by Jas Jain
January 1, 2006

If You FULLY Exclude Energy From the CPI
We Already Have Price Deflation In the US

The Inflation Conundrum

Had anyone told you in 1998 that we will have the largest bubble in the Scam Market, followed by the largest Housing Bubble, one of the largest fiscal and monetary stimulus in history, comparable to 1934-36 New Deal, and in addition the Crude Oil prices would quadruple, and then asked: What would happen to the Price Inflation? Any inflationist worth his salt would have said that it would be well above an annual rate of 10% and a probable Hyperinflation. Sorry, it has remained in the 2-3% annul rate range if you exclude short-term volatility and measure over a 3-year period. We surely have a conundrum.

Energy Prices Driven By Bubbles and Stimuli Led Spending

Based on the average price for the year, the Crude Oil prices have the following approximate behavior:

1999-2000 Double

2001-2003 Flat

2004-2005 Double

Thus, the Crude Oil prices have quadruped over the past 7 years. I would argue that some historic events in the US economy, including the asset markets, were the primary driving force behind this demand�driven rise in the Crude Oil prices (the supply constraints have arisen because the demand in 2005 is far higher than anticipated 5-10 years ago and it takes a very long time to rectify the situation unlike in other areas of demand). Let us summarize these events:

1. Scam Market Bubble, bigger than any such bubble in history that led to the �wealth effect� driven spending. Since this bubble was global in scope it might have been be the biggest driver of demand for energy that led to doubling of the Crude Oil prices from 1998 to 2000.

2. The largest Fiscal and Monetary stimuli in the US since 1920s, as a percent of the GDP, excluding the WW II, during 2003-2005 that was comparable to the Great Depression�s New Deal stimulus of 1934-36.

3. The largest Housing Bubble, where most of the monetary stimulus in #2 ended up, which gave rise to extraordinary consumer borrowing and spending on all kinds of goods and services in addition to homes.

Even the so-called high demand for Crude Oil from China and India has its source in the US consumer spending that has greatly boosted these economies.

Remember that the prices are determined at the margin and a 3-5% per year higher demand than anticipated can drive up the prices of very long lead items such as energy very rapidly.

Energy Prices and the General Price Inflation In the US

I am sorry but those who claim that the govt. CPI understates inflation are plain wrong and if one looks at the long-term behavior of the CPI there is no evidence to support such conspiracy type claims. Furthermore, I can only work with the data that is available and the data seems consistent to me despite the fact that some items have gone up lot more than the reported inflation rate. Also, I am only going to talk about the Price Inflation and not about the Monetary Inflation, which could be the cause as well as an effect of Price Inflation and other phenomena, e.g., asset bubbles.

The Bureau of Labor Statistics reports monthly data fore CPI including all items, or headline CPI, as well as CPI excluding Energy, excluding Food, and excluding Food and Energy. It is very important to note that the CPI Ex-Energy EXCLUDES ONLY DIRECT PURCHASES OF ENERGY by consumers and NOT THE PASS THRU of energy costs that go into almost all products and services. My best guess is that the PASS THRU costs of energy and energy-derived materials over the past three years, cumulatively, is anywhere from 7-9%, or 2.3-2.95% annually, of all the purchases excluding the direct purchases of energy by households (don't forget that the natural gas prices have far outstripped the rise in Crude Oil prices). Guess what was the cumulative CPI Ex-Energy in the US over the past three years ending in Nov�05? 6.0%! Hence, IF WE EXCLUDE THE PASS THRU COSTS from the CPI that are a result of increase in the energy prices then OVER THE PAST THREE YEARS THE CUMULATIVE CPI WOULD HAVE BEEN BETWEEN �3.0% and �1.0%! At the very most it would have been 0.0-1.0% and that is deflation for all practical purposes.

A Look Beyond the Recent Rises In Energy Prices

The blue graph in the figure shows the annual rate of CPI Ex-Energy over a 3-year period. The measurement over a 3-year period is not only less volatile than over a 1-year period, but it also brings out some important trends. We can see the effects of Scam Market Bubble driven increases in energy prices and general increase in spending during 1998-2000. The trend of falling inflation, Ex-Energy, was reversed for about 2-3 years. However, the bursting of this bubble immediately resumed the falling trend until it was arrested by the largest Debt-driven consumption since the New Deal in 1934-36. However, this time the trend didn't go up. Why? Because the deflationary forces in most areas excluding energy are very powerful. Just to give you an idea of how powerful the deflationary forces are, the 1934-36 stimulus resulted in inflation rate going from �10% to + 3%. This time it is flat.

As soon as the current stimulus, whose primary vehicle has been the Housing Bubble, recedes, the deflationary forces will be ready to visit havoc on a OVER-FINANCING led false boom. THE OVER-FINANCING IN THE PRIVATE ECONOMY HAS NEVER NEVER FAILED TO WRECK DEFLATIONARY HAVOC ON THE US ECONOMY. Go and read your history. This time it would be different? Don't bet on it, because you will lose. All interventions have their limitations (they can’tgo on forever) and future ill effects. In the longer run, the markets are far more powerful than the interventionists and bigger the intervention bigger is the later depression. With more than 100 trillion dollars in derivatives out there, Bernanke better walk gingerly. They could explode at the slightest excuse to go off.

In order to get an idea of what would the CPI Ex-Energy be in the absence of the extraordinary boost to the energy demand by the events listed at the beginning, I think that what happened to the CPI Ex-Energy after the Gulf War I is a conservative estimate for the downwards trend. This trend-line is shown in brown in the figure. I have shown in red a trend-line with the same slope to get an idea of what might have taken place in the absence of the bubbles over the past 7-8 years.

All signs point to the resumption of the falling inflation, led by the bursting of the Housing Bubble, and the only question is: How rapid a fall? My prediction is: 70% chance of outright Price Deflation in 2006 and 95% chance of before the end of 2007. The 10-Year US treasuries will fall below 3% some time between 2006Q3-2007Q2. Then, below 2% before the end of 2008.

Happy Deflation Year!

© 2006 Jas Jain
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Jas Jain

Tehachapi, CA USA

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