Safehaven | Inflation; Rotten to the Core

August 03, 2007

Inflation; Rotten to the Core
by Paul Mladjenovic

Recently, a venerable financial news website ran a recent headline (July 31, 2007) about the core rate of inflation; "U.S. core rate of inflation falls to three-year low of 1.9%". It is pronounced as a positive development for our economy and therefore treated as if it were an important piece of news. Before we get to the "hard-core" analysis, I think it would be helpful to do a brief primer on inflation. In the general financial media, there is a surprising amount of misunderstanding and misinformation on inflation in general and on the "core rate" in particular. Let's get some perspective on the terms and principles (just in case a politician, bureaucrat or financial reporter is reading this):

What is inflation?
Let's first break this question down into the two types of inflation; monetary inflation and price inflation. Price inflation is the general rise in prices of goods and services. This is the one everyone talks about. You here the complaint "Gee...how expensive "fill in the blank" has gotten!" It is important to point out that price inflation is not a problem; it is a symptom. This is a very crucial difference. If price inflation is a symptom, then what is the problem? The problem is monetary inflation. "Monetary inflation" is a fancy phrase meaning the creation (really "excessive" creation) of a particular currency. In our case, it is the excessive creation of dollars. Those dollars can be infused into the economy either through the actual printing (or electronic creation) of dollars or through credit ultimately issued by a central bank. In any case, monetary inflation is the cause of price inflation.

Stated another way, monetary inflation is the problem and price inflation is the symptom. Monetary inflation means increasing the money supply. Keep in mind that when we talk about "price inflation", it doesn't always mean rising prices of goods and services; it can also mean that assets can experience price inflation as well. Whenever we hear about an "asset bubble" it is a reference to how an asset has risen in price far above its realistic market price (the effects of supply-and-demand) due to an excessive influx of monetary inflation. Some recent examples of asset bubbles (excessive price inflation of assets due to the problem of monetary inflation) are the Internet/ Tech stock bubble of the late 1990s and the real estate bubble of 2002-2006.

It is an important distinction to point out the difference of a "bull market" and an "asset bubble". A bull market -- rising prices for an asset (such as stocks, real estate, etc.) -- is a natural and ordinary event. It is an extension of supply-and-demand; there are more buyers than sellers of the asset so the result is "rising prices." An asset bubble is an artificial and unnatural event. The rise in the price of the asset is primarily driven by monetary inflation (such as through the excessive issuance of credit). Because a bubble is unnatural and ultimately unsustainable, it inevitably "pops"; the artificial boom then becomes an artificial bust. As the economist Ludwig von Mises (www.mises.org) painstakingly pointed out, booms and busts (as well as recessions, depressions and hyper-inflation) are not creations of a free market; they are in fact created by government mismanagement of monetary and fiscal policy. Back to inflation...

Why is it necessary to "fight inflation"?
Inflation is a pernicious and destructive economic force. Inflation at a real-world rate of 2% or lower (preferably "zero") is tolerable for an economy. 3-5% inflation is bad but it can be manageable. Beyond that, it can be destructive. When inflation soars into double digits and beyond, it can cause tremendous damage to the economy. Thanks to the efforts of private sources (coupled with data from the Federal Reserve), it has been recently (early 2007) calculated that price inflation is in the 6-9% range and the money supply is expanding at an alarming rate of about 13%. Keep in mind that inflation is effectively a hidden tax that wreaks the most havoc to lower income and middle income folks. Inflation destroys purchasing power and those with limited income, fixed income or little in the way of savings are hurt the most. This is why there are many analysts that have voiced the opinion that the United States (specifically the Federal Reserve) should significantly limit and/or shrink the growth of the money supply and eventually return to the gold standard.

During the hundred-year span of 1812-1912, there was virtually no price inflation as our country strictly adhered to a gold standard. From 1913 to the 1930s, the United States slowly, partially and then completely abolished the gold standard in our economy. The end result was that a dollar that was worth 100 cents in 1913 is now, in 2007, worth less than three cents.

