The U.S. Bureau of Labor Statistics announced on Wednesday that inflation, as indicated by the Consumer Price Index (CPI), rose by 0.3 percent in September. This increase was primarily driven by higher prices for energy and food. Annually, the inflation rate for September stood at 3.6 percent, closely matching the CPI’s overall 3.9 percent increase over the past year.
With an annual inflation rate of 3.9 percent, one might assume the economy is thriving; however, the reality tells a different story. The latest GDP report indicates that the economy is growing at an annual rate of just 1.3 percent. When adjusted for inflation, this reflects a contraction of 2.6 percent annually—essentially, the economy is in decline.
Those dependent on a regular paycheck can attest to this troubling state of affairs. Even individuals receiving modest pay raises have seen their gains eroded by inflation. Others have suffered job losses, and those on fixed incomes are experiencing a double squeeze from meager treasury yields amid rising prices.
On Wednesday, the government also revealed that Social Security payments would increase by 3.6 percent next year. However, despite this adjustment, recipients will actually receive 0.3 percent less when taking inflation into account than they did the previous year. Consequently, this supposed “boost” offers little comfort.
For central bankers, these conditions reflect their broader economic strategy. As John Maynard Keynes observed long ago, “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
The Self-reinforcing Cycle of Deflation
However, public awareness of this issue is growing, as many now recognize how the Federal Reserve effectively diminishes their savings. At the Economic Prism, we believe that central bankers operate under the misguided assumption that they can manage the economy and smooth out the business cycle. Let’s delve deeper.
Typically, when economic activity slows, inflation wanes. If inflation decreases too swiftly, central bankers become anxious about deflation. Declining prices enhance the dollar’s value, placing cash at a premium.
Yet, deflation poses a significant threat: it exacerbates the burdens associated with existing debt. In an economy already burdened by debt, like that of the United States, this scenario can spell disaster for the financial system. Prolonged deflation leads to increased bankruptcies, disrupts capital markets, and potentially plunges the economy into a depression characterized by soaring unemployment rates.
This scenario creates a self-reinforcing cycle. Falling prices discourage spending, leading to higher bankruptcy rates among individuals and businesses alike. As companies fail, unemployment surges, creating a cycle that terrifies both politicians and central bankers.
Central bankers favor inflation over deflation. When the economy is booming, and consumer prices are rising, they can cool the situation by increasing interest rates and tightening the money supply. Conversely, in a deflationary cycle, their monetary tools become largely ineffective. They may inject unlimited amounts of credit into the financial system, but often this money remains unused, trapped in bank reserves.
The Wrath of Inflation
Federal Reserve Chairman Ben Bernanke’s approach to deflation is to promote inflation. His strategy aims to expand the money supply and stimulate rising prices, thereby alleviating the debt burden on individuals, businesses, and governmental structures. Above all, he seeks to prevent the emergence of a self-reinforcing deflation cycle.
However, this is a precarious game, blending art and science. While the Fed can typically manipulate money supply, it cannot dictate where that money flows or how it behaves once released into the economy.
In a slow economy, the abundant cheap money might linger on bank balance sheets or be funneled back into Treasuries, doing little to boost economic activity. Yet, once that capital enters the real economy, it can multiply, creating effects that the Fed has little control over.
Inflationary episodes often begin with a passive expansion of the money supply. Initially, this money sits dormant, much like a ticking time bomb without visible impact. However, changes in public sentiment or banks’ willingness to lend can ignite action at any moment, leading to a rapid increase in the velocity of money. Almost overnight, prices can surge in an inflationary explosion.
Since the financial crisis of 2008, the Federal Reserve has expanded its balance sheet by $2 trillion. Most of this liquidity remains parked in U.S. Treasuries and bank reserves. Yet, rumors are circulating that the Fed may begin charging banks fees for maintaining excessive reserves, prompting them to increase lending in an effort to revitalize the economy.
When pressured, banks typically respond to the Fed’s desires and extend loans. Before long, however, they may lend excessively, unleashing inflationary forces that destabilize the economy.
What follows can be astonishing.
Sincerely,
MN Gordon
for Economic Prism