Friday, August 20, 2010

The Phony Inflation-Deflation Debate

This post is mostly so that the next time someone sends me an email as to why we absolutely positively are going into a great deflation, or someone else sends me an email telling me why we are absolutely going into a great inflation, I can send them a link to this post as a way of rebuttal.

In reality there are absolutely no built in long waves, mystic forces or economic forces that are pushing the economy inevitably toward inflation or deflation. The Federal Reserve controls the game and can change the game in either direction at any time.

Anyone who thinks the Fed is impotent to fight deflation simply doesn't understand the basics of  central bank money creation. If the Fed wants to create money it can simply buy Treasury bills, or anything else it so chooses, as long as the money isn't bought from those within the system, i.e., banks that can dump all the money into excess reserves, the money enter the system bidding up prices. Ask yourself this question? Suppose the Fed came to you and said, "Hey, we are having a little trouble fighting deflation, if we print up a million dollars and give it to you, would you be willing to buy things with it?" You know, you might answer, "Yes." Deflation problem solved.

The reason they aren't coming to you to solve the "deflation problem" is because they have a long list of actors way ahead of you on the list they will call, if they need to "solve" the deflation problem, first and foremost among them the United States government, who would be more than happy to issue T-bills for Federal Reserve notes, if the Fed called on them.

That said, we do have a mad scientist at the head of the Fed, Ben Bernanke, who likes new tools when he plays with his money printing machine. While it is clear there are tools, as explained above, that will get money into the system, it is not clear how Bernanke's new tools will work in creating money under all conditions. Further, the Fed may, and many current Fed members do, consider the low interest rates as an easy money policy. If real rates (market rates that would occur if the Fed didn't manipulate the money supply) are naturally low, as they are now, the Fed can mistakenly believe they have a loose money policy, when in fact they have nothing of the kind. Indeed, until recent weeks, money supply (M2) growth was essentially flat in the U.S. for months. This is deflationary and was most likely caused by Bernanke not fully understanding how his new tools work and other Fed members who misinterpreted current low real rates to mean an easy money policy. These factors have all acted as deflationary price factors on the economy, but there was nothing that was inevitable about this trend. It occurred because of very specific actions by the Fed. If the Fed changes its actions, the price deflationary trends will end.

Overall, the Fed does have somewhat of an inflationary bias in its system, given that the members of the board are government appointees. nominated by the President and confirmed by the Senate, and government is always looking for easy money to expand its reach, but this does not mean there can not be short periods, such as we have now, where the Fed intentionally, or by error, slows money growth.

Bottom line: There are no inevitable ironclad inflationary or deflationary trends in the economy. The trends are all created by current Federal Reserve operations.  In the long-run there is an inflationary bias to the Fed, but as we can now see by the current economy that trend can be broken on a short-term basis.


  1. So why can't Japan inflate itself out of its ten year deflationary doldrum? The fed cannot make anyone borrow. For the US to issue more T-bonds to sell to the fed requires Congress to raise the debt limit. The American public, it seems to me, is about ready to vote out of office any politician who advocates more federal debt. Greece is falling into thierd world status yet alt politicans in Europe are preaching and voting for less debt.

  2. Anonymous because they know that if they abuse the currency too much they can hyper-inflate. They are scared of that so they try to be prudent.

    But theoretically the Fed can end price deflation any time it wants. In reality, the Fed knows price deflation is what the system needs to regenerate itself. But it wants to go through the deflationary process keeping the banks and government alive.

  3. As I understand it, we are already in a deflationary environment. Trillions in assets have already been destroyed (along with the underlying credit) and trillions more are in serious danger of being destroyed. The FED can change some policies and money will rapidly flood the market, encouraging more malinvestment in "quick sale" long-term toxic assets. This "boom" will be more short-lived than the last, and much less exhuberant, but the end result will be more suckers holding worthless assets.

    The FED has one last hurrah in it, but it will be the "Hail Mary" pass that loses the game. What happens after THAT will be the catastrophe.

  4. Japan has been waiting for a "Hail Mary" pass for a couple of decades. You can grow old and die (as many have) waiting for the great hyperinflation.

  5. I agree that the Fed controls inflation/deflation. However, there really does seem to be a 38 year cycle at work too: