Inflation

At the end of September, I noted how interest rates around the world were being kept low and how this was discouraging saving and investment in financial assets and pushing for price bubbles.

I have often noted how inflation measures seem to be lacking in the sense that if, for example, share values increased, soon enough so will houses, and inhabiting a house would eventually cost more, either via higher rent or via higher costs to build a house.

The price of oil, or of platinum, and the many other commodities which are increasing and which are not directly captured in the basket of goods and services of the consumer price index (CPI) will influence the cost of living because all the different components of the economy are linked.

Nor can we argue that they might lead to future inflation, rather than inflation today, because our concept of income is discounted future cash-flow and so should be our concept of expected inflation, on which our central banks are supposed to set interest rates.

Since my September piece, the Federal Reserve in the US kept on tightening and, as I write, the news that the European Central Bank has raised interest rates by 0.25 per cent to 3.25 per cent is flashing across the screen.

European finance ministers, of course, keep insisting on low rates of interest and that is understandable. Big borrowers love low rates. Low rates also hide a lot of mismanagement and the notorious structural rigidities of the "social model". Such borrowers and their advisers want savers to continue subsidising their wayward ways while at the same time expect others to restructure and invest. So it goes on.

Low interest rates have inflated asset prices at a time when independent monetary policy is supposed to defend the attractiveness of financial assets so that money doesn't go rushing to real assets. Investing today consists of jumping from bubble to bubble. The silence on such matters is so deafening that even echoes seem to have lost their way back.

But let us never lose hope entirely. The US has been tightening - and Europe has just started - and interest moves have a tendency to continue in the same direction for some time, even though the ECB is insisting that this rise might be a one-off. This statement is worrying in another way.

Recently, in a mid-October issue of The Economist, reference was made to a paper by Ricardo Reis of Princeton University, with the subtitle "the cost of living has been increasing faster than you thought". Ah, I thought, at last.

I got to Prof. Reis's paper and it is basically concerned with the problem of someone with a portfolio which s/he wants to hedge for inflation retirement and eventual demise. How should one go about this? One certainly cannot rely on the CPI!

Prof. Reis developed on the work of others and calculated a "dynamic price index" (DPI) which takes in consideration a lot of different assets, not just the "consumer basket" so popular with statisticians.

According to Prof. Reis's DPI, since 2000, inflation was 7.4 per cent per annum compared to the 2.3 per cent per annum reported by the ordinary CPI. So now you know, thanks to Prof. Reis, that inflation, at least in the US, depending on how you measure it, might have been three times what you thought till now. If we did the calculations for Malta, it is unlikely it would have been much less than 7.4 per cent, seeing that US prices were the main culprit for the higher rate.