Inflation by Stealth

Over the past two years, the federal government and the Federal Reserve have dispersed trillions of public dollars, run up enormous deficits, and kept interest rates at zero. In just about any economic textbook, this combination of policies would be described as the perfect recipe for inflation. Yet, with the exception of the usual increases in health care and education, prices by and large are not rising. Many have concluded that our economic leadership has simply outsmarted the textbooks.

The benign CPI figures are serving as a rallying point behind which the financial talking-heads are forming a parade of optimism. The low CPI is their 'proof' that inflation is not a pressing concern. This view is two dimensional.

Inflation is classically described simply as an increase in the money supply. Although these changes will impact price levels, it doesn't necessarily follow that prices will rise when inflation is high. Instead, inflation may merely result in stable prices at a time when prices would otherwise be falling.

In the popular mentality, however, inflation is simply defined as prices rising. After decades of steadily rising prices, people seem to have forgotten that prices sometimes fall. In light of the bursting of a number of record-breaking, government-fueled asset bubbles, prices should be declining across the board (as they did in the Great Depression). The fact that prices are stable, or have even rallied in some sectors, indicates that inflation is already spreading across the economy.

After falling to just 6,547 in the months after the crash, the Dow has rallied past the 10,000 mark. This should strike even novice investors as unjustified. Jobs are still being lost, a massive healthcare entitlement and carbon tax are winding through Congress, and no one with at least one foot in the real world has a palpable sense of imminent recovery. Corporate earnings have fallen far behind the rally in shares prices, stretching valuation multiples to pre-crash levels.

While not quite as frothy, home prices are now moving up for all the wrong reasons. The seminal Case-Shiller Index of home prices is now up for the fourth month in a row. The index's designer, Professor Robert Shiller, has stated recently that the current upward trajectory is unsustainable. In fact, the levels are still above the 50 and 100 year trend lines.

In the worst economic climate since the Great Depression, and after the largest housing bust on memory, single-family home prices should be falling well below the trend lines. But with a doubling of the monetary base and special interest programs like the homebuyers' tax credit, home prices have stabilized and even increased in some markets. That's the work of inflation.

With GDP growth now returning to positive territory, many inflation hawks ask why inflation has yet to truly manifest. The explanation can be found in the difference between monetary base and money supply.

The latest $1.9 trillion injection of government money was composed of some $900 billion of stimulus, of which only about 20 percent has been distributed. However, in its attempts to stabilize the financial system, the government has already spent some $1 trillion of TARP-type funds.

The TARP money, financed by an increase in the monetary base, has been provided to the banks at zero cost. And for the first time ever, the Fed is paying interest on bank reserves. Therefore, the banks can loan money to the Fed and to the government, via Treasury securities, at an interest rate spread of some 3 to 4 percent without risk. Given these incentives, it makes no sense to loan to anybody else. So, despite a massive increase in the monetary base, credit remains tight and price levels flat.

However, if the Fed stops paying interest on bank reserves or otherwise 'persuades' the banks to lend, the $1 trillion will be leveraged up by the banks and spewed out into the economy. Fractional reserve banking will transform a $1 trillion monetary base injection into a $9 trillion increase in money supply. When that happens, prices for everything will go through the roof.

So for now, inflation is like a ninja stalking our economy. It's lurking in the shadows but can't easily be seen. But once its strikes, it will be fast and deadly.

Comments

[chris coonan:]

Aha! Yes, stable prices right now DOES mean inflation....very good observation.

With more and more unemployed and on the gov't check, things are much less affordable for the masses, yet prices are the same, or higher.....ouch. When interest rates rise, it will be a real killer.

Oct 29 05:57 AM

[User 353732:]

1. A Dow of 10,000 means substantially less in real terms than it did 10 years ago yet most investors seem fixated on the number rather than its meaning in terms of purchasing power. A home selling for the same price as 5 years ago does not mean "stabilization" but a real decline, yet most homeowners are fixated by nominal price comparisons. The home is worth less in real terms yet the total cost of home ownership(mortgage, insurance, utilities, maintenance, municipal services) has risen notably.
Money illusion is a curse and snare.

