Saturday, December 15, 2007

Inflation vs. Unemployment v.3

This is the chart I posted previously in Inflation vs. Unemployment. It is rather complicated and it would be easiest to simply read (or reread) what I said then.

Picosec left me a comment and was curious if I could improve the correlation by imposing a lag. This is a chart showing the results of doing that. I've introduced a 26 month lag (seemed to be the highest correlation). So what does this mean? If inflation is running hot, it seems the Fed sees that inflation and spends the next 26 months trying to stomp it out. In other words, the inflation comes first and then the unemployment. I find that very interesting.

Let's not stop there though. Due to the way I'm calculating the CPI there is already an inherent six month lag. For example, we know the unemployment rate rate right now but we're using a year's worth of data to calculate the CPI (so it is therefore about six months lagging on average). That would put the true lag at 32 months if I am thinking it through correctly.

Let's double check the math slightly using some real world data points.

Year over year CPI growth peaked at 14.76% in March 1980. Unemployment was 6.3%. Unemployment peaked in November 1982 at 10.8%. That was 32 months later. The math is pretty close. 26 months is what we were shooting for (since it too has the bonus six months lag already inherent in it).

Now let's talk about our current situation. The highest recent (since 1991 anyway) year over year growth in CPI happened in September 2005. It was 4.69% and that was 26 months ago. Unemployment is currently lower now than it was then. In my opinion, the Fed is having a hard time (due to the credit crisis) doing what it wants to do.

There are plenty of deflationary forces attempting to cause pain right now and there are also plenty of inflationary forces attempting to do the same. I see the combination as painful even if the CPI does behave itself, go figure. However, inflation is currently running hot on almost every time scale (3 months, 6 months, 1 year, 2 year, and 5 year). It's hard to put a happy face on that, especially 32 months from now if history is any indicator. It will be even worse if inflation continues to climb of course.

Here's a chart showing that same 26 month lag applied to an era when we were on the gold standard. There's almost no correlation at all. Inflation did its own thing and didn't seem to care what unemployment was doing.

Either that, or the Fed simply didn't have nearly enough data on hand to know what to do. That's also possible. We no doubt have vastly more data at our disposal than the Fed did 50+ years ago. It is amazing to me how much data can be extracted from just two long-term series. The St. Louis Fed provides over 13,000 such data series.

Is is also possible that the Fed has more control over "consumer" inflation now that the "consumer" is hooked on debt. Can you imagine what our economy would do right now if interest rates rose to 10%? Somehow sticking a fork in it and calling it done doesn't quite do the situation justice in my opinion.

Once again, thank you Picosec for prompting me to go down this path! In my opinion, imposing a lag has been extremely enlightening.

I'm once again reminded of that quote I saw somewhere on the Internet. In the beginning of a great inflation everyone benefits and nobody pays. In the end nobody benefits and everyone pays. It looks to me like "payday" generally comes about 32 months later.

See Also:
Inflation vs. Unemployment
Inflation vs. Unemployment v.2
Trend Line Disclaimer

Source Data:
St. Louis Fed: Civilian Unemployment Rate
St. Louis Fed: Consumer Price Index for All Urban Consumers: All Items

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