buy more gold.

In the chart above, the day-to-day differences in gold's value between the two currencies are indexed and plotted. The black dashed line represents the decadelong trend line mathematically implied by the actual data points plotted in red. A rising line coincides with dollar inflation; falling values denote deflation.

While there's a fairly acute angle to the trend line, there's no shortage of volatility in the daily inflation values. The past two years have been especially unstable. After breaking down from the cycle top in the spring and summer of 2008, inflation has bounced along a rising trend line, though it's failed to attain, much less surpass, its previous peak.

Technically minded traders will recognize an equilateral triangle described by inflation's recent pattern of successively lower highs and higher lows.  This congestion represents the tug and pull of competing economic forces that will likely lead to a breakout move in the inflation rate. The question, of course, is what direction the breakout will take. Will monetary inflation's uptrend resume with a vengeance, or are we headed for a deflationary collapse? We've certainly heard both stories from respected pundits.