This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.
In my last email, I posted the chart below (which I saw posted on LinkedIn by Gustavo Philippsen Fuhr) with the statement that “I love this chart.” In this essay, I explain why I love this chart.
I love this chart because it dramatically demonstrates what economists have known for a long time; namely, that stock prices, bond prices (i.e., interest rates), oil prices, foreign exchange rates, commodity prices and inflation cannot be predicted. This essay begins with a discussion of the predictability of commodity prices. The extension to inflation comes later.
The unpredictability of interest rates, exchange rates and commodity prices generally is encapsulated in what is known as the efficient market hypothesis (EMF). The origin of the EMF is difficult to pin down, but it is widely associated with a paper by Eugene Fama (1970).
In its fundamental form, the EMF implies that today’s price reflects all of the information known today, including market participant’s expectations of future events. [Note: the EMF doesn’t outlaw bubbles and other types of expectations-dependent phenomenon.]
The EMF implies that future prices cannot be predicted by historical information because this information is already imbedded in today’s price. The empirical evidence is overwhelmingly consistent with the EMF. Hence, tomorrow’s prices will be determined by the new information (news) the market receives tomorrow. Of course, tomorrow’s prices will reflect all the information known tomorrow, so the next day’s prices will be determined by the news received the next day, and so on and so forth.
If you want to predict the prices a month from today, you will have to predict all of the news over the next month. This is a psychic’s dream. Psychics should be incredibly rich, right? Well, not likely. The problem is they also have to predict the magnitude of the response of the prices to each piece of news. They also would have to then calculate the cumulative response for each price. This is an impossible task even for psychics.
If past information is useless and future information and the market’s response to it is unknowable, commodity prices, interest rates and exchange rates will be essentially unpredictable. This doesn’t mean that someone can’t get lucky or that people can’t worry when prices seem out of line with economic fundamentals, as Robert Schiller did with house prices in the mid-2000s before home prices fell nationally.
It doesn’t mean that prices might not necessarily collapse. However, it does imply that the date of the collapse will be unpredictable.
Price Predictability and the Predictability of Inflation
Today’s price is the consequence of the demand and supply for a product. Tomorrow’s price will be determined by the supply and demand for the product tomorrow. In the case of Sony TV’s, McDonald’s hamburgers, juicy fruits, wages and many consumer products, it is a good bet that tomorrow’s price will be the same as today’s. However, it is much less certain what the prices will be a month or a year from now.
The consumer price index (CPI) and personal consumption expenditure (PCE) are indexes of a very large number of prices, including food and energy prices and a vast variety of commodities whose prices are unpredictable. The prices of some of these products, such as food and energy and housing, affect the CPI and the PCE directly because they are included in the index. They and a host of other prices affect the CPI and PCE indirectly. This is one of the reasons that inflation is difficult to predict.
Another reason that inflation is difficult to predict is that it is a complicated dynamic process—it occurs over time. This dynamic process is poorly understood. Was the Great Inflation of the 1970s and early 1980s due to the Fed creating too much money, the OPEC oil cartel, high wage growth, output growth above potential output, i.e., the Phillips curve (ok, we can eliminate this one; it wasn’t called stagflation for nothing!) or was it due to a complicated interaction of all of the above and perhaps other factors that are less obvious. After all, the Great Inflation was a global phenomenon. Inflation in some European countries went higher than in the U.S.
The recent acceleration of inflation has been attributed to the Ukraine war, supply chain issues, the overly generous Cares Act, the Fed’s aggressively easy monetary policy, labor shortages, and perhaps others I haven’t heard about. It is difficult to know what started the acceleration of inflation, what keeps it going, or what causes it to decelerate.
In this regard it is important to note that economists’ models are static—point in time models. Any dynamics that occur in economists’ models are built into the model by the modeler. There is absolutely no reason to believe that the model’s dynamics have anything to do with an economy’s dynamic process.
For one thing, an economy’s dynamics, like the weather and nearly all dynamic processes, are state-dependent: The dynamics depend on the conditions that exist at the time the dynamic process is observed. I say observed because, like the weather and the earth’s climate, an economy’s and the global economy are continuous dynamic processes.
These facts, coupled with the fact that commodity prices and a host of other prices are extremely difficult to predict makes inflation likewise difficult to predict. There are too many things that can possibly drive inflation that it is impossible to predict how these things will evolve over time—even if you are a psychic.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
