Has the inflation monster really been captured?

The European Central Bank claims to have captured the inflation monster. No chance, says Mike Shedlock in the Daily Reckoning. For a start, inflation is merely an increase in the money supply - and central banks are the main culprits when it comes to that. All they can do is make the inevitable credit crunch much worse...

I am pleased to report that the inflation monster has been captured and placed in a jar.

This stunning announcement as well as an accompanying video detailing the highlights was made by the European Central Bank, in cooperation with the national central banks of the euro area. Along with the announcement, the ECB has produced an information kit on inflation entitled 'Price stability: why is it important for you?' It is targeted at young teenagers and teachers in all the official languages of the European Union.

The ECB's eight minute video is actually somewhat entertaining so I recommend that everyone click on this link take a look:

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Even though it is entertaining, it sure flops as an educational tool unless of course the goal is self-serving propaganda by the ECB, for the ECB.

Unfortunately the video does not explain that the real source of inflation is the printing of money by the central bank itself. Nor does it explain why 2% is such a good inflation target. Finally it does not explain how prices across the board can be contained by broad-brushed practices like setting of short-term interest rates.

Those things were not explained simply because they cannot be explained.

Why should inflation be targeted at 2%, not 1% or 3%? Why should any inflation be targeted at all? Even if it were for some reason smart to target prices, can prices really be measured accurately? What do central banks do to overcome lag effects of monetary tightening and loosening? Is this just blind faith that 'we know neutral when we see it'?

The problem, of course, is targeting prices in the first place. Sometimes, money flows into houses and shares and bonds, instead of goods and services. Sometimes, productivity improvements mask inflation. Sometimes falling commodity prices mask inflation. Of course, I am talking about 'real inflation' as measured by increases in money supply, as opposed to hedonically adjusted price inflation, as seen through the eyes of central bankers.

The last paragraph is exactly what made a fool out of Alan Greenspan. In the mid-to-late-1990s, 'real inflation' (a rampant increase in money supply) was masked by productivity improvements, falling oil prices, and falling prices of goods from Asia. Greenspan called it a 'productivity miracle'. It was a 'miracle' indeed.

Rampant increases in money supply fuelled the 2000 stock market bubble and spawned nonsensical talk about 'new paradigms'. Then, in the sheer 'after-the-bubble-pops' panic adjustments that he likes to make, Greenspan refused to allow a recession to run its course. Instead, he slashed interest rates to 1%, fuelling the biggest housing bubble the world has ever seen.

Here we are three short years later, now facing a 'new paradigm' in housing, with debt levels far worse at both consumer and governmental levels.

Greenspan will soon be gone. Bernanke is next to bat, waiting in the stands. Like the ECB and also the Bank of England, which started this whole charade of course - Bernanke wants to set US price inflation targets of 2%.

I have some advice for him: It simply cannot work.

With all the hedonic adjustments, with all the nonsense about core versus noncore inflation, with all the imputed economics, with all the understating of medical costs, and with enormous discrepancies between rental costs and housing ownership costs, there is not a person on this earth who could possibly know 2% price increases if they hit them smack in the face.

Compounding the problem for these so called 'inflation fighters' is energy costs. One reason energy costs are rising is Peak Oil. Another reason oil costs are high is geopolitical tensions. A third reason energy prices are high is supply disruptions. Finally, oil and natural gas demand are relatively inelastic. As prices go up, people more or less have to pay. To maintain a CPI price target of 2%, central banks might have to raise interest rates to unreasonably high levels if energy prices are included in their measurements. That clearly would be bad policy. The root problem, of course, is assuming it is wise to target prices, rather than money supply, in the first place.

I almost forgot to mention that the ECB claims to have 'the deflation monster' bottled up as well. I guess we will see, but I think they are hopelessly wrong. The ECB points out 'deflation monster' problems when, in fact, deflation is both a blessing as well as the natural state of affairs.

Rising productivity is 'price deflationary'. More goods are produced faster by fewer people. Prices naturally decline as a result. Look at how few farmers today produce more grain than 100 times as many farmers did not that long ago. Corn prices fell to 1943 levels a couple weeks ago. Is that a problem? For whom? It's only a problem because the United States' and Europe's central banks blow countless billions of dollars every year on price crop supports. It is a total waste of money.

