Wednesday, October 27, 2010

Two Kinds of Inflation

Inflation can be observed and measured in two ways. One is changes in the Consumer Price Index (CPI), a representative basket of goods and services that excludes financial assets, but measures the rental value of owner-occupied housing and rental housing. A second is asset price inflation, which includes changes in the prices of stocks, commodities, houses, and precious metals.

The U.S. Federal Reserve Board looks at CPI-based inflation, which is further segregated into core and non-core inflation. Core inflation excludes food and gasoline. The Fed may glance at asset-price inflation, but does not give it the same attention in setting monetary policy.

The Fed prints money when it purchases financial assets (quantitative easing). Most analysts forecast another half-trillion or trillion dollars of additional fed purchases in the coming year. Where does (will) this money go?

If banks don’t want to lend when they can borrow from the Fed at zero interest and buy long-term treasuries at 4%, why should they undertake more risky lending? If business firms with lots of cash on their balance sheets don’t want to invest, which would mean more jobs, why will additional money matter (so long as the Fed gives the impression that deflation is a bigger risk than inflation)? That leaves precious metals, commodities, and equities to absorb the additional cash, as money will not flow into housing given the foreclosure mess.

If this line of thought is correct, by the time fears of deflation have been fully arrested, and the Fed begins to offload the financial assets it has purchased over the past few years, a new bubble may have formed in the financial markets. To arrest that bubble without popping it could be the next exciting adventure in the world of money.

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