A Leading Index Of U.S. Inflation

A reliable leading indicator of domestic inflation could enhance understanding of lagged responses that exist between changes in monetary policy and movement in real gross national product (GNP), the overall price level, and interest rates. Examination of the quarterly behavior of the quantity theory variables (GNP, deflator, monetary base, and velocity) between 1947 and 1979 is very revealing. Changes in real GNP are highly correlated with changes in the velocity of the monetary base. Changes in the GNP deflator have their strongest correlations with annual changes in the monetary base. Velocity of the monetary base, especially since 1960, has financed 1/2-2/3 of an expanding real GNP. Inflation has the effect of accelerating the velocity of money by penalizing savings and rewarding current consumption. A cumulative inflation index, derived from summing the quarter-to-quarter annualized differences between growth of the monetary base (M) and the GNP deflator (P), can identify quite consistently the turning point in the GNP deflator in a subsequent quarter. There is a lead time of 4 or 5 quarters.