2. All Corrupt Authority everywhere in all ages relies on money illusion to concurrently steal and bribe. Hence all Corrupt Authority debases the currency. Inflation is but a quantified consequence of this debasement. Money illusion is effective, easy and reliable which is why debasement is consistently popular and potent: inflation overt or covert is but the mechanism through which thievery and bribing occur. If Bad Authority could pillage and bribe without inflation they would but they have found nothing better so far.
3. Combine a reserve currency with monumentally Bad Government(WashDC-Wall St) and BOTH unredeemable debt currency debasement, hence inflation, are inevitable.

Oct 29 06:45 AM

[John Galt:]

> "Inflation is classically described simply as an increase in the money supply. Although these changes will impact price levels, it doesn't necessarily follow that prices will rise when inflation is high. Instead, inflation may merely result in stable prices at a time when prices would otherwise be falling."


True. We are in a deflationary period, but the government has enacted very inflationary policies.

The inflation camp: Peter Schiff and many others on Seeking Alpha believe in inflation due to what Bernake and the clowns at the central bank did. True, they did very inflationary things.

However there is an even larger deflationary backdrop.

If they didn't expand the money supply, prices would have fallen further ( many argue that is a good thing). Would you rather use a higher or lower percentage of your salary to buy a home, a car, groceries, gas, clothes etc.? Bernake is worried about the dramatic fall in demand for... everything, while Schiff is worried about what Bernake did to combat that worry.

I believe that in the "inflation" years the government underreported inflation. The government reported CPI numbers were a joke and in reality prices were going up much more than they said. NOW, they are also inflating the CPI. In reality, prices have fallen MORE than they report. They under reported inflation, and are under reporting deflation.

Oct 29 10:45 AM

[Crocodilian:]

author writes:
"So for now, inflation is like a ninja stalking our economy. It's lurking in the shadows but can't easily be seen."
----------------------...

Yes, because we're busy fighting off the far more pressing danger of a deflationary depression. Is there a risk of inflation from the measures taken to keep our economy from imploding? Sure there is: but we have good tools for fighting inflation if it occurs., and right now, we have a much more pressing problem.

The world is generally beset with too much industrial capacity, too much debt, asset prices that still look too high, and end user demand that's very suspect.

In that circumstance, the immediate risks of inflation are quite low-- what's going to drive it?

Remember, its not just money supply that determines the risk of inflation, its (money supply)*(velocity of money), which stands equal to (price of goods)*(quantity of goods). This is called the "Exchange Equation" in economics, and what it tells you is that if velocity of money has collapsed (and it has), even a large increase in money supply won't have an impact on prices.

Oct 29 10:57 AM

[cyclingscholar:]

<<Inflation is classically described simply as an increase in the money supply>>

No, inflation is DEFINED as a sustained increase in the general level of prices.

Your article can't even get that right, and its all downhill from there.

Oct 29 12:39 PM

[TinyTim:]

"inflation may merely result in stable prices at a time when prices would otherwise be falling."

Good point.
If banks start lending and the money velocity picks up, which is what was supposed to happen, then both prices and the GDP would be expected to go up.
The ninja question is really the Fed's reaction. It's all in the timing and quantity of relief from QE. Actually, if the Fed "responds", it's probably already too late and we're screwed with high prices. So the Fed has to use the magic eight ball.

Oct 29 04:33 PM

[Moon Kil Woong:]

I like your ninja analogy. There is other things stalking the banks worse than inflation though, it's called mark-to-market losses and off the books derivatives.

Mark-to-market has already stung banks and is like a slow acting poison since they can hide their condition with accounting tricks.

Off the book derivatives is like gangrene. Already a great portion if not all of many too big to fail banks are dead. Thus banks are forced to hoard every last bit of zirpish money they can and then some to stay alive. The extra comes in the form of service fees and churing out even more bad home loans which they can mark up and dumping on Fannie and Ginnie Mae, Freddie Mac, and the FHA.

These afflicted banks sucking up all our economic green blood are much more likely to die long before the ninja arrives.

Oct 29 10:52 PM

[Michael Clark:]

John:

I agree with everything is this post. I'm definitely one of those who wish BB (Boom Boom) Bernanke would have let prices find their own level. You're absolutely right about the inflation years being factored out and ignored by the government.


