The Wrath of Inflation

The U.S. Bureau of Labor Statistics reported on Wednesday that inflation, as measured by the Consumer Price Index, increased 0.3 percent in September.  Increases in energy and food prices were the main contributors to the rise.  On an annualized basis, price increases in September were 3.6 percent, which is about in line with the 3.9 percent CPI increase over the last 12 months.

With an annual inflation rate of 3.9 percent you’d think the economy was running white hot.  But, alas, it is not.  The latest GDP report said the economy was expanding at an annual rate of 1.3 percent.  Accounting for inflation, the economy is growing at an annual rate of minus 2.6 percent.  In other words, the economy is shrinking.

No doubt, anyone who works for a pay check knows this is true.  Even those fortunate enough to get a small pay raise have watched, helplessly, as inflation has gobbled it up. Everyone else has lost ground…some have even lost their job.  Moreover, those on fixed incomes have experienced the double whammy of low treasury yields and rising prices.

On Wednesday the government announced that Social Security payments will increase 3.6 percent next year.  Yet, even with the increase, they will still payout 0.3 percent less in inflation adjusted terms than they did last year.  In short, recipients will not find much pleasure in their new found boost.

But for central bankers this is their handiwork in its fullest glory.  For as John Maynard Keynes noted long ago, “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

The Self-reinforcing Cycle of Deflation

These days, however, the secret is getting out…more and more people are on to how the Fed robs their savings out of their bank account in broad daylight.  Here at the Economic Prism we don’t believe there are necessarily sinister motives at work.  To the contrary we believe there is a conceit by central bankers that they can somehow manage the economy and smooth out the business cycle.  Let’s explore…

Generally, when the economy sags inflation subsides.  When inflation subsides too quickly, central bankers fret about deflation.  When prices decrease the dollar’s value increases.  In this situation cash is king.

The problem with deflation, however, is that it increases the burden of existing debt.  In an over indebted economy, like the United States, this is the death knell for the financial system.  If deflation persists, bankruptcies increase, capital markets break down, and the economy falls into a depression as unemployment soars.

When the economy deflates, a self-reinforcing cycle develops.  Prices rapidly decline but so does spending, which accelerates personal, business, and government bankruptcies.  As businesses fail the unemployment rate skyrockets.  This scenario scares politicians and central bankers alike.

Central bankers much prefer inflation to deflation.  When the economy is overheating and consumer prices are escalating the central bank can cool prices by increasing interest rates and contracting the money supply.  When the economy falls into deflation their monetary powers are compromised.  They load up the financial system with an endless supply of free credit and the money sits in the on bank balance sheets as reserves…hardly a cent trickles into the real economy.

The Wrath of Inflation

Of course, Federal Reserve Chairman Ben Bernanke’s solution to deflation is inflation.  The aim of his policies is to expand the money supply and create rising prices.  He wants to reduce the debt burden and bail out individuals, businesses, and federal, state, and local governments.  Most importantly, he wants to prevent the self-reinforcing cycle of deflation from developing.

Obviously, it’s a dangerous game the Fed is playing.  What’s more, it is more of an art than a science.  While the Fed can generally expand or contract the money supply, they cannot control where the money goes or the life cycle it takes on once it is born.

During a sluggish economy cheap money from the Fed may sit on a bank’s balance sheet or be recycled back into treasuries where it does little good or harm to the economy. However, if that dollar is released into the real economy it can multiply and magnify and there’s nothing the Fed can do about it.

Episodes of inflation typically start with a passive expansion of the money supply.  This money expansion initially sits quietly like a ticking time bomb with no apparent or observable effect.  But one day, people’s willingness to hold or spend money, or a bank’s willingness to loan money, can change for psychological reasons…and this change can turn on a dime.  When this happens, the velocity of money spikes.  After that, the price of just about everything spikes in an inflationary blowout.

Since the financial crisis of 2008, the Federal Reserve has increased their balance sheet by $2 trillion dollars.  To date that money has mainly sat passively in U.S. Treasuries and bank reserves.  However, there are rumors the Fed will start charging banks a fee for maintaining a certain level of reserves.  The Fed wants banks to lend money to boost the economy.

When push comes to shove the banks will do what the Fed wants…they will loan out money.  Before anyone knows it, they will loan out too much money.  After that prices will skyrocket and the wrath of inflation will bear down on the world in full destabilizing force.

After that something astonishing will happen.

Sincerely,

MN Gordon
for Economic Prism

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