The Independent Market Observer

1/11/13 – Inflation Part 3: The Fed Solves the Deflation Problem?

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Jan 11, 2013 11:20:59 AM

and tagged Market Updates

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The economic slowdown on the financial crisis, combined with rapidly declining asset values, put the economy at risk of deflation. For reasons I discussed in the last post, the Federal Reserve (Fed) is actually trying to create inflation as a preferable alternative to deflation.

There are other reasons why the Fed is trying to create inflation. The first is to attempt to bring asset prices back up, especially in housing and the stock market. The stock market is definitely back, and there are signs that the housing market is well on its way back, too, although it hasn’t come as far as the stock market. Sounds like we should be on the watch for inflation to take off again, right?

Not so fast. The Fed has indeed reflated some asset markets, and there are signs of low to moderate inflation in other areas, such as food and gasoline, but across the economy as a whole, pricing pressure is still low. Bond yields, which generally ticked up with pending inflation, are still at very low levels, and many inflation-protected bonds are actually trading at negative yields in many cases. What is going on here?

The problem is that, although the supply of money has indeed been inflated, and in some areas—stocks and housing—demand has picked up enough to start making that money circulate, in most areas demand is still below the levels needed to promote general price inflation. The best example of this is wages. With the unemployment rate still well above historical levels, wages are growing slowly, if at all. There is no excess demand for workers, or supply constraints, that would force wages up and create additional demand for goods across the economy. Consumer demand, which is driven by wages and borrowing, is about two-thirds of the economy. Until wages start to come back, or consumers start borrowing again in a big way, inflation should not be significant.

Business investment, another critical component of the economy, is also at low levels. In this case, the low level appears to be driven by uncertainty rather than lack of money, but the effect is the same: a lack of demand is leaving inflation at low levels.

Government, the third component, is not poised to pick up the slack either. With the tax increases already in place—which will hit consumer demand—and spending cuts pending, government will act as a net drag on the economy. Again, not a driver of inflation.

With demand not positioned to drive inflation, the only potential cause in the short term would be cost-push inflation. For example, if energy prices, such as oil and gas, went up, then that would propagate through the economy and potentially raise the inflation rate. Such a cost-driven increase, though, would create an offsetting decrease in demand—as consumers spent more on gas, they would have less to spend on other goods—which would act to limit the effects. Still, this is one thing we need to watch for.

Given that there appears to be little reason for inflation to rise in the short term, what else do we need to watch for advance warning?

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