The most important forces affecting inflation are monetary ones (growth in monetary aggregates and real short-term interest rates) as we will see in detail in Chapters 5 and 6. However, inflation has very distinct cyclical timing (Fig. 3-5).

The purpose of this section is to review how and why the forces of inflation develop, and above all, how they are part of the overall business cycle. The objective is to emphasize the positive feedback of inflation. When inflation declines, real income (income less inflation) increases and provides consumers with extra stimulus to spend. On the other hand, rising inflation sets in motion a negative feedback. Rising inflation decreases real income, and therefore, consumers become more cautious about their spending plans.

Let’s start again with the simple inventory cycle model. Inventories are low, but business recognizes the opportunities for future sales, so they start planning to increase inventories. In order to do that, they have to increase production and employment. But to increase production, they need raw materials.

Since raw materials are very sensitive to changes in demand, as soon as business improves, raw material prices tend to rise because activity eventually becomes very strong and raw material, interest rates, and wages begin to rise. These increased costs are initially absorbed by business, but eventually they are passed to the consumer by raising prices.

As consumer prices increase, consumer confidence declines. The reason is that as inflation increases, income after inflation, that is real income, decreases. The decline in consumer purchasing power has a negative impact on the consumer’s attitude towards the future. As a result, consumers begin to spend less. This has a negative impact on the inventory-to-sales ratio as sales slow down relative to inventory. As a result, the inventory-to-sales ratio starts rising.

Business recognizes that inventories are out of line so they start cutting production. Cutting production implies that they have to cut raw material purchases and employment. Because of this decline in raw material purchases and the decline in employment, raw material prices decline, wages slow down and eventually consumer prices also slow down.

The decline in consumer prices is good news for consumers because now their income after inflation improves. As a result, their outlook for the future becomes more optimistic and they start spending more. Because of the increased sales, the inventory-to-sales ratio declines, production is increased to replenish inventory, and the consumer cycle starts all over again.

As you see from this and the previous cycles, every time the economy expands, something else develops to correct the growth and eventually cause the business cycle to slow down. What is happening is an automatic self-correcting mechanism.

In all the cycles we have discussed, the main point to focus on is that every time the economy expands, it causes developments that will correct its excessive growth (negative feedback) and eventually bring down growth of the business cycle closer to the long-term average pace of the economy, which is close to 2.5-3.0%. The business cycle has delicate and pervasive self-correcting mechanisms to bring back economic and financial conditions close to their long-term patterns. Higher inventory-to-sales, rising inflation, rising short-term and long-term interest rates, and higher unit labor costs are the most important of these forces. It is just a matter of time before they impact the economy in a negative way.

As you can recognize from the previous examples, actions that happen at a certain point in time have a ripple effect in the economy through a cause and effect relationship. For instance, the strong growth in money supply that was induced by the Fed to solve the savings and loans and real estate debacles in 1992 and 1993, caused a strong economy in 1993 and 1994. However, the strong economy in 1993 and 1994 caused raw material prices and interest rates to move higher. Eventually these same trends caused the 1995 slowdown.

This slowdown had a negative impact on employment and on income, and the economy remained soft until 1996. This allowed interest rates and commodity prices to decline again, which caused the economy to strengthen in 1997 and 1998. As you can see, current events caused future disturbances that propagate. In the 1970s these ripple effects were violent because of rising inflation. Following early 1980s, these fluctuations were milder to due to declining and low inflation.

The forces of inflation increase following a period of strong growth in the economy. Depending on monetary conditions, which will be discussed later in Chapter 5 and Chapter 6, inflation could rise very much or remain muted. In the 1970s every time the economy strengthened, inflation rose considerably from 3% to 5% in one cycle to be followed by an inflationary burst from 6% to 8% in the following cycle. The causes of these trends will be discussed in detail later.

Since 1982, these conditions have changed and inflation has remained muted. However, its cyclical timing can still be recognized. For instance, following the strong growth in monetary aggregates from 1992 to 1993, the economy strengthened considerably in 1994 and the outcome of this strength has been rising commodity prices, due to strong production and strong sales. The CRB raw industrial price rose quite sharply through 1994 and this was accompanied by much higher interest rates. So you already see the prices of two basic assets, commodities and money, rise after a period of strong economic growth.

Unit labor costs also had a mild uptick, but very minor. The increase in these prices resulted in an acceleration in the producer price index of crude materials. This increase rippled through the chain, but in a very mild fashion, almost indistinguishable. The outcome was that consumer prices through 1994 and 1995 had a very small increase, but quite muted.

The slowdown that took place in 1995, that was caused by the increase in interest rates and inflationary pressures in 1994 kept commodities from rising further and remained fairly stable through 1995.

(From Chapter 3 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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