Tuesday, June 08, 2010

Bernanke’s Swatting at the Deflation Windmill

Of late, economists, policy makers and pundits have joined forces to denounce the avowed common enemy of deflation, or falling price levels. Not surprisingly, the Federal Reserve (Fed), much like Don Quixote’s attack on animated windmills, stands ready to slay an imaginary foe; in this case deflation.

Supporting the Fed’s hand wringing and angst, Fed Chief Ben Bernanke points to a core consumer price index (CPI) that climbed at its slowest pace since 1966, or just under one percent over the past year. Unfortunately it is inflation and prices bubbles, in my judgment, that jeopardize U.S. economic progress. Remember the CPI is the price gauge for a market basket of goods purchased by an average urban consumer. Much like the drunk with one hand in the refrigeration and the other in the fireplace, everything is on average “ok.”

That is, averages are masking price bubbles and troubling trends in certain areas. For example over the past year, education prices climbed by 4.8 percent and medical costs expanded by 3.3 percent. Furthermore with the CPI overweighting housing, pullbacks in housing prices are producing a CPI that is not representative of a bubbling brew of inflationary pressures that once underway become very, very difficult to slow or halt. A second more sinister outcome is an asset bubble, or an extended period of time, in which assets are overvalued. That is, the mantra “buy low, sell high,” is replaced by “buy high-sell higher.” Under the guidance of Bernanke, the U.S. central bank has lowered the federal funds rate from 5.25 percent in June 2006 to the current level of 0 percent. This aggressive and record rate cutting has contributed to gold prices soaring by more than 98 percent and 10-year U.S. Treasury bond prices skyrocketing by approximately 42 percent. These and other bubbles will burst with very negative consequences unless the Fed begins immediately to increase interest rates.

Ernie Goss

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