Is This Inflation or Deflation?

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May 22, 2012 1:21pm NYSE:GLD NYSE:SLV

Jeff Harding: The official “inflation” numbers came in last week and they show declining prices, something that the Fed calls “deflation”. The Fed and most policy makers will panic if deflation continues and prices steadily drop. It’s a tricky thing to evaluate


because much of the decline in prices has to do with reduced demand as worldwide economies cool off. But, with the U.S. economy flattening out, the Fed will reach for the last arrow in their quiver, money steroids, and print another round of quantitative easing. Here’s what will happen.

With all the fiat money pumped into the U.S. economy (plus “liquidity” made available to the European Central Bank) by the Fed, one would think that we would be having high price inflation. Instead we are seeing declining prices. I suspect that one could debate the issue of whether or not the various official indices are low-balling the numbers, but that’s just another way to avoid explaining and understanding the issue.

The price data that came out of the Bureau of Labor Statistics last week certainly seemed to show that “inflation” is at best subdued. If you don’t trust those numbers look at MIT’s Billion Price Project for corroborating results.

Here is the official BLS CPI calculation:

There was no increase from month-to-month, and the year-over-year was +2.3%. One would think this is a good thing, and in many respects the fact that prices are declining sounds good to me as a consumer. But … is it? Before I answer that question, look at the producer price index for all types of goods were negative, but the most significant tell-tale was the index for crude goods (commodities) was -4.4% MoM (-7.3% YoY):

The prices of goods are declining because the materials they are made of are declining. That usually means that worldwide demand for crude goods has declined which usually means that either recessions or economic flattening is occurring worldwide. And that is the case.

Also real earnings continue to decline or flatten (in April):

All-in-all I think most economists and analysts expected to see low price inflation, so it is not a surprise. And they think in one sense that’s a good thing because they believe that the Fed will print money, revive the economy, and then everything will be fine again. They know that the inflation hawks on the Fed Board will try to block more money printing if price inflation is heating up. But with the economy flattening-to-declining, and with low price inflation, they hope this will encourage the Fed to turn loose the money spigots again.

The Fed looks at it similarly except they have one more big concern. Declining prices. In their eyes this equals deflation and they think that is bad. Which, again, is also incorrect. I mean if your wages are dropping, but the prices of goods are dropping, that should be OK. It maybe bad for debtors because it takes more dollars to pay back debt. It depends on whose debt we are talking about.

Most consumer debt is the detritus of the boom-bust cycle that we are still in. Consumers are shedding debt, but the debt levels are still high relative to historical trends. They engaged in “malinvestment” by leveraging up debt on their homes to support their lifestyles during the boom years. Those overvalued homes are still sinking in value, so with declining prices (“deflation”), mortgage debt and home equity loans will be more difficult to pay, which will lead to more bankruptcies. It is something that cannot be avoided.

We all know who the biggest debtor in the world is. The Fed is very concerned about the impact of deflation on our sovereign debt.  Declining prices and declining incomes means less revenue for the US government, which make the debt burden on U.S. sovereign debt (about $15.7 trillion) more expensive (interest cost is about $500 billion currently). So, in their logic, if we print more money today and create inflation, not only will it revive the economy, but it will make the world’s biggest debtor happy because it can pay debt costs in cheap(er) dollars.

They will ignore the fact that two rounds of money printing (quantitative easing), zero interest rate policy (ZIRP), and various Twists and turns, haven’t worked yet. But it’s the only thing they know how to do.

Eventually the Fed could get it “right.” That is, according to their flawed economic theories, at some point they could print enough money to create high (>4%) YoY price inflation. Of course, in reality that is entirely wrong. Whether that will happen with the next round of QE is difficult to judge. What they fail to appreciate is that there is significant weakness in “real savings.” It is real savings that create growth, not fiat paper. That is, real wealth saved from the profits of organic growth rather than just so-called profits in the form of new fiat dollars.

That lack of real savings is what is dragging the economy down, a phenomenon very reminiscent of Japan’s experience over the past 20 years or so. Each round of QE will be weaker than the last one because QE actually destroys real capital required for growth. When that next round of money printing fails, what will happen next as the economy stagnates and shrinks?

My bet will be in favor of more money printing. It’s the thing that central banks and governments know how to do best.

Related: SPDR Gold Trust (NYSEARCA:GLD), iShares Silver Trust (NYSEARCA:SLV).

Written By Jeff Harding From The Daily Capitalist

The Daily Capitalist comments on economics, politics, and finance from a free market perspective. We try to present fresh ideas the reader would not find in contemporary media. We like to call it “unconventional wisdom.” Our main influences are from the Austrian School of economics. Among its leading thinkers are Carl Menger, Ludwig  von Mises, Friedrich von Hayek, and Murray Rothbard. There are many practitioners of this school today and some of their blogs are shown on the blogroll. We trace our political philosophy back to Edmund Burke, David Hume, John Locke, and Thomas Jefferson, to name a few.

Our goal is to challenge contemporary economic thinking, mainly from those who promote Keynesian economics (almost everyone) and those who rely on statist solutions to problems. We apply Austrian theory economics to investments, finance, investment risk, and the business cycle. We have found that our view has been superior in analyzing and understanding economic and market forces. We don’t consider ourselves Democrats or Republicans, right wing or left wing. But rather we seek to promote free markets and political freedom.


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