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Why Fed Policies and Treasury Department Bailouts Will Lead to Inflation Rather Than Deflation

By Martin Hutchinson
Contributing Editor
Money Morning

The U.S. Producer Price Index (PPI) and Consumer Price Index (CPI) both fell in October. Those declines – combined with sharp downward spirals in worldwide stock and commodity prices – have caused many analysts, and even central bankers, to worry that we are on the brink of deflation.

Such concerns may be warranted in the short-term. But in the long run, deflation won’t be the challenge we face.

Thanks to an overly aggressive central bank, and more than $1.5 trillion in U.S. Treasury Department bailout programs – as well as other factors related to the ongoing global financial crisis – inflation will be the problem that ultimately bedevils us.

As long as oil and commodity prices drop, the PPI and CPI indices, which include oil and commodity prices, also will fall. Such a decline, however, does not constitute deflation; it is simply a one-time price adjustment. This is particularly true if most of the commodity-price declines are simply a reversal of excessive increases that had occurred over the previous year. That’s essentially what we’ve been seeing here.

However, the deflation believers currently have an additional argument: With output in the United States plunging, and the stock market down around 50% from its October 2007 peak, there are very few pressures pushing prices upward. For instance:

  • Manufacturers, facing sudden sales declines, cut prices in an attempt to clear inventories or engage in foreign sales drives, intensifying price competition in all markets.
  • Nobody is pushing for wage increases – folks are all too pleased to keep their jobs, and their employers know this.
  • So while the U.S. economy is declining sharply, prices will not increase significantly and may even decline.

But even this will not turn into deflation, unless the recession is exceptionally prolonged. Currently, output and employment are dropping very sharply, as is the stock market. This cannot continue for more than a few months – the latest being perhaps late spring of the New Year. As output declines, forces pushing it towards recovery will become stronger and equilibrium will appear.

Provided world trade remains open healthy – and doesn’t plunge by 60%, as it did during the horrid stretch from 1929 to 1932 – we will avoid a second Great Depression, so the bottom in output cannot be all that far down, and will be reached relatively quickly.

Since inflation was running at more than 5.0% when output began its steep descent, it is unlikely to have turned significantly negative by the time the economy reaches bottom. After all, the so-called “core” PPI rose at a rapid clip of 0.4% (equivalent to 5.0% per annum) even in October, while the Cleveland Fed’s “median” CPI, which smoothes out fluctuations, rose by 0.1% in October and 3.2% over the past year.

Once the bottom has been reached, the excess liquidity that has been created over the last few months through the various bailouts – such the Treasury Department’s $700 billion Troubled Assets Relief Program (TARP), which is fueling bank takeovers, and not expansionary lending, and the follow-on $800 billion credit-market stimulus unveiled late last month – will combine with the huge federal budget deficit to spur inflation. By that time, discounting will have become much less prevalent, as the most aggressive discounters will have gone out of business and inventory excesses will have been worked off. Costs will have increased, since many producers will be operating well below capacity.  And the excess money supply will push up inflation.

This time, there will be no surges of foreign competition restraining price increases – Chinese producers are currently suffering high inflation in both wages and prices, so their sales prices are increasing fast.

To estimate the inflation rate we might see, you can look at money supply growth over the past year. The St. Louis Fed’s M2 money stock, the broadest money supply growth now reported by the U.S. Federal Reserve, has increased by 10% over the past year, while the St. Louis Fed’s Money of Zero Maturity (MZM), the nearest we can get to the old M3, has increased by 7.4%.

Both those rates are far higher than the increase in nominal Gross Domestic Product (GDP). In fact, money supply has been increasing about 65% faster than GDP since 1995, which is when former U.S. Federal Reserve Chairman Alan Greenspan began to overly relax monetary policy. In the most recent two months, MZM has risen only modestly, at a 3.1% annual rate, but M2 has risen much more rapidly, at a 20.6% annual rate. (The difference between the two figures reflects quirks produced by the various bankruptcies and bailouts – for example Washington Mutual Inc. (OTC: WAMUQ), nominally a “thrift,” has been taken over by Bank of America Corp, (BAC), a bank).

