Our Inflation Problem

We have a problem with inflation, but it's not what you may think.

Inflation isn't too high. The problem is that it's too low.

The Bureau of Labor Statistics reported today that consumer prices, less energy and food, rose last month by only 0.2% compared to April. On a year-over-year basis, the growth rate came in at 1.7%.

You might be wondering why this is a problem. Isn't inflation bad?

The answer is both yes and no. It's bad if it gets out of control. Think the Weimar Republic in Germany between the world wars. People literally had to use wheelbarrows to ferry their paper money between home and the grocery store.

A less extreme example was our own economy at the end of the 1970s and the beginning of the 1980s, when the then-chairman of the Federal Reserve, Paul Volker, was forced to hike up short-term interest rates to stem the double-digit increase in consumer prices. While the move succeeded at its objective, it also sent the economy into a deep recession.

But inflation can be too low as well and it's particularly harmful if it crosses into deflation -- that is, where prices for goods fall. The United States' experience with this in the 1890s triggered civil strife and widespread bankruptcies throughout the largely agricultural economy, as farmers struggled to repay their increasingly burdensome debts with dearer and dearer dollars. More recently, Japan has been mired in a deflationary spiral for much of the last 20 years.

Just like Goldilocks' porridge, then, the ideal situation is when inflation is just right.

What constitutes "just right" is, of course, open to debate and largely informed by one's standing as either a debtor or a creditor. If you're a debtor, like the farmers in the 1890s or a mortgagee today, then the higher the rate, the better, as this lessens the burden of paying back your debt. But it's for this same reason that creditors prefer lower rates of consumer price appreciation.

For what it's worth, the Fed has targeted a 2% rate of inflation to use as a gauge for its monetary policy. Anything below that, as we have now, will presumably encourage it to stay the course when it comes to monetary easing.

This is good news for equity investors as the central bank's recent easy-money policies have fueled the stock market to all-time highs. It logically follows that this is probably one of the reasons that both the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and the S&P 500 are rallying today on the heels of the BLS's announcement. Since QE3 began, these indexes have shot up by more than 16% each, and seemingly every time a rumor circulates about an abandonment of the policy, the indexes fall -- and often violently. Neither one, for example, has reclaimed its May high since Ben Bernanke testified on the 22nd of last month that a reduction in support could be decided upon at one of the next upcoming meetings.

Alternatively, a reading above that figure would most certainly induce the Fed to draw down its support, which would almost invariably lead to a reduction in stock prices. This is why Warren Buffett has said that the decision to taper QE3 will be akin to the "shot heard round the world."

To get back to the present, as you can see in the chart at the beginning of this article, the problem is that there's a clear downward trend in core consumer prices since the beginning of last year despite the Fed's massive monthly infusion of liquidity -- under QE3, it's buying $85 billion worth of federally insured securities a month. But while this is good for stock prices, it's horrible for the economy. And that's our inflation problem.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 18, 2013, at 5:45 PM, OnTheContrary wrote:

    Inflation is never "just right". It is an evil, pure and simple. It is a yearly tax on the savings of those who have been responsible enough to not only live within their income, but to save some of that income, and it goes to the government to further enrich the rich and powerful. It also encourages foolhardy investment in economic enterprises that are never going to pay off, and thus accentuates the booms and busts of the business cycle. And it is not the relatively trivial problem suggested by the attached chart, which is based on the government's bogus, heavily doctored CPI. The original, undoctored, CPI pre 1982 tracked by economist John Williams at his ShadowStats website shows that actual inflation has been ranging from 5-10% every year since 1982. All Americans with jobs get a huge chunk taken out every year for Social Security, and after, say, 40 working years, we get paid back anywhere from 10-25 cents on the dollar, thanks to inflation. Inflation is good only for the bloated government parasite, and those who leach off of it.

  • Report this Comment On June 18, 2013, at 10:25 PM, RMengineer wrote:

    What's wrong with 0% inflation? Who says 2% is "just right" based on what? It seems like economists (well, the government policy ones anyway) seem to think that if inflation were to ever dip below 0%, even -0.000001% the planet would explode or something. Instead they make us suffer and burden us with the stealth tax of a "target" of 2% inflation for no good reason other than their abject debilitating fear of even the slightest hint of deflation. Maybe if they weren't so obsessively afraid of deflation they could have some rational economic policies that don't create major economic crises every 5-10 years.

  • Report this Comment On June 19, 2013, at 9:22 PM, damilkman wrote:

    This article reminds me of the silver verses gold standard wars of the 19th century. I have to agree with the others that I do not see any evil with 0% inflation. The author seems to be treating inflation verses deflation as a primary cause instead of a symptom.

    If there is deflation because of reduced economic activity, we may say that deflation is bad. However the real badness is the reduced economic activity not the symptom. Conversely if there is deflation because some activity can be done more efficiently then deflation is good as the entire market benefits. An innovation that generates a disruption may be an issue short term. If an economy is efficient those workers displaced go somewhere else. The crux then becomes how efficient are we in moving people where they are needed. That is a challenge of the 21st century world.

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