The Inflation Versus Deflation Argument - Part 1

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

One of the Federal Reserves two major purposes is to provide price stability for the American economy, a goal they chose to abandon in September 2007. While the Fed's interest rate policies after that time were highly inflationary, Fed officials excused their actions by denying that inflation was a problem, making rosy predictions that it would subside, and by assuring the public that they were capable of handling it and taking care of it in case it became a problem. None of this was true of course and the Fed's position increasingly lost credibility as gasoline and food prices skyrocketed in the U.S.

The Fed's biggest cover for its actions was the official inflation figures produced by the U.S. government statistical agency, the BLS (Bureau of Labor Statistics). The method of calculating the CPI (Consumer Price Index) was modified several times during the 1980s and the 1990s, with each modification producing a lower reported inflation number. Essentially these modifications involved reducing the importance in the CPI calculations of anything that was experiencing significant prices rises, thereby automatically lowering the final reported inflation numbers. It was hard for significant inflation to show up in the official government figures given this approach. By May of 2008, year over year CPI was only 4.2% in the U.S. despite rapidly rising energy and food prices during that period.

Recalculating CPI using the 1970s methodology indicated U.S. inflation was more likely around 12% (for more info: http://www.shadowstats.com/), almost as bad as it had been at its height in 1980. It became increasingly hard to convince the public otherwise, when the average U.S.consumer saw regular price increases at the gas pump and in the supermarket. Nevertheless, U.S. media continued to dutifully report the unrealistic official inflation figures as if they were true, helping the Federal Reserve perpetuate the fantasy on which it based its irresponsible monetary policy.

While the Federal government altered inflation calculations to produce the desired numbers in order to fool the general public about current inflation, lying about future inflation could not be done so easily. The augurs of where inflation was going, the money supply, are generally only looked at by the financially sophisticated. To solve this problem, the Federal Reserve simply stopped publishing the broad M3 money supply figures, the most telling number series of all, in 2006. Since many people realize that when a government hides information, its almost always information that would be particularly damaging if known, attempts to reconstruct M3 by private parties began immediately. By the spring of 2008, the reconstructed figures indicated that M3 was growing at approximately 20% (MZM, zero money, or cash and its equivalents was growing at an over 30% rate). The money supply figures indicated that U.S. consumer inflation was likely to peak at a minimum of 20% to 30% sometime around 2011. Depending on future readings, much higher inflation levels were possible.

The U.S. government's long-term misinformation campaign about inflation rates and its secrecy concerning money supply figures apparently didn't provide enough cover for the Federal Reserve. One group of apologists for the Fed (and the Fed had a legion of apologists who were feeding off the easy money gravy train that it was providing them at the expense of the American public) began publishing arguments about the risks of deflation in the U.S and how this justified an even easier money policy. Claiming that deflation actually existed in a period when inflation was getting out of control was by no means a new idea. It was in fact a prelude to some of the worse inflationary episodes in history.

NEXT: The Inflation Versus Deflation Argument - Part 2

For notes related to this talk, please see, 'Inflation vs Deflation Argument' at:
http://investing.meetup.com/21/Files

Daryl Montgomery,
Organizer, New York Investing meetup

For more about us, please see our web site: http://investing.meetup.com/21

Central Bankers Gone Wild

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

The New York Investing meetup has made a companion video to this blog entry. To see it, please go to: http://www.youtube.com/watch?v=y9kzKAzn2Ig

In the hundred years before the Federal Reserve existed, aggregate inflation in the United States was approximately zero. This does not mean that there was never any inflation, inflation did indeed exist, but that the periods of inflation were offset by periods of deflation so that over a long period of time there were essentially no changes in prices. A new era for inflation began when the Fed was created in 1913. Except for the Great Depression in the 1930s, deflation essentially disappeared from the United States economy and there were only periods of lower or higher inflation. This continuing inflation resulted in a 1923% inflation (based on understated official figures) for the first 95 years of the Fed's existence. Conversely, it could be said that the U.S. dollar had lost 95% of its value during this time. And the remaining 5% seemed to be endangered as well.

The beginning of 2008 saw what was probably the biggest injection of liquidity into the U.S. monetary system by the Fed in history. There were two massive rate cuts separated by only 8 days. First there was a 75 basis point cut in the Funds Rate on January 22nd and this was followed by a 50 basis point cut on January 30th. The previous time the Fed had cut rates by 75 basis points was when the Funds rate was at 20%. The January cut took place from a 4.25% level and was the first inter-meeting cut since the 9/11 crisis. Only two months later the Fed would again cut the Funds rate by another 75 basis point, this time from the 3.00% level. Based on the starting levels, the cuts in the Funds Rate was enormous and took place in a very brief span of time.

The cut in the Funds Rate was by no means all the liquidity that the Fed was pumping into the system. The TAF (Term Auction Facility) auctions were raised from $20 billion to $30 billion each by January and would reach $50 billion for each auction in March. Two additional auction facilities were added to the TAF by March - the TSLF and the PDCF. The TSLF (Term Security Lending Facility) was set up to swap $200 billion of treasuries for illiquid securities being held by the banks. The PDCF (Primary Dealer Credit Facility) opened the Fed's credit operations to the 20 firms that bought treasuries directly from it. The Fed had only lent money to commercial banks during its entire history and the PDCF represented a big extension from its traditional scope of operations.

The impact of the Fed's liquidity boosts caused the money supply to explode. MZM (money with zero maturity and therefore available for immediate use) grew by an over 37% annual rate in the first quarter of 2008. This would have been OK if the economy was expanding by around 37% as well, but the economy was contracting instead. The difference between money supply and economic growth was more than enough to create a massive future inflation problem and possibly even hyperinflation. How much inflation would actually take place was something only time would tell.

NEXT: The Fed's Manipulation of the Stock Market

Daryl Montgomery

Organizer, New York Investing meetup

For more about us, please go to our web site: http://investing.meetup.com/21