In any case, it seems likely that inflation in the 7%-10% range lies in our future once output stabilizes. The deflationists here have a huge problem: Their view of falling prices is in incompatible with swiftly rising money supply, so only a sharp fallback in money supply, which we are not seeing, would make deflation plausible. The Fed has been blamed so widely for not expanding money supply fast enough during the Great Depression, that it is showing every sign of making the opposite error now.

If inflation does return with renewed force, we need to invest accordingly. One way of doing so would to use Treasury Inflation Protected Securities (TIPS). TIPS yields have recently risen, as investors have focused on deflation. Indeed the 10-year TIPS currently yields 3.11%, only 0.08% lower than the 10-year conventional Treasury, so the market is saying inflation will average 0.08% over the next 10 years. That’s nonsense, and such a mis-pricing makes TIPS an attractive investment, even though conventional Treasuries are vulnerable.

Another investment that benefits from inflation is gold, which has declined in price, albeit less than oil, and is currently selling around $770 per ounce. If inflation is expected to take off, gold prices will rise sharply, and a gold price of $1,500 per ounce is by no means out of the question. The most efficient way to buy gold is through the SPDR Gold Shares ETF (GLD).

News and Related Story Links:

  • National Park Service:
    The Great Depression

Join the conversation. Click here to jump to comments…

  1. Econ101 | December 3, 2008

    If (when?) gold reaches $1500 an ounce what will the government do to stem the distruction of their fiat money? At what price will the government decide that Americans dont have enough sense to own gold and confiscate it ala FDR? $1500? $2000? What price??

  2. H. Craig Bradley | December 3, 2008

    Q: What if the Fed looses Bernanke and gains a new inflation hawk in the mold of Paul Volcker (a Obama financial advisor)?

    What investments would work best if we end up with much higher interest rates to counter the inflation forecasts in high single digits?

  3. Robert | December 4, 2008

    I have seen NO analysts who are predicting deflation except for those who say a lot of analysts think we are headed for deflation. Name your sources.

    What I have read is with the FED printing money and China selling US securities to back their bail out everybody sees that next year or so we will see inflation. For now the dollar is strong and even getting stonger short term but that will all turn around.

  4. James MacInnis | December 4, 2008

    During the Nineteen seventies, as chairman at the Fed, Paul Volker was responsible for wrestling the Genie of inflation back into the bottle. He used Milton Friedman's monetary policy (monetarism) to do so.
    Restricting the money supply, a deep recession was the result because of the effect high interest rates had on borrowing. Where the economy wanted to expand and create wealth it could only do so by borrowing, borrowing at high interest rates that accelerated to over 20 per-cent.The national debt also grew as a result because interest charges on previous debt compounds every several years and as revenue drops. automatic stableizers kicked in, increasing the cost of government.

    Monetarism was not the panacea it was percieved to be because, while it solved the problem of inflation, it raised the national debt and that is probably one of the the reasons it was abandoned. I doubt if Paul Volker could get away with raising interest rates this time. America is a debtor nation that is the reason for the inflation of the money supply in the first place.

    The first challenge is for America to get its current account deficit back to equilibrium. Since repatriating productivity is highly unlikely as a result of globalism Im not very optimistic. However, China does not wish to lose its best customer and America does not wish to see its currency collapse. Perhaps a restructuring of the Breton Woods Agreement into a truly international institution giving the World Bank the power to write off balance of payments deficits would be a possible solution.

  5. Robert Piantoni | December 4, 2008

    What happens to the nominal value of homes and apartments if we have high inflation? I think a house or small apt. building with a 5-7% fixed mortgage will increase in value with 10% inflation.

  6. Darrell Wyse | December 5, 2008

    The Fed does have the option to soak up liquidity and raise interest rates when the equalibrium you are looking for appears. This would mitigate inflationary pressures and is a central argument of those economists who are championing the bailout mania. Of course timing is an issue as well as the will to act when and if the time comes. No one in government seems to have enough faith in the markets to allow them to readjust on their own, so the meddling could forestall your hoped for equalibrium almost indefinitely!

