Fed's Problem: Deflation?

The latest report on the Consumer Price Index (CPI) shows inflation edged up only 0.1 percent in August, less than expected. And the year-over-year inflation rate is only 1.15 percent. So is that good news, or bad?
This post was published on the now-closed HuffPost Contributor platform. Contributors control their own work and posted freely to our site. If you need to flag this entry as abusive, send us an email.

If inflation isn't a worry, maybe deflation is the problem. The latest report on the Consumer Price Index (CPI) shows inflation edged up only 0.1 percent in August, less than expected. And the year-over-year inflation rate is only 1.15 percent. So is that good news, or bad? And how could these low inflation numbers influence Fed policy - and your lifestyle?

First, in order to forestall your complaints that your own inflation figures don't match up with the CPI, let's acknowledge that the index doesn't fairly reflect rising costs in many areas that affect some consumers. If you're paying for college, costs are still rising well beyond the CPI- though at a far lower rate of increase than in previous years. If you're paying out-of-pocket for medical expenses or paying your own health insurance premiums, you've likely seen price increases far beyond the reported CPI.

Putting inflation in perspective, you can see from this chart of the CPI for Urban Consumers (the number that is reported in the headlines) that the number is volatile from month-to-month, and your expenses clearly don't track the index on a real-time basis.

But for a moment, let's just accept that the CPI for Urban Consumers as reported by the Bureau of Labor Statistics is the accepted measure of inflation, or the lack of it. What impact could that number have on various sectors of the economy?

The Federal Reserve -- Will low inflation temper the taper? That is, if there is no upward pressure on prices, will the Fed reconsider, or at least delay, its plan to withdraw credit from the bond market? The entire idea of "tapering" was designed to keep the economy from developing a new credit bubble -- a distinct possibility, given that the Fed's bond-buying program is paid for with newly-created credit of $85 billion injected into the system as the Fed "pays" for the bonds it buys.

Best bet is that the inflation number will not impact the Fed's plans, because they know that all that money they've created is just sitting out there on the books of the banks and corporations, waiting to move into action. If "velocity" picks up, prices could spurt higher quickly. Just look at how much money the Fed has added to the system in the effort to save the economy since the financial collapse.

The Fed has purchased bonds, now sitting in its "inventory." The issue of "taper" is not whether the Fed will sell those bonds, sucking money out of the economy, but whether they will stop buying more every month.

Retirees & Savers: The low CPI is bad news for retirees and savers in two ways. First, the annual Social Security Cost-of-Living (COLA) increase is based on the CPI. Lower reported inflation means smaller increases in Social Security monthly benefits. In fact, the Congressional Budget Office has already estimated that the 2014 increase will be only 1.5 percent, slightly less than the meagre 2013 increase of 1.7 percent. The typical monthly benefit would increase by about $18.36, or $220 per year. (If the president's proposal to use the "chain-weighted CPI" goes into effect, the monthly increase would be even lower, resulting in only a roughly $15 monthly increase, according to Bankrate.com.

All of these "savings" on Social Security because of lower inflation is good news for the Federal budget, but bad news for retirees. Then add in the lower interest rates that typically accompany low inflation, and retirees' income from interest will also remain low.

Business and Jobs: While low inflation is good for business, if inflation drops even to a negative level -- deflation -- it would be very bad news for business, and the jobs created by business. Deflation would signal falling prices, and likely falling profits. That is not an environment in which business decides to expand, even if it can borrow at low rates.

Borrowers: Deflation hurts borrowers. It makes debt more expensive to repay. That's just the opposite of inflation, which makes debt repayment easier because you're repaying with cheaper dollars. But deflation, even in a low interest rate time, makes it harder to get the money to repay debt -- whether you're a business trying to make profits, or an employee who doesn't get a raise.

Well, I should qualify that last paragraph to say: Deflation hurts borrowers -- unless you can print the money to repay your debts!

That's the strategy being followed by the Fed to help the U.S. government repay its $17 trillion national debt. They can't afford inflation and rising interest rates on U.S. debt.

But it's a tricky strategy, because if the economy falls into true deflation and shrinking growth, no one will win. And that's The Savage Truth.

Popular in the Community

Close

What's Hot