The cause of inflation down to the last decimal point WAG.

Years ago, I  took over a commodity brokerage with an employee who recently had won a chartist competition. A chartist is a securities researcher or trader who analyzes investments based on past market prices and technical indicators.

He had endless historical data and formulas for that data, and based on all that, he predicted the markets.

Despite winning a national competition, his trading proved to be a spectacular failure. While past data told him what had happened, He had no idea why it happened, so his predictions were worthless.

He didn’t understand cause and effect.

In this vein, an article claims to explain the cause of inflation to the last decimal point. Do you believe it?

Federal spending was responsible for the 2022 spike in inflation, research

Increased federal spending helped the economy bounce back during the pandemic, but it also caused a surge in inflation, research reveals. Inflation is difficult to control. Its cause is often even harder to pinpoint.  

Yes, if all you have is formulas and you don’t understand how an economy works, the cause is hard to pinpoint. But that doesn’t stop technicians from trying to identify it.

In attempting to understand the 2022 spike in inflation that followed the pandemic, some policymakers — up to and including President Joe Biden — blamed shortages in the supply chain. But a new study shows that federal spending was the cause — significantly so. 

“Our research shows mathematically that the overwhelming driver of that burst of inflation in 2022 was federal spending, not the supply chain,” said Mark Kritzman, a senior lecturer at MIT Sloan. 

Fascinating that Mr. Kritzman should conclude inflation was caused by spending.

If he were correct, net spending, i.e., the difference between taxes and gross spending, would cause inflation. That is what puts spending dollars into consumers’ pockets.

Net spending, or deficit spending, tells us how much money the federal government adds to the economy after taxes are subtracted.

Here is some data Mr. Kritzman may have overlooked:

Not only does Mr. Kritzman overlook the data showing no correlation between net government spending and inflation, he tries to put mathematical measures on how much total federal spending (ignoring taxes) affects inflation.

In writing “The Determinants of Inflation,” Kritzman and colleagues from State Street developed a new methodology that revealed how certain drivers of inflation changed in importance over time from 1960 to 2022. 

In doing so, they found that federal spending was two to three times more important than any other factor causing inflation during 2022. 

Specifically, their results showed that:

• 42% of inflation could be attributed to government spending.

• 17% could be attributed to inflation expectations — that is, the rate at which consumers expect prices to continue to increase.

• 14% could be blamed on high interest rates.

When you see those kinds of specific percentages, you should be doubtful, and when you see them attributed to something like “inflation expectations,” you should be incredulous. Does Mr. Kritzman believe he can measure consumer expectations and include that in an equation? Really?

You might have noticed that his results totaled 73%, leaving only 27% for oil shortages—the real cause of inflation.

The graph shows the essentially parallel tracks of oil prices and inflation. This is no coincidence; oil costs are part of virtually every product and service. In April 2020, OPEC agreed to a historic cut in oil production by 9.7 million barrels per day starting in May 2020. 

Despite massive federal net spending after 2015, inflation (blue) remained relatively low until COVID hit in 2020. Then, we had a recession (vertical gray bar), cured by increased federal net spending.

Inflation didn’t begin until April 2020, when OPEC cut oil supplies to raise prices. This reduction in supply led to inflation (green) that is only now being cured as oil prices drop.

Here is a closer look at inflation and oil during COVID:

Kritzman said that using government stimulus money to help the economy rebound during the pandemic made sense, given the unprecedented circumstances. “People really didn’t know if we were going to have a 1930s-type depression, so the government erred on the side of more stimulus than less stimulus,” he said. 

“I don’t judge that to be a bad thing to have done, but it did cause this big spike in inflation,” Kritzman said. “What was surprising is not just that [the driver] was federal spending but that it was so overwhelmingly federal spending.”

Wrong. It was overwhelmingly OPEC oil shortages, along with other COVID-related scarcities of food, shipping, metals, lumber, computer chips, labor, and other scarcities, that caused inflation.

Here is how they came to their conclusion: 

The authors arrived at their conclusion by using the Mahalanobis distance statistic, which has been used in a range of projects, from measuring turbulence in the financial markets to detecting anomalies in self-driving vehicles. 