Bear in mind that China is actually losing textile jobs. The enquiring mind might be asking to whom? The answer might be shocking: to no one. Fewer workers are needed to turn out the same amount of goods. That is one of the reasons this protectionist talk you hear right now out of Congress is total nonsense. Those jobs simply are not coming back, ever. Cranking up money supply in an attempt to create jobs lost by productivity improvements and outsourcing can only result in asset bubbles and/or increased overcapacity. Besides, who does not like lower prices on goods and services?

If deflation is such a good thing, why do central banks fear it? One answer is because deflation is debt's worst enemy. If asset prices and wages fall, people cannot possibly ever pay back what they owe. Banks and credit card companies don't seem to like that state of affairs.

Is that a problem with deflation? No, that is a problem created by reckless lending, easy credit, and the endless cheerleading on CNBC every time consumer spending rises and people sink heavier into debt.

The second answer is because inflation benefits those who receive money first. The government and banks are at the very top of the list. The former benefits via automatic tax increases not indexed to inflation (especially property taxes), the latter simply because banks are first in line to receive money from the Fed or the Bank of England or the ECB at rates no one else sees. By the time lending standards drop so that the masses have access to credit, the boom is well under way. By the time credit is granted to anyone that can fog a mirror, the boom is nearly over. Those buying assets late in the game will eventually be crushed by those selling assets who got in early. Simply put, inflation eventually becomes a moral hazard.

We are now at or close to the pivot point. The pivot point - or tipping point, if you prefer - is when consumers cannot or will not take on any more debt and/or corporations simply are unwilling or unable to extend more credit. I have been writing about various tipping points for some time now, and we seem to be hitting those tipping points simultaneously in many areas: jobs, housing, consumer spending, and credit expansion.

The mal-investments of the have-it-now, me-too ownership society are about to be unwound. We are where we are because central banks have printed ever-expanding amounts of money to prevent normal business cycles, to satisfy politicians wanting to waste more taxpayer money with silly projects, and to foolishly fight deflation.

The only thing the central banks have accomplished is putting off the inevitable deflationary credit crunch, while making it worse along the way.

There are many who think true deflation meaning a decrease in the money supply - cannot happen under a fiat system. I disagree, but perhaps the point is moot.

Money supply itself actually never contracted in Japan. Instead, it grew very slowly for quite some time.

However, bank credit outstanding contracted for 60 months in a row. Clearly, there was a credit contraction. How did money supply still manage to grow?

Fiscal deficits were ramped up immensely, roads to nowhere were built, and the Bank of Japan monetised all of it.

In addition, money velocity plummeted. The net effect of the credit contraction on prices was clearly what one would nowadays call 'deflationary'. Prices across a broad range of assets and goods and services fell.

Indeed, practically everything fell but government bonds. People were amazed at the alleged 'bond bubble' as well as the zero interest rate policy (ZIRP) of the BOJ. However, a 1% interest rate on a 10-year bond makes sense when prices fall 2.5% annually. The real yield is, obviously, far higher than 1%. Perhaps a practical way to think of deflation under a fiat system is the destruction of credit/debt that exceeds growth in money supply.

Regardless of social and economic differences, I fully expect the United States to follow in the footsteps of Japan. Although a central bank might be able to sustain a certain amount of inflation by resorting to extreme measures, it cannot stop a credit contraction in the private sector. Nor will a central bank bail out consumers at the expense of themselves and other creditors. The Fed, like the BOJ, will stop short of destroying itself and its power.

Life would be so much simpler if central banks everywhere would stop trying to micromanage both prices and economic cycles. Quite simply, they are trying to achieve nirvana when nirvana cannot possibly be measured, nor can nirvana be achieved in the first place with the policies they have in place.

Yes, we will still have economic cycles if central banks do those things, but the cyclical peaks and valleys would not be as exaggerated as they are now. It seems as if we have learned nothing from the Great Depression or the more recent experience of Japan. I fear we may get a second chance.

By Mike Shedlock for The Daily Reckoning

Michael 'Mish' Shedlock worked in the US financial services industry for 20 years at some of the top institutions in the country including Harris Bank, the Bank of Montreal, Bank One, First National Bank of Chicago, and First Data Corp. Mish runs one of the more popular stock boards on the Motley Fool, Investment Analysis Clubs/Mishedlo and one of the more popular boards on Silicon Investor, Mish's Global Economic Trend Analysis. You can see more of Mish's writing on his blog also entitled Mish's Global Economic Trend Analysis, and he also writes regularly for the Whiskey & Gunpowder newsletter.