The problem today is that most people think that inflation is low yet the public record clearly shows monetary inflation (and the resultant price inflation) growing at a dangerous rate. The public needs to be informed so that proper planning can avert a long-term disaster. If the situation does not markedly improve, 2010-2020 could rival the 1930s in terms of economic hardship.

If monetary inflation is the problem, who is responsible?
"Monetary inflation" and "monetary policy" are the responsibility of those in charge of the money supply; typically the nation's central bank. A central bank is essentially the government-sanctioned entity that creates and manages the general money supply of the country whether that money ("the currency") is in the form of dollars, euros, yen or what-have-you. For the United States, our currency is obviously the dollar and our central bank is the Federal Reserve. The bottom line is that the Federal Reserve is responsible for the money supply and, therefore, monetary inflation.

By the way, let me address a point before people email me about it. Yes...the Federal Reserve is technically chartered as a private corporation but please make no mistake about it; it is a government entity with the full backing and sponsorship of the federal government. What private corporation has the ability to print money? Only a government-sanctioned entity; in this case, the "Fed".

When you hear the Federal Reserve chairman, Ben Bernanke talking about "price inflation" and "keeping a close eye on what happens with rising prices" and how "rising prices are inflationary" and so forth, it has to make a logical and discerning person scratch his/her head. It is much like a prolific arsonist wondering out loud about suspicious fires. Find out for yourself; here's a research tip: Read (or listen to) Mr. Bernanke's recent speeches. He will talk very much about price inflation but little (anything?) about monetary inflation. The last speech I heard, he made inflation almost sound like the weather as if it "just happened" and it was out there floating around in the atmosphere. At congressional hearings, you'll even hear him say things like "the Fed will do everything it can to contain inflation". At what point will those politicians just say "stop printing so much damn money and price inflation will come down!" It would be like the authorities saying to the arsonist "If you would just stop setting fires there would be less stuff burning down!" Get the picture?

So what should the Fed be telling us about inflation?
They should be informing us about monetary inflation. Specifically, the management and growth of the money supply. The Fed can start by reinstating the M3 money supply measurement which they stopped reporting in March 2006. M3 is the broadest measure of the money supply and it is indeed a critical number for the financial markets. Fortunately, M3 was reconstructed by private sources (such as www.shadowstats.com). The money supply growth rate hit an astounding and disturbing 13% recently. This is the real problem and all of us need to be informed about excessive monetary inflation and its' insidious effects.

What is the core rate of inflation?
Price inflation is usually reported in two basic ways; "headline inflation" and the "core rate of inflation". Headline inflation generally includes a cross section of the prices of a representative basket of goods and services that consumers ("the public") contends with. The "core rate" is inflation excluding "food and energy". As headline inflation was running 6-9%, the core rate was running at just under 2%. Ironically, even though headline inflation is a more realistic measure of price inflation, it is the core rate that actually gets all the headlines!

Why does the core rate exclude food and energy?
That is a good question and quite frankly, you will not get a rational, logical answer. The answer most frequently given as to why food and energy are excluded are because they are too "volatile". I think a reasonable response should be "So what?" If you can't provide a meaningful measure on a monthly basis, then do it quarterly, semi-annually or annually. If we can "send a man to the moon" then surely we can provide a meaningful measurement of the rising prices of consumer necessities (which definitely includes food and energy!).

Why is the core rate important?
Here is where the controversy lies. When you talk to some reporters and economists, they will tell you that the core rate is important to the Fed and to the financial markets. Please understand the following point; the core rate is not important and it should be dropped or ignored. As a financial planner, educator and writer, it is definitely not important to me or to my clients, students and readers. What possible importance does it have? It is only important to the Fed and to some politicians but beyond that, the core rate is useless, meaningless and misleading. If this commentary sounds too harsh, then let's think about it for a moment. Think about why the core rate is only important to the government.

