Our Current Low Inflation Environment

There is no inflation right now because people are deleveraging by cutting down their debt loads. Credit is still very very hard to get for the average person, I just applied for a mortgage and the fees alone are outrageous, but credit is limited and those who offer credit can charge whatever they want to. Most banks aren't interested in lending.

Americans understand that they can't spend like they used to, debt loads cannot continue to go up like they did before, the banks/credit lenders won't allow it and people don't want more debt anyway. So instead of spending and bidding up prices by demand, people are paying off debt as they can. We won't see inflation until the average American's balance sheet is repaired.

That means government fiscal policy will not be able to increase aggregate demand. As soon as government stops spending, demand will fall back to levels Americans find appropriate. However, should government continue to spend and spend, a new crisis will emerge pertaining to government debt loads. We'll be in the same position as Japan, the spending having accomplished nothing but with a huge debt weighing on our heads. Unlike what MMT proponents say, government cannot finance its debt and interest payments by itself, any attempt to do so will cause a collapse in confidence and bring about a crisis, much like the one we're witnessing in Europe.

The European crisis is one of the reasons for such low Treasury yields. Investors are pulling money out of Europe, selling their bonds, and investing in US Treasuries instead, causing a decline in yields. If there is one thing to be learned, it's that the financial landscape can change very very quickly once a tipping point is reached. Once confidence is lost and fear takes over, a stampede for the exits ensues. The collapse of the Euro from $1.50 to $1.23 was as quick as lightning. And it only took a matter of months for Greece to find out that their debt could only be sold at incredibly high interest rates, that is if it could be sold at all.

A similar tale awaits the US should it continue on with reckless spending, especially the useless pork barrel spending that the Congress is accustomed to. Once it becomes evident that the debt load is too large to finance, yields will rise very quickly and capital will flee the scene. Confidence once lost, is hard to regain. Draconian cuts to government spending will be demanded and government will have to surrender to the bond vigilantes and speculators as they have done in Greece, Spain, and even France.

We don't have to go down that road. And it bothers me that what money is being spent is not being spent well. At the very least spend money for productive projects that has some chance of paying off in the future, not on cars for clunkers or any of the crap that has so far been proposed. Tax breaks for corporations to buy equipment? No thanks. How about extending the Bush tax cuts permanently if you insist on continued stimulus? Allowing Americans to deleverage faster by taking less from them is the quickest way out of this crisis. The economy cannot heal until Americans are in better financial shape and are ready to spend again.

Where Was the Inflation? Right In Front of Your Nose!

I think we need to seriously reconsider the basket of goods used to measure inflation. Intermediate and manufactured goods are becoming cheaper thanks to emerging countries like China and Vietnam. We are in an era of greater manufacturing productivity being passed on in the form of lower costs for manufactured items. So we will not see inflation in this era as long as we measure inflation primarily through manufactured goods.

Commodity, energy, and asset prices, on the other hand, don't benefit from lower cost manufacturing. If the Fed is using inflation as an indicator of whether monetary policy is too tight or too loose, they must understand that the manufactured item category will give them a lower inflation rate than normal thus fooling them into thinking monetary policy is tighter than it is. The Fed should look at inflation ex manufactured items or at least adjust for the China effect that skews the inflation numbers. They are treating current CPI numbers as if they were the same as CPI in the 1980's or 1990's, but the era has changed.

I believe this is why the Fed has adopted a monetary policy far far too loose, because they are being tricked by a natural deflation in manufactured goods due to the entry of China and other emerging markets. If they adjust for these factors, they would see that inflation was out of control in the 2000's, but unfortunately, they did the opposite. Instead of paying attention to food, energy, and asset price inflation and ignoring manufactured goods, they used the CPI ex food and energy as their main measure of inflation. How stupid! Furthermore, a change in the housing component of CPI to owner equivalent rent removed housing asset prices from CPI and replaced it with a non-asset alternative. No wonder they haven't been able to pick up inflation, they've removed everything that can rise in price from the CPI!

Now if someone like me can see this, why are Fed members still scratching their heads over the lack of inflation? It should be obvious by now, and I'm going to give Bernanke the benefit of doubt when he says that he will be alert to inflation and raise rates quicker than the Fed did in the past. So the real key is how commodity, energy, and asset prices behave. Oil and gold are already at elevated levels, the stock market has recovered. Should we see food prices skyrocket as they did during the bubble and oil go back to 100, we will know that inflation is back and out of control again. But should the Fed continue to be clueless and look at CPI ex food and energy, then they will never see the signs of loose credit and they'll never get why their policies are causing bubble after bubble.