Inflation Concerns? That's So Yesterday

The great sucking sound on Wall Street has few redeeming features, with the possible exception that it'll cleanse the economy of long-running financial excess and dampen, if not kill, the former inflation for a time.

Today's update on consumer prices for August offers a preview of things to come. The CPI dropped a seasonally adjusted 0.1% last month, the Bureau of Labor Statistics reported today. That's a sea change from the surges of 1.1% in June and 0.8% in July. The last monthly decline was -0.4% in September 2006.

That still leaves CPI higher by 5.4% in August from 12 months previous, but the annual pace of CPI is likely to fall further in the months ahead. The reason, of course, is that demand generally is retreating. From commodities to large-screen TVs to the three-bedroom ranch in the suburbs, the marginal growth in buying overall has evaporated.

One need only read the newspapers in the past 24 hours to understand why. Deflation, in short, is the big risk at the moment. It may or may not pass quickly, but that's the primary hazard hanging over the economy as we write. Rest assured that the Federal Reserve will continue to inject liquidity into the system as insurance to keep the blowback from Wall Street from infecting Main Street. The helicopters are surely in the air and Captain Ben is about to release the proverbial bags of money.

We have no problem with the central bank going to extraordinary lengths to keep the system from seizing. That's the only challenge today. The question is whether, and when the bank will commence a mopping up effort at the appropriate time down the road. Keep in mind that the government is accumulating lots of new debt as a result of the financial troubles. The recent bailout of Fannie Mae (FNM) and Freddie Mac (FRE), for instance, will increase government's red ink by a tidy $300 billion, estimates economist Nouriel Roubini in an interview via Advisor Perspectives. And it's not clear how much more the government will have to spend before the crisis is over. Meanwhile, the ongoing expenses of modern government continue to roll on, i.e., the expanding price tags for Medicare, Social Security, the Iraq War, and on and on.

The path of least resistance is still printing more money. For now, however, no one really cares, given the turmoil of the moment. And rightly so. Focusing on whether AIG (AIG) will be liquidated, for instance, is the priority, as today's FOMC meeting will surely reflect. The long-term isn't dead, but it's taken a back seat to the events of the moment.

Nonetheless, for those who can still look out a year or more, inflation is still an issue, although the future of pricing pressure depends on what unfolds in the coming weeks and months. How bad will the economy be hurt? How steep will job losses be? How will foreign economies be affected? And on and on.

Monetary policy is fated to attack the virus du jour, which is a function of falling demand and the associated illness of deflation, either real or perceived. No wonder, then, that the stampede into Treasuries went up a few notches yesterday. And for good reason, since there are real and present deflation dangers afoot. The D risk may soon pass, and it may evade us entirely, but for the time being no one really knows and so the Fed will and must act on the side of assuming a rising D risk.

The Faustian bargain of central banking is on full display. Trading long-term price stability for short-term comfort is always lurking, although it's rarely on such a stark display as it is now. The good news is that enlightened policy can navigate the two quite well by satisfying the immediate needs of liquidity without throwing away price stability over time. The bad news: human error hasn't been banished.

Comments

[JasonC:]

Anyone worried that inflation will be high a year from now or two years from now, is constitutionally incapable of opening their eyes, and it reading from a one-note ideological script. There won't be any meaningful inflation for 3 to 5 years, and we will be lucky - yes lucky - if the overall price level doesn't drop materially.

2008 Sep 16 10:58 AM

[pochovilla:]

Wow! A .1% drop in the rate of inflation and ya'll declare victory. At this rate we'll all be able to afford gasoline, diesel, and utility bills in about 10 years if health care, taxes/insurance and "fees" of all types don't take away the meager gain. Lets see milk at $3.00 per gallon before spend all this new found wealth on a 60" LCD HD TV at the trailer park.

2008 Sep 16 11:16 AM

[anarchist:]

Who does the shopping in your home JasonC?

2008 Sep 16 11:19 AM

[css1971:]

Um... Central banks exist to prop up normal banks that's what's meant by "stability". If you simply remember that, then it's clearly inevitable that the central bank will pump cash into an emasculated financial system.

2008 Sep 16 11:22 AM

[Chris B:]

1) The recent bailouts and, more importantly, the rapid increase in the national debt were paid for with a great expansion in the supply of money. The national debt is set to break records for each of the next several years (wars, baby boomers retiring, govt-owned mortgage losses, tax cuts...). This is inflationary.

2) Further, interest rates seem likely to stay low, or even fall lower, as the govt. tries to give the banks enough breathing room to recover from their mortgage losses over the next couple of years and to reduce unemployment during this multi-year consumer-driven recession. Low rates are usually inflationary.