It is not an accident that Bernanke and other officials spend most of their time talking about the core rate and not about monetary inflation or "real-life" inflation. Imagine for a moment that you are the head of the Fed. Would you rather talk about monetary inflation and the money supply (what you are directly responsible for) or about something vague and distant like ... the core rate of inflation? If you were responsible for inflation, what would you rather talk about; an inflation rate of 6-9% (the realistic inflation) or about some benign, vague rate that is only a measly 1.9%?

Let's face it; the more Bernanke talks about "the core rate" and about "being under 2%", the more the financial press reports the same. The average reporter ends up thinking "gee, he's talking so much about the core rate...it must be important!" Again, it is important to the government because that way they can talk about some seemingly innocuous measurement and essentially keep everyone calm. "Excited? Concerned? About what? After all, the core rate is only a measly 1.9%!"

The more tangible reason for the government to under-report inflation is so that payments to Social Security recipients and other pensioners are lower. Keep in mind that the initial wave of baby boomers (78 million total.) start retiring in 2008. Over time, every percentage point that is not being paid is worth trillions. So now we can see a solid reason why a lower inflation rate is important to the government. A lower rate is good publicity and it also means trillions in savings.

Why isn't the core rate important to the financial markets?
After the government, who's left? Is the core rate important to the financial markets? In the financial markets, there are trillions of dollars in bonds and other fixed-interest vehicles. Much of it is with rates in the 3-5% range. If they think that the official rate of inflation is under 2%, they will presume that they are ahead of the game. But is that reality? Of course not. What good is a 5%, 30-year bond if inflation is 6-9% (or higher)? Over time you are falling behind. In regards to the financial markets, the core rate is misleading.

Why isn't the core rate important to retirees?
Millions of retirees have their money in safe investments such as savings, certificates of deposit and bonds. They have worked all their life to accumulate money for their retirement years. Unfortunately, inflation is a cruel and stealthy tax that can destroy their purchasing power. The "cost-of-living" increases they will get from Social Security and other pension programs will not keep them ahead of real-world inflation. Millions of older citizens will see their prosperity erode over time. The core rate is useless to them. It is in fact very detrimental to retirees.

Why isn't the core rate important to investors?
As you read this, millions of investors are making choices with their money. What will they invest in? If they think that inflation is benign, then they will invest accordingly. But what if they were aware of real-world inflation? Think about your own actions. What would you do differently if you knew that inflation was 8% instead of 2%? You would certainly invest at least a portion of your portfolio in inflation hedges such as gold, silver, energy and related securities. For investors, a return must be generated that meets or exceeds the real-world rate of inflation. Yes...that includes the costs of food and energy. Therefore, for investors, the core rate is meaningless.

Perhaps I have missed someone in this inflation discussion. How about you... the reader? How important is the core rate to you? If it is important, then please tell me why it is important. Please feel free to email me at my website, www.supermoneylinks.com. If you have been able to get by without food and energy costs...hey...I'd love to know how you do it. I will even provide your answers to the readers of my newsletter, the Prosperity Alert (with your permission, of course). I thank you in advance!

But before you send me any messages about inflation (core or otherwise), allow me a moment to write my own letter...
An Open Letter to Ben Bernanke

Dear Mr. Bernanke,

I hope all is well with you. I write you as a concerned citizen regarding your recent public testimony. Your job as the head of the Federal Reserve, America's central bank, is assuredly a daunting and difficult task and I wish you much success. The Federal Reserve plays a vital and pivotal role in our country's economic well-being. Forgive me for being so forward but please consider the following. I think that you could serve our citizenry much more effectively if you enact a few relatively simple changes. They may be simple but they may not be easy. After all, nothing worthwhile is easy. Here goes...

Please reinstate the M3 money supply metric. It is an important measure of monetary inflation. This is a good way to know how monetary inflation is affecting us today and how it will impact our future real-world cost of living and the value of the dollar.
Please stop talking about the core rate. It is a useless, meaningless and misleading metric that serves no one except the government. It is very much like my local grocer boasting about the low "price of clouds".
Give us a realistic measure of inflation. This is critical to know so that we can better manage our finances and that of our families and businesses.
Stop excessively inflating the currency. History tells us overwhelmingly that excessive monetary inflation has driven man-made currencies into oblivion and has resulted in economic & social chaos for civilized society.

