Inflation and the Rebalancing Process

Inflation is good if you are deeply in debt. The relative size of your debts shrink, as the value of the dollar declines. The roughly $10 trillion we owe to foreigners will be very easy to pay back if we just print up the the money and ship it to our creditors on the next boat heading out of port. Unfortunately, that would be just a wee bit inflationary. As of last Wednesday there was only $795.862 billion of currency in circulation. Banks wouldn't want to increase the size of their deposits and loans more than 10-fold, and as people, companies and governments tried to spend and invest the money, the price of just about everything would shoot up by a factor of at least 10.

Nevertheless, the size of our debts has become so overwhelming that continued monetary expansion seems to be the only way to keep up with payments. Most of our main creditor nations appear to have pulled the plug on our credit lines, leaving the Fed to inject more when needed and hedge funds to borrow more money into existence to buy up new Treasury debt. Other countries helped keep inflation down in the US for a long time by building up reserves of dollar denominated assets, but they seem to be reaching a saturation point. For those reasons, we can expect inflation in the US to be high for many years to come.

Inflation in the US is the worst among 9 major economies. While the countries in that report all use slightly different methods and inflation numbers are highly politicized, I think the general impression given by the report is valid:
1. Inflation is rising globally.
2. Inflation is worse in the US.

As bad as the published numbers are, the real story is probably much worse. Our government tries to keep published numbers down to maintain confidence in the economy and keep the cost of entitlement programs under control. It does this in 4 main ways:
1. The use of hedonic adjustments to lower price increases on goods that are supposedly improving in quality. (note that I've never seen a downward hedonic adjustment for all the goods and services that have deteriorated in quality)
2. Adjusted weightings to favor goods that have slowly rising costs over goods that have rapidly rising costs.
3. Excluding the effects of supply disruptions that boost the costs of certain goods.
4. Focussing on a "core" rate that ignores the rise in cost of the things people need most to survive.

Even with all the fudging that goes on, inflation remains high in the US economy, with the CPI coming in at 4.1% over the past 12 months and a 4.5% compound annual rate over the last 3 months. Anything over 2% is considered unhealthy because it distorts economic decision making, so we still see rationalizations and excuses whenever the Fed or government officials are feeling pressured by the numbers.

It's a game that has been going on for over a year now and should continue going forward. The Treasury needs money supply expansion (and therefore inflation) to keep paying its bills without draining to much money out of the private sector. The Fed will keep talking down inflationary risks and long term interest rates and talking up the dollar to protect the primary dealers. Yet, the dollar will continue to trend down, the economy will contract, and the purchasing power of the American consumer will erode. Measuring the rate, timing and nature of those declines is a major purpose of this blog.