A few days ago Lars Christensen posted at The Market Monetarist an interest post commenting whether or not Argentina could be facing a real inflation above the 100% threshold.
Officially inflation in Argentina is around 11%. However, anybody who has just a minimum of knowledge about the Argentine economy knows that the Argentine inflation numbers are as real as Mickey Mouse. Inflation in Argentina is not 11%, but much higher.
Lars thinks the inflation may be even worse than that of the so-called Congressional Index (around 25%). Given the presence of price controls and Mickey Mouse official estimations, how can we proxy what inflation could really be in Argentina? The problem with estimations like that of the Congressional Index is twofold: (1) lack of resources for a comprehensive estimation and (2) it captures changes in prices under a price control environment, not changes in free prices.
When the post was uploaded I was travelling, and couldn’t get into it until a couple of days ago.
Lars refers to a paper by Steve Hanke (CATO Institute) and Alex K. F. Kowk where they say that in countries with high inflation, or hyper-inflation, one can proxy inflation with the foreign exchange rate and the purchasing power parity (PPP) which is based on the law of one price. They use this idea for the case of Zimbabwe. The argument is that in periods of high inflation, the long-run shortens due to a higher velocity of arbitrage. Therefore, even if the PPP and law of one price does not hold in the short-run under normal conditions, it does son when high inflation is in place because the long-run becomes the short-run.
With foreign exchange rate controls, then the black market (the “dolar blue” in Argentina) becomes the relevant price of reference. If we estimate the price level assuming that PPP holds for the period 2007-2008 using the “dolar blue,” then the price level doubles (100% inflation). For the last 3-6 months, the annualized inflation rate is 126%, above the 100% threshold level. Of course, like Lars and readers point out in his blog, this estimation is not perfect. The point is that inflation in Argentina is getting out of control and a situation of hyper-inflation becomes more likely.
We know that the central bank has increased the money supply by 35-40% during recent years. If we assume 100% inflation and 40% increase in money supply, then we have the following (where number between parenthesis is the percent change) relation:
M(40%) * V = P(100%) * Q
There is a 60% difference to be explained by an increase in V and by a fall in Q. It is very likely that money demand is falling (increasing V) given the high inflation and the expectations that it won’t go away (more intense arbitrage). It is also expected that GDP will fall, or stay stable at best. Is this enough to explain the difference between the increase in money supply and the 100% inflation level? If GDP falls, say 5%, can V explain the remaining 55%?
A couple of issues of why the 100% may be an over-estimation:
Even though the law of one price holds “better” under high-inflation rates than under normal conditions, there is no conclusive evidence that it holds as expected when the nontradable and tradable component of prices is separated (the “PPP puzzle.”) Papers like those of Betts and Kehoe (2006), Burstein et al. (2006), Chari et al. (2002), Dotsey and Duarte (2008), Engel (2009) and Groen and Lombardelli (2004) show that the law of one price is sensitive to how the nontradable component of market prices is estimated. I don’t know, however, how much of this problem remains under high inflation; or if it worsens or goes away. A higher intensity of arbitrage can improve the fit, but if inflation affects relative prices in the short-run then prices may move one way or another.
The demand for dollars in Argentina is highly influenced by hoarding. Therefore, the increase in the foreign exchange rate has at least to drivers: (1) the inflationary effect captured in the PPP and (2) a change in the relative price due to the increase in hoarding of USD. I’m not sure how to separate these effects.
Now, whether or not the inflation rate is or not close or above the 100% is not the main message, but that inflation is about to get out of control. I agree that the inflation problem in Argentina has gotten worse in the last months, regardless of how accurate the 100% value might be.