On Oct 29 10:45 AM John Galt wrote:

> > "Inflation is classically described simply as an increase in the
> money supply. Although these changes will impact price levels, it
> doesn't necessarily follow that prices will rise when inflation is
> high. Instead, inflation may merely result in stable prices at a
> time when prices would otherwise be falling."
>
>
> True. We are in a deflationary period, but the government has enacted
> very inflationary policies.
>
> The inflation camp: Peter Schiff and many others on Seeking Alpha
> believe in inflation due to what Bernake and the clowns at the central
> bank did. True, they did very inflationary things.
>
> However there is an even larger deflationary backdrop.
>
> If they didn't expand the money supply, prices would have fallen
> further ( many argue that is a good thing). Would you rather use
> a higher or lower percentage of your salary to buy a home, a car,
> groceries, gas, clothes etc.? Bernake is worried about the dramatic
> fall in demand for... everything, while Schiff is worried about what
> Bernake did to combat that worry.
>
> I believe that in the "inflation" years the government underreported
> inflation. The government reported CPI numbers were a joke and in
> reality prices were going up much more than they said. NOW, they
> are also inflating the CPI. In reality, prices have fallen MORE
> than they report. They under reported inflation, and are under reporting
> deflation.

Oct 30 12:56 AM

[Michael Clark:]

Yes, Moon: mark-to-market suspension was the first HUGE mistake of the government, for it allowed everyone to pretend that the problems of banks would be fixed by looking the other way and piling huge sums of taxpayer money back into stocks and housing. Instead of facing the problems we have, we denied them and began cheerleading, thinking positive thoughts and blind belief could overcome all evil.

Gangrene? What a nice image. Off-the-book derivatives are SO SCARY that all of Wall Street realized we could not afford to face the problem...facing the problem would force us to realize that the nations top five banks were leveraged at a rate of $196 trillion (bets in the derivative market) vs roughly $737 billion in assets. Anything goes wrong, with say 2% of the 'bets' and half the banks' equity is wiped out. That's only with 2% losses. What if the losses are 15%?

From Graham Summers' recent post - "A Derivative Time Bomb Waiting To Go Off" --

seekingalpha.com/artic...

" 1. The current notional value of derivatives on US commercial banks’ balance sheets is $203 trillion.
2. 97% of these ($196 trillion) sit on FIVE banks’ balance sheets (more on this shortly)
3. If even 1% of this $203 trillion is “at risk” … you’re talking about $2 TRILLION in at risk bets made in the derivatives market
4. If 10% of that 1% end badly, you’re talking about $200 billion in losses

Total equity at the five banks is $737 billion. So, if you assume that only 1% of derivatives are “at risk” (odds are it’s more) and 10% of that at risk money is lost, you’ve wiped out nearly 1/3 of the banks’ equity.

If 2% of derivatives are “at risk” and 10% of those bets go bad, you’ve wiped out $400 billion or nearly half of the banks’ equity...."

We are standing on the edge of the abyss, looking down. The abyss is looking at us. Ninjas aren't going to help. The banks need to be broken down, reconfigured, kept small.

Too much bank profit means too many Americans are in too much debt. There is an inverse relationship between bank profits and the enslavement of the populace.

On Oct 29 10:52 PM Moon Kil Woong wrote:

> I like your ninja analogy. There is other things stalking the banks
> worse than inflation though, it's called mark-to-market losses and
> off the books derivatives.
>
> Mark-to-market has already stung banks and is like a slow acting
> poison since they can hide their condition with accounting tricks.
>
>
> Off the book derivatives is like gangrene. Already a great portion
> if not all of many too big to fail banks are dead. Thus banks are
> forced to hoard every last bit of zirpish money they can and then
> some to stay alive. The extra comes in the form of service fees and
> churing out even more bad home loans which they can mark up and dumping
> on Fannie and Ginnie Mae, Freddie Mac, and the FHA.
>
> These afflicted banks sucking up all our economic green blood are
> much more likely to die long before the ninja arrives.

Oct 30 01:12 AM