3) If retail/commercial lending rates nonetheless tick up a couple/few percentage points, that won't cause a shortage of money (deflation). More likely, it would attract back some of the massive dollar reserves held in foreign countries. Also, most measurements show that the consumer is pretty much tapped out and overburdened with debt. That alone will reduce the demand for loans, regardless of interest rate. So money shortages (deflation) seem unlikely.

4) Decent bond yields at some point in the near future might be possible. The problem recently has been that massive amounts of cash piling into bonds and treasuries have depressed yields. Again, not deflationary. That cash is waiting to pounce on the next opportunity to earn slightly better yields - even if it isn't interested in the failing financial/mortgage companies right now.

A few years from now, with inspiration from low interest rates, that cash will inflate the next bubble.

2008 Sep 16 11:27 AM

[bearfund:]

Hmm, printing more money while output of goods and services is contracting. Can't imagine how that could cause prices to rise.

2008 Sep 16 11:27 AM

[John Walter:]

Does anyone else worry that the recent strength of the dollar is VERY temporary under the best of circumstances given this country's massive debt and increasing responsibilities in the private sector?

If the author forecasts that the Fed will pour money on our liquidity problem, it seems to me that, given just a little spark (e.g. threat to shipping in the Persian Gulf, or a major bankruptcy by a company like GM or Ford), inflation caused by an imploding dollar has the potential to raise commodity prices so rapidly it'll make early 2008 look tame.

Face it. We were on a balance beam which is quickly narrowing to a 2x4 and then to a tightrope. The Fed has precious little margin for error and the stakes are very high to the economy.

As usual, my 2 cents.

2008 Sep 16 11:30 AM

[bbzz24:]

JasonC,
To make such comments you must not possess any knowledge of what causes inflation, and not understand what the Fed and Trasury are doing: fighting deflation by increasing the money mass and creating new debt to support asset prices.

2008 Sep 16 11:42 AM

[Nikola:]

Look up! Ben's already dropping money from a helicopter.

2008 Sep 16 11:52 AM

[Lex Luz:]

It seems to me that deflation, while inarguably painful for many, is PRECISELY what is required to clear the space for a real economic recovery to begin. Yet it is also manifestly clear that the Fed is playing a one-note song titled "inflate at all costs." The end result of this policy may not be disaster, but it seems to me that it has a greater likelihood of bringing on calamity than just letting the cycle play out. To my way of thinking we should be letting the deflationary forces run, and looking toward a future in which free markets can be restored on the strength of sane regulation that promotes transparency and a meaningful pricing of risk.

Instead we are about to get a new series of rate cuts, the creation of additional lending facilities that will take the contents of bankers' wastepaper baskets in trade for treasuries, and one more inflationary bailout after the next. Prices may fall in the short run on the back of flagging demand, but ultimately with all this nonsensical expansion of money supply we will see the collapse of the dollar and that seems to me to be far, far worse than a period of deflation.

2008 Sep 16 12:11 PM

[Chris B:]

Lex,

The problem with deflation is that it would increase the cost of the national debt. I suspect that some people in govt. realize that we will never get out from under the burden of our snowballing debt unless we inflate it away, and repay it in dollars that are worth much less (screwing over the creditors). This weak-dollar approach has been tried for 8 years. The problem is, wages have not risen with prices and are roughly flat for the decade.

Thus, unless wages skyrocket soon, the govt. faces higher costs for the physical goods it buys (e.g. fuel, concrete) and a shrinking tax base for its revenue. In other words: inflation without the wage growth component. This means even greater government deficits.

In a world where American workers are competing with cheaper Asian and Latin American workers, any economist will tell you that productivity growth is the only thing that will justify higher wages. Yet it seems that most of our financial resources are now not being devoted to productivity-enhancing investments such as education, infrastructure, or technology - they are being devoted to obtaining fossil fuels and government bailouts.

2008 Sep 16 12:46 PM

[Jason Rines...:]

These are good comments. And to Bearfund's point, isn't the classic definition of inflation too many dollars chasing too few goods? The flight to safety for the mid-term seems to be consumer staples, energy and healthcare the basics people can't do without in other words. Tightrope is right John Walter...

2008 Sep 16 01:54 PM

[Yoski:]

"In other words: inflation without the wage growth component. This means even greater government deficits. "
Most importantly this means a reduced standard of living for the vast majority of us.
If we would let poorly run businesses fail instead of bailing them out we might stand a chance to get back on our feet after a while, no matter how painful in the short term. Nationalizing poorly run business and piling onto the debt like there's no tomorrow will guarantee us that we will be a much poorer nation for generations to come.
While we're at it we should also nationalize brothels, that way at least we can make some money while getting screwed.

2008 Sep 17 06:43 AM