The Solution to Deflation

The stock market laid another egg yesterday.  We won’t dwell on it much.  Only enough to make the observation that change is in the air.  You can see it.  Feel it.  And even smell it.  Nonetheless, being prepared for it – both for profits and protection – is the real challenge.  Here’s what we mean…

The United States dollar has strengthened against other currencies over recent months.  The dollar index – a measure of the U.S. dollar relative to a basket of foreign currencies – was around 80 for the first half of the year.  But since July it has run up significantly.

Currently, the dollar index is around 86.  That means the dollar has increased in value by 7.5 percent on the foreign exchange market over the last three months.  What are the consequences of a stronger dollar?

Naturally, there are both advantages and disadvantages to a stronger dollar…depending on how you look at it.  A more valuable dollar is a good thing for the typical saver and consumer alike.  In general, it means imported goods become cheaper.  Dollars stretch a little further at the store.  Conversely, it means U.S. exports become more expensive.  This could result in less U.S. made goods being exported abroad.

Of course, one of the more technical gripes about a stronger dollar comes from the Federal Reserve.  For a stronger dollar lowers the rate of inflation.  Moreover, if the dollar strengthens too quickly, inflation could turn to deflation.

Fed Headwinds

The Fed, however, doesn’t want deflation.  Rather, the Fed wants inflation.  You see, the Fed is a perpetual credit creator.  They need continuous inflation – 2 percent annually is their preferred target – to erode public and private debt burdens.

Just a pause to inflation, or a touch of deflation, and the credit structure that has been pyramided up by cheap credit and inflating asset prices comes cascading down.  Bankruptcies skyrocket…as borrowers owe more than their assets are worth.  Thus banks and lenders suffer the consequences of making questionable loans.

Over the weekend, the Fed commented on their strong dollar concerns…

‘“A stronger U.S. dollar is an obstacle to the Federal Reserve’s ability to meet its inflation mandate and will impede growth,’ Charles Evans, the president of the Chicago Fed, said on Saturday.

‘“It’s a headwind,’ Evans told reporters after giving a speech on the sidelines of the International Monetary Fund’s annual meeting.

‘“[A] Higher dollar is going to have an effect on our net exports, it is going to reduce it a bit.  And it is also going to lead to lower import prices and likely have an effect that our inflation data will be lower,’ Evans said.”

The Solution to Deflation

What Evans doesn’t mention are the headwinds blown by the Federal Reserve’s policies of mass inflation for workers and savers.  Remember, inflation acts as a hidden tax on savers.  It devalues the purchasing power of their accounts.

Ask any retiree living on a fixed income or a hardworking prudent individual skimping to squirrel away some nuts for retirement.  Policies of inflation are like sailing into an onshore flow.  The deceptive forces of inflation erode away people’s hard earned savings.

Yet, in the erudite world of monetary policy makers, inflation is the ultimate goal.  For inflation is the solution to deflation.  Moreover, in a world where debts are levered up to the moon, deflation must be avoided at all costs.

QE3 is due to end this month.  Unfortunately, the financial system has become entirely dependent on these continuous liquidity injections.  Perhaps a stronger dollar will give the Fed the rationale they need to launch QE4.

When it comes down to it the Fed must create monetary inflation to prevent complete collapse of today’s financial system.  This is the Keynesian model.  Inflate or die.

Sincerely,

MN Gordon
for Economic Prism

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