Inflation is the name commonly given to the declining purchasing power of a currency, in our case the US dollar. It is the result of the combined efforts of the Federal Reserve and the Federal government. Inflation is primarily created by the excess demand for goods and services that results from government deficit spending.
The Fed believes that inflation is a monetary phenomenon, that is, the quantity of money in the economy together with interest rates are sufficient levers with which it can control economic growth and inflation and manage them to a target. The Fed wants inflation in part because wages are “sticky.” That is, people will reluctantly accept not receiving an increase, but strongly resist cuts in their wages. Inflation means that a fixed nominal wage declines continuously in real terms. The Fed also believes that inflation helps to reduce the economy’s debt burden.
The Fed’s strategy for managing money supply and interest rates is the purchase and sale of debt securities, limited by law to securities issued by, or guaranteed by, the Federal government. This year the Fed also purchased corporate securities by means of dubious legality, but these purchases were aimed at boosting the stock market rather than managing rates or credit. The Fed wants to boost the stock market primarily to protect the public sector’s pension funds but also because it still believes in the discredited “wealth effect.”
The Fed’s strategy to boost economic growth is to boost the stock market, by providing liquidity (money), encouraging and financing stock buybacks, and enabling government deficit spending by monetizing the fiscal debt.
The Fed has announced that it is going to allow inflation to “run hot” for some indeterminate period. This is hardly surprising considering their recent behavior, but is very dangerous. Once the fire of inflation gets going, it tends to rapidly spin out of control and aggressive measures, which inevitably result in recession, must be undertaken to bring the fire under control. Otherwise, inflation can turn into hyperinflation, which is the most dangerous and destructive form of inflation. I’ll let Wikipedia speak:
Almost all hyperinflations have been caused by government budget deficits financed by currency creation. Hyperinflation is often associated with some stress to the government budget, such as wars or their aftermath, sociopolitical upheavals, a collapse in aggregate supply or one in export prices, or other crises that make it difficult for the government to collect tax revenue. A sharp decrease in real tax revenue coupled with a strong need to maintain government spending, together with an inability or unwillingness to borrow, can lead a country into hyperinflation.[3]
Hyperinflation generally completely destroys the value of the currency affected so that it is discarded and replaced with a new currency.
Disinflation is simply a falling trend in the rate of inflation.
Deflation is a trend of increasing purchasing power of a currency. It is not dangerous, despite the Fed’s self-serving claims that it is a menace. Deflation is normal for a healthy and balanced economy, due to increasing productivity from technological improvement and capital investment.
Measuring Flation
The government makes every effort possible to downplay consumer price inflation. The CPI, Consumer Price Index, is calculated by means of surveying prices for a supposed average consumption profile. It is important to note that your family consumption profile and price sensitivity will almost certainly be different, and in most cases dramatically so.
We are told to ignore food and energy, 20% of the index, because they are “too volatile” and instead look to the “core CPI”, which is everything else. However, 41% of “core CPI” is the cost of shelter which is mostly expressed by “OER” – Owner’s Equivalent Rent. This is measured by asking a sample of homeowners what they think their house would rent for. Sophisticated, eh? Most other countries go for the actual cost of shelter, i.e. mortgage interest, taxes, insurance, etc. and properly ignore the financial asset treatment of houses. BLS does this because, historically, renting out single family houses has been a losing business, relying on appreciation and eventual sale of the houses for profit. But this makes the costs look lower than they truly are, which is why they are so heavily weighted. If you have kids in college or about to go to college, you might be a tad surprised to find that education and information technology command a towering 0.5% of the index.
The annual CPI is currently 1.7%. Other indices you might look at are the GDP Deflator (1,57%) and the Personal Consumption Expenditures Deflator (1.4%).
The long and the short of it is that the CPI and those other indices are pure propaganda, designed to make things look better than they really are. You need to have your own CPI based on your own consumption patterns.
What prices are important?
To start with, it is critical to keep an eye on the government deficit. For inflation, we really don’t care about taxes because this is money that, at least supposedly, you would have spent on fast women and slow horses if the government had not taken it away before you over-indulged yourself. Deficit spending creates demand for goods and services which isn’t compensated for or earned by any production. So more demand with no associated production means higher prices. The federal budget deficit alone was $3.3 trillion in FY2020. That’s $10,000 per man, woman and child, based (conveniently) on a population of 330 million. Think about that for a moment. That’s free money bidding up the prices of things you might want. The prices that follow can give you a general idea of inflationary trends in the economy.
Number one is energy. Everything takes energy. It turns out that the most important influence on food prices is the price of energy, although there are large deviations from time due to weather or, well, pandemics for example. You can get the price energy by using crude oil as a proxy – or even by watching prices at the gas station. The caveat here is that oil prices can swing wildly in the short term due to market manipulation.
Number two is labor. Not in the CPI at all, but of huge importance to the economy. The price of labor is the wages and benefits paid to employees and is reported monthly by the BLS. Without wage inflation you can’t have price inflation because people can’t pay.
Number three is the value of the US dollar in international markets, usually measured as the exchange rate of the dollar against a basket of major currencies. There is a good index, the US Dollar Index, which is based on 6 major currencies – EUR,JPY, GBP, CAD, SEK, CHF. Since one year ago, the US Dollar index has declined by 6.2%. Compare to the other indices mentioned above. The caveat here is that the other currencies may be losing purchasing power as well, which would reduce the usefulness of this indicator.
A market forecast of inflation over a given period may be obtained from the spread, or difference, between the yields of TIPS and Treasuries to similar maturities. A bond calculator will usually be needed to obtain the yield to maturity. Find online or use your HP-12C. Of course you have one. Or two, like me. Or three if you count the iPad app that emulates one.
Financial asset inflation
Another side effect of excessive money-printing – ok, “currency creation” which sounds better but is more deceptive – is a rising trend in the prices of financial assets. Credit is cheap, so people borrow to buy financial assets that they think will appreciate more than the cost of financing them. This tends to become a self-fulfilling prophecy as the value of collateral increases, tempting people to borrow more, and is otherwise known as a “bubble.” Remember that money and credit are isomorphic. New credit creates money. Defaulting credit destroys money. So when the bubble collapses, the value of collateral drops leading to credit defaults. This is deflationary, as the money supply is thus reduced. While deflation itself it not generally harmful, a sudden deflationary shock can be, as defaults cause the lender, itself a borrower, to default on its lenders. USW as the Germans say.
OK enough for one day. Maybe everybody knows this, but it helps me to write this stuff as I look forward to a difficult financial environment in the next few years. The difficulty stems from the likely even greater market impact from incompetent and dangerous government interference. Beginning in 1995 under Alan Greenspan, the Fed has indulged in money-printing to excess, which has then resulted in serious expansion of the Federal deficit in order to fund bailouts from the periodic bubble deflations, so far 2000 and 2008. The next, and biggest by far, is yet to happen. Sauve qui peut.
Financial Reality 