Friday, November 30, 2007

What Is Inflation ?

Let’s first break this question down into the two types of inflation; monetary inflation and price inflation. Price inflation is the general rise in prices of goods and services. This is the one everyone talks about. You here the complaint "Gee…how expensive "fill in the blank" has gotten!" It is important to point out that price inflation is not a problem; it is a symptom . This is a very crucial difference. If price inflation is a symptom, then what is the problem? The problem is monetary inflation. "Monetary inflation" is a fancy phrase meaning the creation (really "excessive" creation) of a particular currency. In our case, it is the excessive creation of Riyals. Those riyals can be infused into the economy either through the actual printing (or electronic creation) of riyals or through credit ultimately issued by a central & commercial banks. In any case, monetary inflation is the cause of price inflation.

Stated another way, monetary inflation is the problem and price inflation is the symptom. Monetary inflation means increasing the money supply. Keep in mind that when we talk about "price inflation", it doesn’t always mean rising prices of goods and services; it can also mean that assets can experience price inflation as well. Whenever we hear about an "asset bubble" it is a reference to how an asset has risen in price far above its realistic market price (the effects of supply-and-demand) due to an excessive influx of monetary inflation. Some recent examples of asset bubbles (excessive price inflation of assets due to the problem of monetary inflation) are the Internet/ Tech stock bubble of the late 1990s and the real estate bubble of 2002-2006 and the saudi stock market's bubble of 2006.
It is an important distinction to point out the difference of a "bull market" and an "asset bubble". A bull market—rising prices for an asset (such as stocks, real estate, etc.)—is a natural and ordinary event. It is an extension of supply-and-demand; there are more buyers than sellers of the asset so the result is "rising prices." An asset bubble is an artificial and unnatural event. The rise in the price of the asset is primarily driven by monetary inflation (such as through the excessive issuance of credit). Because a bubble is unnatural and ultimately unsustainable, it inevitably "pops"; the artificial boom then becomes an artificial bust. As the economist Ludwig von Mises ( painstakingly pointed out, booms and busts (as well as recessions, depressions and hyper-inflation) are not creations of a free market; they are in fact created by government mismanagement of monetary and fiscal policy. Back to inflation…

Why is it necessary to "fight inflation"?
Inflation is a pernicious and destructive economic force. Inflation at a real-world rate of 2% or lower (preferably ‘zero") is tolerable for an economy. 3-5% inflation is bad but it can be manageable. Beyond that, it can be destructive. When inflation soars into double digits and beyond, it can cause tremendous damage to the economy. Thanks to the efforts of private sources (coupled with data from the Federal Reserve), it has been recently (early 2007) calculated that price inflation is in the 6-9% range and the money supply is expanding at an alarming rate of about 13%. Keep in mind that inflation is effectively a hidden tax that wreaks the most havoc to lower income and middle income folks. Inflation destroys purchasing power and those with limited income, fixed income or little in the way of savings are hurt the most. This is why there are many analysts that have voiced the opinion that the United States (specifically the Federal Reserve) should significantly limit and/or shrink the growth of the money supply and eventually return to the gold standard.
During the hundred-year span of 1812-1912, there was virtually no price inflation as our country strictly adhered to a gold standard. From 1913 to the 1930s, the United States slowly, partially and then completely abolished the gold standard in our economy. The end result was that a dollar that was worth 100 cents in 1913 is now, in 2007, worth less than three cents.
If monetary inflation is the problem, who is responsible?
Central bank / commercial banks
So what should the Fed be telling us about inflation?
They should be informing us about monetary inflation. Specifically, the management and growth of the money supply. The Fed can start by reinstating the M3 money supply measurement which they stopped reporting in March 2006. M3 is the broadest measure of the money supply and it is indeed a critical number for the financial markets. Fortunately, M3 was reconstructed by private sources (such as The money supply growth rate hit an astounding and disturbing 13% recently. This is the real problem and all of us need to be informed about excessive monetary inflation and its’ insidious effects.

What is the core rate of inflation?
Here is where the controversy lies. When you talk to some reporters and economists, they will tell you that the core rate is important to the Fed and to the financial markets. Please understand the following point; the core rate is not important and it should be dropped or ignored. As a financial planner, educator and writer, it is definitely not important to me or to my clients, students and readers. What possible importance does it have? It is only important to the Fed and to some politicians but beyond that, the core rate is useless, meaningless and misleading. If this commentary sounds too harsh, then let’s think about it for a moment. Think about why the core rate is only important to the government.
It is not an accident that Bernanke and other officials spend most of their time talking about the core rate and not about monetary inflation or "real-life" inflation. Imagine for a moment that you are the head of the Fed. Would you rather talk about monetary inflation and the money supply (what you are directly responsible for) or about something vague and distant like … the core rate of inflation? If you were responsible for inflation, what would you rather talk about; an inflation rate of 6-9% (the realistic inflation) or about some benign, vague rate that is only a measly 1.9%?
Let’s face it; the more Bernanke talks about "the core rate" and about "being under 2%", the more the financial press reports the same. The average reporter ends up thinking "gee, he’s talking so much about the core rate…it must be important!" Again, it is important to the government because that way they can talk about some seemingly innocuous measurement and essentially keep everyone calm. "Excited? Concerned? About what? After all, the core rate is only a measly 1.9%!"
The more tangible reason for the government to under-report inflation is so that payments to Social Security recipients and other pensioners are lower. Keep in mind that the initial wave of baby boomers (78 million total.) start retiring in 2008. Over time, every percentage point that is not being paid is worth trillions. So now we can see a solid reason why a lower inflation rate is important to the government. A lower rate is good publicity and it also means trillions in savings.
Why isn’t the core rate important to the financial markets?
Why isn’t the core rate important to retirees?

Why isn’t the core rate important to investors?
As you read this, millions of investors are making choices with their money. What will they invest in? If they think that inflation is benign, then they will invest accordingly. But what if they were aware of real-world inflation? Think about your own actions. What would you do differently if you knew that inflation was 8% instead of 2%? You would certainly invest at least a portion of your portfolio in inflation hedges such as gold, silver, energy and related securities. For investors, a return must be generated that meets or exceeds the real-world rate of inflation. Yes…that includes the costs of food and energy. Therefore, for investors, the core rate is meaningless.

* We spend little or no time addressing the problem (monetary inflation).
* We spend too little time addressing real-world price inflation
* We spend very little time addressing the point that the dollar is losing value due to excessive monetary inflation.
* We spend too much time talking about the core rate of inflation which has no real value to consumers, retirees, investors or anyone else for that matter.

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