Oh, wow, how I love watching the movie, “Ghostbusters.” Just saw it again the other night. One of the main themes of the film is, “don’t cross the streams.” Of course when the ghostbusters do cross the streams of their nuclear guns, they destroy the enemy.
Is inflation an enemy? One of the responsibilities of the U.S. Federal Reserve Bank (the Fed) is controlling the inflation rate in the United States. Destroying inflation is not a good thing. A result of destroying inflation is the possibility of deflation. Wait a minute, let’s get a couple of definitions out of the way first then get on with the story of the “villains” inflation and deflation.
Here we go, Investopedia’s definitions of inflation and deflation:
DEFINITION of ‘Inflation’
Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
Read more: investopedia definition: inflation
DEFINITION of ‘Deflation’
A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. Central banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the excessive drop in prices to a minimum. The decline in prices of assets, is often known as Asset Deflation.
Read more: investopedia definition: deflation
Inflation and the 2008 Global Recession
The Fed monitors the “rate of inflation” very closely. When the Fed implemented its QE (quantitative easing) programs there was a lot of concern about the vast amount of money (more than 3.5 trillion dollars) being introduced in the U.S. economic system, e.g increasing the money supply. Would this vast amount of money cause hyperinflation?
Central banks have tried to learn from such episodes, using monetary policy tools to keep inflation in check. Since the 2008 financial crisis, the U.S. Federal Reserve has kept interest rates near zero and pursued a bond-buying program – now discontinued – known as quantitative easing. Some critics of the program alleged it would cause a spike in inflation in the U.S. dollar, but inflation peaked in 2007 and declined steadily over the next eight years. There are many, complex reasons why QE didn’t lead to inflation or hyperinflation, though the simplest explanation is that the recession was a strong deflationary environment, and quantitative easing ameliorated its effects.
Read more: http://www.investopedia.com/terms/i/inflation.asp#ixzz3jDZ6ow1l
An example of hyperinflation is the economic crisis that the country of Argentina experienced in the late 1980’s. See this article from the New York Times.
The U.S. stock market, “Wall Street”, has been anticipating that the Fed will be raising rates for the past year or so. The Fed has been monitoring the inflation rate. Interest rates might rise depending upon how much (high) the inflation rate rises. This is a very complicated calculation that the Fed compiles. The inflation rate is calculated using the Consumer Price Index, which, in itself, is a controversial measurement tool.
The Fed also watches the unemployment rate for a guide to decide upon raising the interest rate. As mentioned in an earlier blog (Eye Crosser#5: What is Inflation?), the Fed has three (3) mandates:
- promote maximum employment
- stable prices
- moderate long-term interest rates
The Fed has maintained a “near” zero percent interest rate in the United States for almost ten (10) years. This has meant that savers have earned very negligible (if any) interest on their savings, money market or CD (certificate of deposit) accounts on deposit at banks. This zero interest rate policy has devastated savers. They are using (spending) the principle and not just the interest earned on their savings. Those on “fixed incomes” meaning collecting Social Security, and not working in the U.S. workforce, are using up their retirement savings at a more rapid rate than anticipated.