Thursday, February 10, 2011


Inflation is a function of supply and demand.  If supply is greater than demand, prices fall. If demand is greater than supply prices rise.  Pretty basic right?  You could also argue though that the thought of rising prices increases demand which then in reality causes higher prices.

Two years after the US downturn, there still lacks true demand.  From high unemployment to damaged balance sheets, the American consumer is less willing to spend on discretionary items. One of the goals of quantitative easing is to increase inflation expectations.  In a deflationary environment where prices fall, why buy today what will be cheaper tomorrow.  In an inflationary environment where prices rise, why not buy today what will be more expensive tomorrow.

So if you can increase inflation expectations you can basically pull demand forward.  This increase in demand in theory causes more production and thus more jobs further increasing demand.  In theory, if you can pull demand forward enough, you can jumpstart the economy.

The ability to control inflation is difficult though.  As prices rise, consumers need more money to maintain their standard of living and thus demand higher wages.  Higher wages increase costs which further add to inflation.  Once an employer raises wages though, it's almost impossible for them to lower those wages.

During congressional hearings on February 9, Paul Ryan asks Bernanke about this balancing act of creating enough inflation to stimulate growth but not so much that prices grow out of control.  In a free, democratic, market driven economy it is truly amazing that one man controls monetary policy and yet the implications of that policy are very far reaching.

Equally disturbing are the responses from Bernanke (at 5:25 in the video)

"Overall inflation including food and energy is still very low..."

"There is no indication in our financial markets that in the United States there is an expectation of inflation..."

These comments are disturbing for reports of inflation are rampant.  Bernanke discounts inflation and uses the five year Treasury TIPS spread at 2.10% as proof that inflation expectations are in line with Fed policy.  He is aware of the inflation that is here and that which is coming but publicly he cannot state that as he is trying to increase expectations. The man who said subprime was contained though is now entrusted to adjust monetary policy at that precise moment that inflation grows beyond control.

From a macro standpoint it is my belief that all this rising inflation will do is choke off demand and push the US back into recession.   One has to wonder if the strength in durable goods and CAT earnings are driven partly from farmers reinvesting profits from rising prices, the same prices that will slowly stifle the US economy.


No comments:

Post a Comment