  7. James MacInnis | December 5, 2008

    Nominal value is not real value. If inflation increases 5-7%, the dollar decreases in value and it takes more dollars to buy the same house. The public thinks the house has increased in value but in fact the purchasing power of the dollar has declined.
    The law of supply and demand cannot be conned.

  8. Myron Martin | December 7, 2008

    Inflation is in effect a "HIDDEN TAX" which represents the unpayable interest that is the CURSE of our fractional reserve debt based fiat monetary system! As a former Governor (Graham Towers) of the Bank of Canada (our equivalent of the Federal Reserve) stated before a Parliamentary Committee, "every bank loan is a new creation of money and when it is paid back it ceases to exist" it necessarily follows that our DEBT PYRAMID from Federal, State/provincial corporate and personal levels constitutes all the interest siphoned off by the central banking system because technically it can never be paid since it is never created!

    Banks only create the PRINCIPAL of a loan, never the interest, so it requires an exponentially growing level of NEW LOANS to allow the interest to SEEMINGLY be paid while in reality it is accumulating as DEBT at all levels constantly increasing the interest burden until the DEBT pyramid becomes so top heavy we experience deleveraging to cleanse the system as we are now experiencing.

  9. James MacInnis | December 11, 2008

    In response to Myron Martin's comment; I couldn't agree more. Interest is a tax we pay on the principal of a loan. While the borrower recieves the principle he does not recieve the interest therefore the interest is not a loan.
    In addition, Consumption is a function of disposable income. We serve the economy by consuming the goods and services that our neighbors make. Because the principle of a loan was used as disposable income to purchase something of intrinsic value such as a house or a car wealth is created.
    However, the borrower must forgo spending that portion of disposable income on goods and services which is required to pay the interest on the debt. Interest payments are debt with no intrinsic value and where government debt increases interest compounds every several years. The agregate effects on the economy of interest payments is visible in the recurring recessions that appear from time to time.
    Government should not have to pay interest when it uses its own money supply for sound public investments such as infrastructure, particularly when public investments increase the capital stock and stimulate the creation of wealth in a nation. By deferring complete contol of the money supply to the banks one has to question who runs the country in the first place because in effect the borower is servant to the lender. It should be the other way around; the banks should pay a premium to the people for the right to print money and that could be in the form of interest free loans to fund necessary public investments.
    Interest payments should only be charged to the private sector

  10. Allen | December 14, 2008

    I have a question that I wonder if any of you more versed in Econ can answer. About deflation vs inflation, I read a case for deflation that stated that with all the bad loans that will never be repaid, companies going bankrupt, that destruction of credit IS deflation: a reduction in available money to pursue goods. I have also heard the argument for inflation that Martin makes in the article. I am unable to reconcile them. Which is it? There is no doubt that credit has been destroyed; there is no doubt that the Fed has been creating liquidity. Is it just a question of which dollar amount is bigger, the negative or the positive?

  11. Peter Pablo Delfim | February 17, 2011

    The U.S. needs to make money. Boost the economy. Generate jobs. Lower costs. Sell more. Increase exports. Collect more taxes. Increase profits. Increasing National Wealth. Make people feel confident and happy again. You must go to the big banks. Give money to major banks. Banks lend money to those who want to produce very low interest rates. The large banks will lend much. will have many happy returns. Profit means the return of money to the government. Cash return of all. For the Government lends atravez all of the Grand Banks. All the money the government borrows the big banks are securities backed by the long-term foreign debt has placed on the market and bought by the Government. Large banks may also buy but only with loans from the Government. The bonds will be purchased by 8% to 12% of face value. The lender will then Government of handling all the applications and money from banks and Government itself. The Government will be the financier of much wealth and so will receive an enormous wealth. Does this wealth internally and externally. The titles can be saved because the wealth will then be backed in his own wealth to develop a trajectory in order to expand irreversibly, putting its dependence on the markets.


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