Thursday, July 13, 2006

Managing inflation expectations

Jim Puplava discusses the purposeful jawboning of the Fed's "Open Mouth Committee" in a segment from the June 1 Financial Sense Newshour broadcast. What is the purpose behind this non-stop barrage of talk and signaling to the markets? Jim shares his view:

I think what you saw happen and this was the Open Mouth Committee that you saw throughout the month of May, and parts of June, that scared the bloomers off everybody was inflationary expectations started to increase. The last thing you want as a Federal Reserve is for those inflationary expectations to take hold because then what you have is your money velocity starts to increase. People start buying and spending their cash faster because buy now because the price is going to go up.

That was what they were trying to control with the Open Mouth Committee and they were successful. They brought some of those inflationary expectations down, and that’s why they were so active.

The need to manage inflationary expectations is paramount among central bankers; they must keep up the appearance of "inflation fighters", thereby distracting the public from the true causes of inflation. In a fiat money system, in which currencies are backed by nothing of real value, the currency is held up by government dictat and public faith. When faith in money erodes, the purchasing power of that currency erodes with it. This happens gradually over time and sometimes culminates in a rapid depreciation of monetary value known as hyperinflation.

Many commentators today confuse the cause of inflation (expanding supply of money and credit) with its frequent effect: a rise in prices of goods, services, or assets. A similar confusion exists regarding the true nature of deflation (a contracting supply of money or credit).

The classical definitions of inflation and deflation have been subject to change over time and this is reflected in the current debate. The following quote is taken from an article by Tim Picks entitled, "Understanding Inflation and Deflation".

the definition of inflation has changed over time and is now accepted to mean something very different from its original definition. Dictionaries only reflect what is currently popular, so such definitions should not be blindly accepted.

Originally, inflation meant an increase in the supply of money and credit. Then it morphed into: a rise in the general level of prices caused by an increase in the supply of money and credit. And now it has come to mean the CPI (Consumer Price Index).

This had caused much confusion. It can also lead to flawed analysis and some very bad policy decisions. In my opinion, the currently accepted definition of inflation is full of assumptions, fallacious reasoning, and faulty conclusions.

Now add Jim Puplava's interpretation of inflation as a monetary phenomenon. From a past article entitled, "Good and Bad Inflation":

When a government or central bank creates additional money through fiat means, it creates inflation. The real definition of inflation is an increase in the supply of money beyond any increase in specie. 1

By its very definition, it attributes the real cause of inflation to its root source which is expansion of the supply of money and credit through artificial means. Its real cause is an act of fraudulent intervention into the financial and economic system distorting values, investments, and in the process, the distribution pattern of wealth and income within the economy.

So as you can see, we have two market participants/commentators who do not accept the popular application of the word inflation. The term has been misdefined, and in the process its true meaning has been obscured. Just some food for thought, so keep your ears peeled the next time you hear someone bandying those terms about.