June 20, 2009


Why the Fed Isn't Igniting Inflation: Yes, the Fed is expanding the money supply. But any inflationary effect will be offset by consumers' new frugality (Peter Coy, 6/18/09, Business Week)

[I]f anything, the wave of money it's generating may not be big enough. How can that be? Because the inflationary effects of the new money are being fully offset, or more than offset, by the far-reaching and long-lasting impact of household debt repayments. Whether it's voluntary frugality or under the coercion of creditors, Americans have abruptly switched from living beyond their means to saving more and working down the debts they incurred during the bubble years.

The people who worry about inflation—and there are many—may not have fully grasped the multitrillion-dollar ramifications of American households' extended deleveraging. While cleaning up debt is a good thing for the long-term health of the U.S. economy, it's hell on consumer spending, which accounts for about two-thirds of gross domestic product.

The dramatic pullback in consumer spending means money that otherwise would have gone into raising prices is going into propping up the faltering economy. Banks have drastically increased their reserves at the Fed rather than making new loans. That's the biggest cause for the increase in the monetary base. "At every level of the economy and every level of society, the demand for cash is unprecedented," says David A. Rosenberg, chief economist and strategist for Gluskin Sheff & Associates, a Toronto money manager. Says Rosenberg: "If the Fed didn't meet that demand for cash, we'd have a destabilizing deflation on our hands."

As a matter of fact, the economy is teetering on the edge of deflation—a general extended decline in prices—despite the Fed's intervention. Excluding food and energy, consumer prices rose a modest 1.8% in the 12 months through May—and including food and energy, they fell 1.3%, the most since 1950. Cutbacks by consumers are bringing about deflation in business, with unemployment in May at 9.4% and manufacturers using only 65% of their capacity, the lowest since recordkeeping began in 1948. Small businesses that were aggressively raising prices a year ago are now "worried about weak demand, the fact that they don't have many customers," says William C. Dunkelberg, chief economist of the National Federation of Independent Business.

Posted by Orrin Judd at June 20, 2009 6:28 AM
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