Overblown Inflation Fears

I believe the people who say we are going to have 10-12% inflation in the next few years are dead wrong.

http://www.cnbc.com/id/32300097

These people do not understand the nature of this recession. As discussed in an earlier post this recession is unique because it is being caused by a massive decrease in aggregate demand.

When aggregate demand collapses, prices fall, and you have deflation....not inflation. There are basically two types of inflation:

1) Inflation caused by increases in aggregate demand that result from people being willing to pay high prices for a good because they want it badly. This is offset when suppliers increase production to match demand, and prices stabilize, or move back to equilibrium. Or, in some markets, the limited supply keeps prices high relative to other goods or assets.

2) Inflation cause by manipulation of the money supply is different. This is when the government prints money, creating such a large supply of it (the paper stuff) that it takes more money to buy the same product one day than it did the day before. Usually this happens when governments have so much debt that they literally must print money to make the payments on that debt. In this case inflation is a monetary phenomenon.

In order for the first type of inflation to take hold we would have to see a massive increase in aggregate demand, while the government held interest rates very low or close to zero.

In order for the second type to take hold, demand for U.S. Treasuries would have to dry up, foreign holders of our currency would have to start selling it at a rapid pace, and our government would have to make the unwise decision to run the printing presses at full speed. Many people make the mistake of thinking that holding interest rates close to zero is the same as printing money, it is not. The federal reserve can take money out of the system almost as fast as it puts it in when the economy is slow. If aggregate demand was high and the money multiplier effect took hold, that would be a different story. But for now, there is little or no risk of that because the over leveraged unemployed American consumer has no more money to spend.

Cost cutting by corporations is another deflationary force. That is how companies are beating earnings expectations this quarter, not with top line growth. The next quarter will be horrendous, with the possible exception of the financials, because of their trading gains.

I hope that gives you some insight into inflation and why this rally is only a bear market trading bounce.