In their paper, researchers first used a hidden Markov model to identify four regimes of shifting inflation: stable, rising steady, rising volatile, and disinflation.

Then they used the Mahalanobis distance to figure out how eight different economic variables caused the economy to shift between those regimes. The economic variables the authors looked at were producer prices, wages/salaries, personal consumption, inflation expectations, interest rates, the yield curve, the money supply, and federal spending. 

Finally, by applying an algorithm to the data from 1960 to 2022, they were able to see how inflation drivers had changed in importance over time. This enabled them to predict the likely path of future inflation — a capability that could potentially be of  help to policymakers and investors alike.

The results dispel the notion that the supply chain could be blamed for the 2022 spike in inflation, Kritzman said. 

The results may or may not dispel that notion, but they don’t deal with the fact that inflation is caused by shortages of critical goods and services, usually oil and/or food, not federal spending.

Here is their explanatory graph. As you will see, federal deficit spending is not even shown on their graph. Could it be because even they don’t believe it’s a relevant factor?

Examine their graph, and you’ll see a few peculiarities. 

1. The first is that they mix cause and effect: Causes would be Personal Consumption, Interest Rates, Yield Curve, Money Supply, and Federal Spending. 

The effects would be Producer Prices, Wages, and Salaries. It’s not clear how one can claim that producer prices cause inflation when they are caused by inflation.

2. If Personal Consumption is only 6.2% at fault, how is Federal Spending given 41% blame for inflation? Was all that inflation caused strictly by the government’s purchases, not by consumer purchases? Unlikely.

3. And if federal deficit spending flooded the economy with money, how did the money supply only increase by 2.9%? 

4. Finally, there’s that amorphous “expectations” thing. How was that translated into dollars to reach the precise number 16.9%?  If you had inflation expectations, how would you put a number on that?

How would you determine it was 13.9% responsible for changing your consumer buying or business selling prices? 

The numbers in the above graph are what I like to call WAGs (Wild Ass Guesses), made to look scientific by applying fake mathematics.

“The narrative at the time was that the cause of inflation was interruptions to the supply chain because of COVID-19,” Kritzman said. “But that didn’t show up in producer prices

In other words, if supplies became scarce, then the prices of those supplies would go up, which we don’t see in our results at that point in time.”

The narrative should have been that all prices went up because of the scarcity of oil, food, shipping, metals, lumber, computer chips, labor, etc. That is the whole point:

We had inflation, not because of “excessive federal spending” but because of COVID-related scarcities.

Guidance for policymakers

The researchers’ findings indicate that the government and the Fed sometimes operate at cross purposes, Kritzman said. When the federal government overstimulates the economy, the Federal Reserve has to delay lowering interest rates. 

The data refute the “overstimulates” notion. There was no historical relationship between federal spending and inflation.

“The more overstimulation there is, the more hawkish the Fed has to be to keep inflation under control,” Kritzman said. 

Keeping inflation under control is not the Fed’s job. The Fed doesn’t have the tools. It’s Congress’s and the President’s job to prevent and cure the shortages of goods and services that cause inflation.

Taking the same approach that the researchers did, the Federal Reserve might be able to gain a deeper look at “the dynamics that are going on” — not just that inflation is up or down, he said. Instead, it offers insight into how the drivers of inflation change in importance through time. 

Yes, sometimes a shortage of oil drives inflation. Other times, it’s a shortage of food, labor, or other production factors.

“I think that the Fed would be well advised to take this methodology and make it operational in how they monitor inflation and other things that they’re interested in,” Kritzman said. 

No, Congress and the President should stop avoiding their responsibilities. They should assume control over inflation by preventing and curing shortages.

For example, encouraging and aiding oil drillers and refiners and releasing oil from the Strategic Petroleum Reserve were primary factors in ending the most recent inflation.

The same encouragement and aid should be given to all products and services, the shortages of which cause inflation.

Rodger Malcolm Mitchell

Monetary Sovereignty

Twitter: @rodgermitchell

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