Suggestions # 1, 2 and 3 could easily be implemented immediately. Suggestion #4 will take some fortitude since many influential politicians (in both major parties) would prefer you do otherwise. Don't take the politically easy choice. Millions of hard-working folks need you to do the right thing.

I realize that you inherited most of your challenging tasks from Mr. Greenspan but that doesn't excuse you from your role as a responsible chairman of the most powerful central bank in the world today. If you don't enact the hard and diligent responsibilities at hand (see four items above) then America's future will be a difficult one for us and future generations.

I have had the pleasure to hear you speak and to read your comments. As I listen to you, the following comes across loud and clear to me:
* You spend little or no time addressing the problem (monetary inflation).
* You spend too little time addressing real-world price inflation
* You spend very little time addressing the point that the dollar is losing value due to excessive monetary inflation.
* You spend too much time talking about the core rate of inflation which has no real value to consumers, retirees, investors or anyone else for that matter.

Doing the right thing for our country would mean resisting political pressure and shunning political expediency and popularity. But doing so would mean no less than our country's ability to survive and thrive as a great republic. If this sounds to extreme than you may want to take a look at the scope of our daunting challenges as documented at the Grandfather Economic reports (http://mwhodges.home.att.net/summary.htm).

I appreciate your time in reading this sincere letter and again, I wish you much success.
Regards, Paul Mladjenovic

P.S. Since you keep telling us how low the core rate is, can you tell me what consumer necessity has only gone up only 1.9% in the past 12 months? Can you tell us where you shop? It would be nice to know! Thank you...J.
- - - - End of open letter - - - -

In Summary (the bottom line) ...

The core rate is useless, meaningless and misleading.
Monetary inflation is the problem and price inflation is the symptom.
Real-world inflation and the growth of the money supply (which shrinks the value of the dollar) are very real problems and are getting worse.

What you can do about inflation to help yourself and your country...

Voice your displeasure and concern with policy makers at the Federal Reserve. There is contact information at www.federalreserve.gov.
Feel free to pass this article (unchanged) along to others to alert them.
Voice your displeasure and concern with your representatives in Congress. Find them at www.house.gov and www.senate.gov.
Voice your displeasure and concern specifically with the members of Congress's House Financial Services Committee at http://financialservices.house.gov.
When you read financial articles and see obvious errors about inflation or a glowing report on the useless "core rate of inflation", voice your concerns. Again, feel free to reference this article.
Take steps to protect/ grow your wealth in an inflationary environment. Add some gold/silver and other tangible assets to your portfolio, etc.
Make sure your financial advisor understands inflation and how to strategize to benefit you and his/her other clients.
Get and keep informed. See the next section on resources.

Resources to keep you informed about inflation and related economic issues:

Shadow Government Statistics (www.shadowstats.com)
Inflation Data (www.inflationdata.com)
Bureau of Labor Statistics (www.bls.gov)
Financial Sense (www.financialsense.com) Catch their MP3 broadcasts.
Korelin Economics Report (www.kereport.com) Also broadcasts in MP3.
Grandfather Economic reports (http://mwhodges.home.att.net/summary.htm).
Foundation for Economic Education (www.fee.org)

There are other great sites as well but these are good for starters. The wealth of data and informed commentary at these sites will be very worthwhile. If you need more resources, feel free to go to www.SuperMoneyLinks.com to either contact me directly or to get a free subscription to the Prosperity Alert, my financial & business email newsletter.

The coming years will be treacherous for our financial well-being and making informed decisions will not be a luxury; they will be a necessity.

Paul Mladjenovic, CFP
www.ProsperityNetwork.net

Paul Mladjenovic, CFP is the author of Stock Investing for Dummies and his national investing & financial seminars are at www.ProsperityNetwork.net. His blog is at www.Mladjenovic.blogspot.com and he is the editor of the Prosperity Alert newsletter.