Do Rising Prices Indicate Inflation?

Includes: DIA, QQQ, SPY
by: Jim Bradley

A savvy investor will realize that inflation can show in a variety of assets or goods not captured by indexes. Using that fact, an investor can clearly see no present monetary inflation shows in the U.S. after including the deflation in house prices (an effect in the trillions).

To put it clearly (and to measure inflation correctly): only a dollar-volume (price x volume) increase in non-housing prices (like commodities, energy, and grains) which EXCEEDS the dollar-volume (price x volume) drop from housing prices would indicate a present policy of inflation.

The above measurement takes into account ALL goods (not just some goods, as do commonly used indexes) and the demand for money whether for trade or other reasons (i.e. 'monetary demand' - the demand to hold electronic or physical cash).

In my view, an analyst cannot rightly say that the Fed created or sustained inflation by following their policy from 2006 to 2007 when the dollar volume of housing collapses, an effect far exceeding that of the rises in energy and food.

The inflation statistics did not include housing inflation during the time it happened and inflation statistics will not properly reflect the deflation as it happens either. That's a big miss considering housing remains the primary collateral of the banking system in the U.S.

So why do non-mortgage prices continue to rise? Because the effects of PAST policy still remain.

Present consumer and commodity price inflation remains high from Greenspan's loose Fed policy from 2001 to 2005 ... and more importantly from the results of that policy redirecting real capital from more immediately needed items like oil and food to less immediately needed items like new housing (the drops in housing and rising prices of food and oil proves the point!)

Since investors cannot convert the real capital of houses to oil platforms or grain acreage, the correction will take some time and likely will induce a lot of pain from falling house prices and rising commodity prices.

So, although the Fed may yet inflate, they have not recently done so. In fact, the Fed may very likely induce deflation during a recession by their current policy.

An investor may also note that present policy remains tight by observing no permanent (as opposed to temporary) injection of reserves. If the Fed doesn't validate new short-term credit (by providing permanent liquidity or increasing the amount of "permanent" short term liquidity), that credit will eventually decline. So far at least, the Fed has not run an inflationary policy during 2006-2007.

Right now the Fed should not attempt to reverse past inflation, because to do so would necessitate inducing huge deflation in "prices the indexes do not contain" to pull down "prices the indexes contain" - that carries a significant economic cost for those businesses with products that do not appear in the inflation indexes.

If the Fed remains moderately tight, over time the economy will right itself by pulling down house prices and pushing up commodity / energy prices. The more the authorities intervene, the more difficult the transition (and the more likely authorities turn a recession into a depression).

An investor may anticipate the commodity / housing correction to continue for 5 more years under a neutral Fed policy with low overall inflation (taking into account ALL prices). A policy that deviates from neutral (either inflating or deflating) would have effects making the situation much worse.

The basic strategy remains the same as other posts: hold dollars to protect against credit contraction and hold gold / commodities for protection against the falling dollar. Foreign stock markets should continue their performance, but remain aware that they could reverse after several years because they've absorbed so much money so quickly as the U.S. presents a less attractive investment.