Status of inflation and prices today, September 2009

I have four things to say about inflation, prices, and the state of today’ economy, late September, 2009.


NO CREDIT EXPANSION CURRENTLY
One, since inflation is introduced into our economy by means of credit expansion, which means bank lending. Currently, because of the nature of our current mess, i.e., a financial panic, bank lending has shrunk and credit availability has all but disappeared due to the liquidation of bank capital and reserves. You might ask about the money that the federal government has put into banks. It was a lot of money. That money went into three areas. Some did go into the credit area, as the government purchased bad debt, those sub-prime, mortgage-backed bonds. But the government bought them at an extreme discount, so it did not replace much of the credit. The other two areas in banking that received money were those of reserves and capital accounts. These accounts within a normal functioning bank, consist of a significant percentage of fund, maybe as much as 50% of the bank’s checking deposits. However, these funds are not spent, not really invested. They must remain available for the bank’s needs. Consequently, they have never been part of the money supply, M1 or MZM, and cannot really be considered inflationary. The real problem with all of these measures by the government is that the recession hasn’t been allowed to do its work. The misallocations and created money have not been worked out of the system.

FALL OF THE DOLLAR
The upperward pressures on consumer prices today come primarily from two sources: one, the fall of the international value of the dollar. Foreign goods and services are now considerably more expensive that they were just a few years ago. The dollar has dropped in value almost 50% in just a couple years.

There is a second consequence for prices. U.S. goods and services are much cheaper for foreign buyers. That might sound good, but what it really means is that there are more dollars chasing our domestic production, which will mean higher prices for us. It is a double whammy of price inflation.

The current fall of the dollar is happening because foreigners hold so many dollars. They are finally spending them instead of holding on to them. They have been accumulating dollars for almost three decades, from our trade deficit. There is almost $11T in dollars overseas. All of these dollars that we have exported were created dollars. Notice that during the time that foreigners accumulated $11T, we still had constant 2% to 3% price inflation as our domestic money supply grew to over $10T. New money was being created at a tremendous rate. Now the overseas money is beginning to return. It is from our past inflation.

OIL PRICE SPIKE COMING!
Third, there is probably another event that is going to happen soon that will affect us financially. The conditions that produced the oil shock a couple years ago are returning. The world has no new capacity, and none coming on line in the foreseeable future. The existing industrialized countries have not reduced their requirements for oil, and will not do so, unless they retreat from industrialization. Finally, the two largest countries in the world, which are slowly moving into the modern age, and slowly increasing their need for energy, are slowly reemerging from the recession. We are all slowly reemerging from the recession. As we reemerge, more demand for energy will drive the spot prices for oil beyond what it was two years ago. This is not inflation. It is forced shortages. Prices will go up. All goods and services are dependent upon energy, and as energy prices go up, so will all the others.

MEDICARE AND SOCIAL SECURITY SHORTFALL: A REAL MESS!
Finally, in the relatively near future, we come to the fruition of the Medicare and Social Security mess. Medicare already costs more than the annual Medicare taxes bring in, and is consequently taking money out of general taxes. Social Security will follow suit within just a few years. Both programs will begin growing faster than realistic taxes can support. What will happen then? Depends a lot on who is in power and whose voices are being heard. As these two programs grow they will force out everything else, including Obama’s programs, and national defense! If instituted, Obama’s programs will just bring on the mess earlier because the poorer the economy performs, the sooner the shortfall between Medicare and Social Security costs and their direct revenues will occur. Also, the faster consumer price levels rise, the sooner the problem because both programs are tied to the price levels, either directly or indirectly.

The Federal Reserve Board and the Money Supply, Part 2

The Fed has this toy, the deposits of 10% of the country’s banks’ checking deposits. By law, the Fed can do two things with that toy. It can change the percentage of deposits required. If there is a limit on the percentage I haven’t found it. If there is a legal limit, it has no practical significance. We are really left with the Fed being able to set the percentage of demand deposits required by law with just the Fed’s “good judgment”!

The Fed also has the right to change the amount of money that is in a bank’s Fed deposit. The Fed can add money or it can take money away. So there are two parties who can change the bank’s deposits: the bank and the Fed. Now the bank is limited in how it can adjust its deposit. It must be close to the correct percentage. The amount of demand deposits the bank has is figured every week and it must reconcile the percentage at that time. It can borrow to cover a shortfall in its deposits. It can borrow from a bank that has a surplus or from the Fed (called the “discount window” and thus the “discount rate” that we hear so much about).

We are now at the key to the expansion of the money supply. Watch this. When the Fed adds money to a bank’s Fed deposit, the bank can consider the larger deposit as “found money”, and regard the new total deposits as the 10% (again, the current percentage requirement) the bank must meet. Since the size of the bank’s Fed deposit is now larger than it was, the bank may turnaround and expand the demand deposits held by the bank to the extent of the new proportion, 10 to 1, 10 parts demand deposits, 1 part Fed deposit. The bank expands its demand deposits by offering loans. Hospokus, we have credit expansion!

Let’s look at an example. Bank XYZ has $100M in demand deposits. From this, it has placed $10M at the Fed, and keeps, let’s say, $30M as actual reserves (I have no idea what banks currently believe is a reasonable, actual reserve, these numbers are made up by me). The Fed, acting upon its good judgment, puts $1M into XYZ’s Fed deposit, raising it to $11M, and whamo, the bank can expand its demand deposits to $110M. ZYX Bank can now loan out $10M more and be completely legal. (What percentage banks actually loan out is not really relevant. The Fed would just keep adding money to the deposits on hand until they reached their target of credit expansion.).

Whamo, we have now witnessed the expansion of the money supply by way of bank credit expansion.

The Fed uses a certain technique to add or subtract money from banks’ Fed deposits. The Fed buys and sells Federal Treasury Bonds on the open market. What it does, when it buys a bond, it buys it through a bank, and places the payment for the bond in the bank’s reserve. So, in the above example, it bought $1M worth of bonds through XYZ bank, and paid XYZ bank via the bank’s Fed deposit. If it wants to contract bank credit, the Fed buys bonds on the open market, and takes the payment from the Fed deposit.
The open market operation of the Fed is carried out by the, wait for it, Open Market Committee, which meets in the New York Branch of the Federal Reserve System. This Committee makes the open market policy and thus determines the rate of credit expansion. The credit expansion in turn causes an increase in the money supply, which may result in higher consumer prices. The credit expansion may also cause booms in stock prices, residential real estate prices, commercial real estate prices, and many other things. It also finances our export of dollars by way of our trade deficit. Credit expansion is handy for all sorts of things.