Skip to Main Content
PCBB Banc Investment Daily December 02, 2014
Banc Investment Daily
December 02, 2014

Inflation Explained By Fairy Tales

We were pondering a recent article in The Economist about inflation and we thought - this really is the same story as the Beauty and the Beast. You see, inflation is just an awful terrifying monster, but it can be transformed with just a little love and training into something necessary and useful. Lately though, inflation is more on the path of the Three Bears - going directly from scalding porridge that burns the mouth to congealed, cold and unappetizing sludge. Global Central Banks' search for a level of inflation that is "just right" is turning out to be elusive. Recall that inflation is characterized by a rise in prices from too much money chasing too few goods. In an inflationary environment, people want to buy products and services now, because the price is likely to be higher tomorrow.
The opposite of inflation is deflation. In that environment no one buys because things bought at today's prices will likely be cheaper tomorrow. Investments in productivity-improvement projects are also put off as they will be cheaper to do in the future. You know what we are saying if you have shopped for a TV lately. Consider that in 1986, a color Toshiba table top TV with a 19" screen cost $490 (and that is not inflation adjusted). Compare that to a 42" flat screen TV today at Best Buy available for $300. For those willing to wait a year, a comparable device will probably cost even less. Gasoline prices are in a deflationary cycle too, although admittedly they don't count over the longer term as they are generally supply driven. But declining demand due to cooling economies worldwide is currently driving the price of gas down too. All of this seems pretty deflationary.
For their part, Central Banks worldwide have spent decades fighting inflation that was too hot. As long as populations were growing, worker productivity kept improving and other engines kept economies mostly humming along. As a result the decline of inflation was generally seen as a positive. Too little inflation is a bad thing though. Goods are seemingly ever less expensive, so consumers simply wait to buy for a lower price and this slows productivity and the economic growth engine. Given stagnant wages in the US for most people, declining prices of consumer goods have been an important element in maintaining the lifestyle of the general population. The problem here is that there is a limit to the benefit, as prices going ever lower also drive wages and benefits lower for workers. That is because lower prices ultimately drive producers to find cheaper production markets in order to keep up profitability.
The Fed has recently ended its major stimulus effort of buying large quantities of Treasuries and mortgage-backed securities. This effort to drive longer term interest rates down has been successful, but now some are worried because rates have failed to move upwards even as Fed asset purchases have waned. In fact, Treasury yields are significantly lower than they were at the beginning of 2014. The Fed has stated that its longer term inflation goal is 2%, but inflation has been running below that level in the US and abroad for years. In Europe and most of Asia, central banks are beginning new stimulus efforts to fight deflationary pressures.
The tepid rate of growth in Europe and slowing growth in China are exerting downward pressure on prices. Despite this, the US economy continues to chug along and is performing better than most other global economies.
At this point, some fear inflation is simply snoozing like Rip Van Winkle, while others worry about deflation and say let the poor tired man sleep. Overall, a bit more inflation at this point would drive more consumption and improve wages. Given the bad news deflation can bring, for the sake of everyone we hope the world moves closer to a Goldilocks level of inflation.