Published: August 31, 2009 09:05 am      

Timing of financial tools’ use is crucial

Imagine arriving home from work and setting out the contents for meatloaf, the dinner selection you had planned.

You are suddenly invaded by several additional mouths to feed, so you need to stretch the quantity by the addition of cereal filler, thereby debasing the quantity of beef.

You have arrived at a kitchen example of inflation, too many mouths chasing too little food. There isn’t much you can do about the mouths but you can increase the quantity of the food. You could, in theory, continue to add filler to feed an unlimited number of mouths, but eventually the real nutritional value of the beef would be greatly reduced. You would have created meatloaf inflation in your own kitchen.

With huge increases in the federal budget deficit and the government printing money, many see inflation as a foregone conclusion. In fact we currently are experiencing unprecedented inflationary and deflationary forces, with deflation as the more immediate concern.

For inflation to emerge, we need economic, wage and labor, and money and credit growth to significantly step up.

A widely used gauge of inflation is the consumer price index. Approximately one-third of this index is tied to housing and rent measures, with another one-fourth tied to manufactured goods. With home prices still declining and factory utilization capacity below 70 percent, almost 50 percent of the CPI is indicating deflation as still present.

Inflation can be viewed as consumers (governments, corporations and individuals) trying to buy more goods and services than can be produced, so prices rise. Prices are unlikely to rise if the economy can produce more than is demanded. This slack is at record levels, a further deflationary indicator. The government is a consumer and its recent stimulus spending has added additional demand and larger deficits. If sustained, this could ultimately be inflationary, but overall demand would also have to significantly increase.

Demand can come from households. Despite the recent slight improvement in the unemployment rate, the supply of labor exceeds current demand. This places downward pressure on wages or at least low wage growth. With household debt at record levels, battered asset values and low wage growth, it seems unlikely household demand for goods and services will rebound soon.

The supply of money has increased dramatically in the past 12 months, evidenced by the Federal Reserve balance sheet. It is necessary to have an increasing supply of money to create inflation but the inverse is not always true. Just creating new money doesn’t create inflation as there is an additional link in the chain, credit supply and demand. Lending standards have significantly tightened. Loans are needed for expansion and acquisition, also in short supply. Credit markets have begun to improve but have not returned to a healthy state, much less to any definition of normalcy.

All these factors, economic, wage and credit growth must become elevated: then with record government deficits and loose monetary policy, we could enter a troublesome inflationary period. All of the above measures are constantly changing and under review. The usual economic horizon is 12 to 18 months and it would seem unlikely that all three factors would become sufficiently elevated within that time frame to trigger significant inflation above the historic 2 to 3 percent range.

In recent Congressional testimony, Federal Reserve Chairman Ben Bernanke stated that the Federal Reserve has the tools to implement an exit strategy from money creation. Tools, to be effective, must be used and the timing of their use is crucial.

Too soon and the economy worsens.

Too late, inflation.

The use and timing of these tools requires independence of action by the Fed to adhere to their mandate of growth and price stability. Some recent Congressional rumblings have been heard to increase oversight of the Federal Reserve and subject decision making to the political winds of the moments. These breezes would only increase the potential for error on the timing of the current or future decisions to affect interest rates and other tools available to the Fed.

In my original example of the meatloaf, the other household solution is to keep the original recipe and decrease the individual servings. With an increase in mouths, each portion would decrease and you have meatloaf deflation. Finding the proper meatloaf equilibrium is not easy, but a balance needs to be found between hunger and greatly reduced nutritional value.

Of course, you could gently suggest the extra mouths go to their own home and discover the joys of kitchen economics.



David Helscher is a senior vice president and trust officer with Clinton National Bank.