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Saturday, July 13, 2013

Understanding Inflation


It seems that the true definition of inflation has been subject to change in recent times when focusing in the economic reaction to its action.  The original meaning of the word still suffices as a definition that places it in accordance with its monetary results; “to blow into,” “to puff-up.”  However as stated above, inflation’s true origin is forgotten and it is conventionally recognized only as a rise in the price of goods in any given market.  Ergo, it is apparent that the true malicious purpose which inflation serves from time immemorial is seldom understood and is a subject relegated to esotericism.  This is why it is important that inflation’s point of origin and its subsequent myriad forms be defined and explained.

First of all, one must understand how inflation occurs.  Returning to its original definition of to blow into or puff up; inflation does just that to the monetary supply of a nation.  It expands it typically under the auspice of some central planning authority, or bank which by has been granted such rights by government decree.  This decree deems the bank’s notes legal tender for all debts to be paid and therefore a monopoly on money is effectively created.

Central banks expand the nation’s money supply through a few methods.  Primarily as it is the case with Federal Reserve today, it purchases assets on the market through quantitative easing.  It currently does so by its asset buying program to the tune of $85 billion per month.  Should an asset be directly purchased from a bank, then this new money is added to its reserves and the stage is then set for multiple credit expansion if it is loaned out due to the fractional reserve banking system.  However, the preferred asset of central banks are typically government securities.  This serves as an insurance for government that demand will continue to exist for its own securities.  Ergo, allowing for new expenditures in an ever growing debt.  By issuing new bonds, governments quickly inflate the money supply.  Since the central bank is ordered to purchase these securities, a new [supported] price floor is set, thereby causing an influx of treasury bonds into the bank subsequently leading to [seeming] perpetual inflation, i.e., expansion of the monetary supply or base.

Via the asset purchasing program effectively called QE, direct injections of liquidity are made into the open markets leading to a state of Permanent Open Market Operations (POMO) which is quickly evidenced by prior bail out programs and other injections such as operation twist and former quantitative easing(s).  When the market attempts to contract and cleanse itself of malinvestments created by artificial inflationary booms, the aforementioned action helps to instill a sense of security -although temporary - in the economy for it is being supported by the central bank.  This drives equity markets upwards due to increased demand as both institutional and retail investors clamor to ride this wave of easy money into higher returns, effectively chasing ever higher yields since savings provides zero returns due to extremely low interest rates set by the central bank.  This becomes a vicious cycle of further buying that may temporarily take the market to new heights nominally without any real fundamental improvement done to the economy.  Consequently, there is a collective sigh of relief during this illusion known as the wealth effect whereby portfolios, 401k plans, pension plans rise creating a false sense of security that the economic scenario has once again restored itself to previous norms.

In what could only be called a financial pincer movement by central banks to prevent deflationary busts - which are only market corrections - not only are liquidity injections the remedy du jour, but interest rates are arbitrarily and artificially lowered to encourage more spending.  The lower interest rates signal that there are more funds readily available for investment than there actually is, this is an attempt at manipulating the economy back into a ‘boom’ period of frivolity in spending savings that it does not actually have.  This repeated action only exacerbates the issue concluding in another deeper contraction at a later point in time requiring further stimuli by central banks.  This pattern has been recently seen in the dotcom bubble of 1999 and the real estate bubble of the 2000s where by lower rates drove new credit directly into these sectors of the economy creating anomalies which later needed to be divested.

Moreover, as new currency is artificially created, more money is chasing the same amount of goods leading to a devaluation in its purchasing power and an increase in the price of goods.  Due to its [current] global reserve status, the US is in a position to theoretically expand its monetary base without much visible [immediate] effect to its populace since its inflation is concurrently exported to other nations needing Dollars to purchase necessary imports for their own economies, such as oil (petrodollar).  Demand is therefore constant for these new Federal Reserve notes.  As the United States continuously inflates its supply of money so must other nations lest they become less competitive in the export and import market. 

Theoretically, debasing a country’s currency makes its exports more attractive as they become cheaper in the broader global market which consequently leads to a temporarily higher trade surplus or narrower trade deficit depending upon the current account balance the country has with regard to its imports and exports.  However, this a fallacious theory due to the fact that imports themselves become more expensive leading to a lowered standard of living domestically as those goods become gradually less affordable since purchasing power is diminished.  Imported raw materials from other nations will also rise in price due to debasement leading to higher input costs which eventually trickle down to the consumer good’s final price.  This action results in an increased cost of living that progressively chips away at the ability to maintain current standards within the nation.

However, given the velocity of money the above consequences may take a long time to be felt throughout the remainder of the domestic economy.  If the banks which received fresh supplies of reserves do not loan these out and the credit market remains stagnant and in a contraction, the monetary base has indeed expanded, but since the money has not been put into circulation there is no resulting price inflation.  Until such time, inflation’s negative effect is not immediately felt. 

When the money does start taking its effect on the economy and input costs rise they are quickly seen in the supermarket shelves by consumers.  Fortunately for central planners, these prices have been rather slow to rise and to the untrained eye they are not as obvious to spot.  Another manner with which producers can conceal inflation is by decreasing the size of the product’s container or lessen the amount of its contents, e.g., less chips in a bag, smaller rolls of toilet paper, etc.  This is in fact a form of indirect price inflation. 
Furthermore, as the natural interest rate of the market wants to return itself to a level reflective of daily activity, more pressure is placed upon the artificially low rates set into place by the central bank.  This result is seen in higher rates for mortgages and other forms of loans.  Those that suffer specifically are the individuals which are exposed to adjustable rates which consists of a large portion of households in the United States.  Even a small percentile increase can be the difference of tens of thousands of dollars in interest over the life of the loan.  This decreases the amount of monthly disposable income that would otherwise be put to use for home necessities or savings as the mortgage payment rises.  Once again this results in a gradual lower standard of living since a higher percentage of income is put towards the payment of the loan.

Although governments release official inflation figures, these are often fudged statistics that quell public sentiment and quiets those that do not see the rise in prices of goods reflective of the published data.  Often these figures are also backward looking statistics of a basket of goods (of the government’s choosing) to represent the past year or quarter price increases.  Taking alternative calculations utilized by the government in prior decades, percentages for inflation rise when compared to the current method of data collection and calculation.  It is sometimes better to look to commodity prices as forward looking inflation statistics.  It is important to remember that the prices of these goods aren’t rising, but rather the value of the currency in which they are denominated is decreasing leading to the need of more units to acquire the same amount previously requiring less units.

One consideration and often rare caveat to inflation is the pace with which technology allows for further improvements in the daily lives of humans.  These can often be of a big enough positive change which acts as a shield against rising prices.  Newer processes which hasten otherwise clumsy and old manufacturing assembly lines cause input costs to decrease resulting in a potentially less expensive price for a lower order consumer good.  However, should inflation be critical enough then the aforementioned would not be successful in halting or lowering overall prices of a specific good whi
ch its process has been marginally improved by innovative ideas and inventions.

Therefore, it can be rightfully concluded that no matter in which form inflation arrives it is detrimental to the health of any economy.  It is indeed an additional tax on the earnings of a nation’s labor force which diminishes their purchasing power whereby standards of living go down as a result.  This fleecing of the populace has been occurring in grand style since the Federal Reserve Act created the central bank which further consolidated what was once a decentralized banking system which kept a better check on inflationary pressure.  With a central bank observing monopoly rights over the creation of money, it serves as a tool for officials to grant subsidies to their constituency in exchange for votes and it finances all programs which result in government largess that would be impossible in a truly free banking system based upon a commodity standard.  Warfare and welfare would be relegated to exorbitant direct tax increases instead of inflation on the population and the effects of such policies would be heavily felt upon citizens resulting in a much more limited legislative body constrained by the true consent of its people.

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