Friday, January 30, 2009

Inflation Remains a Greater Threat Than Deflation

The Consumer Price Index (CPI) data for December has made many commentators raise the fear of a coming deflation. There is only one problem with these concerns: There are no deflationary forces at work. If anything, a huge inflationary process has been undertaken by the Federal Reserve over the last several months.

The Department of Labor reported January 16 that the CPI for all urban consumers (seasonally adjusted) decreased by 0.7 percent for December and was a mere 0.1 percent higher than a year earlier. Prices have not declined significantly, and the trend certainly has not been deflationary.

Since the time of Adam Smith, economists generally have defined inflation or deflation as a rise or fall in the money supply (broadly defined)...

As shown in the chart below, the Monetary Base (dollar cash held by the public and bank reserves held at the Fed) increased from $871 billion in September 2008 to nearly $1.7 trillion in December 2008. This amounts to a 95 percent increase in only four months. M-1 (Cash and demand deposits) increased by 40.2 percent and M-2 (M-1 plus and variety of forms of demand and savings deposits) grew by 17.4 percent at annualized rates of increase over this period...

By any definition, there has been no monetary deflation that would have decreased the amount of money and credit in the economy. The current monetary expansion comes before any reestablishment of a non-crisis demand for money by consumers, producers, and financial institutions. And its magnitude warns of a serious danger of significantly rising prices in the future if the Federal Reserve fails to reverse the expansion.

The threat facing the economy as a whole in 2009 will be the consequences from this vast inflationary increase in the monetary aggregates.

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