Inflation: Economic Peak PerformanceSubmitted by MD Wendell Wealth Partner on February 20th, 2015
By Mark Wendell
Whether we are talking about our local or national monetary behavior, the function of economics is the same: to understand and influence how people interact monetarily as they go about their daily lives. Because the behavior of an economy reflects the behavior of individuals who make up an economy, we can think locally to understand how economic concepts, such as inflation, work on a national level.
There seems to be a stigma associated with the word inflation. During the 1970s, President Gerald Ford called inflation “public enemy number one.” Over the past twenty years the CPI inflation rate has averaged 3 percent annually, but recently, it has averaged less than 2 percent. Some inflation is healthy for an economy, but because inflation imposes certain costs on a population, attempting to maintain inflation at a minimal level is a goal of policy makers worldwide. Why do we want inflation at all, if it is our enemy? How much is enough or too much? To answer these questions, we need to understand how inflation works.
Inflation is the increase in prices for goods and services. The consumer price index, known as CPI, is the measurement of the change in value of a fixed basket of goods and services and is used to monitor changes in the cost of living over time. Economists use the term inflation to describe a situation in which the economy’s overall price level is rising, and deflation to describe falling prices. The inflation rate is the percentage change in the price level from the previous period. Inflation is a closely watched aspect of macroeconomic performance and is a key variable to guiding macroeconomic policy. Several factors can contribute to changes in the level of inflation: consumer confidence; goods and services supply and demand imbalances; moves by companies to increase prices; labor supplies; average wages paid; and the Federal Reserve’s attempts to influence interest rates, the supply of money and the unemployment rate. As one can imagine, there is a feedback loop that never stops, with one component in the chain affecting the next, and so on.
When unemployment is low and wages are stable, consumers are more confident and more likely to spend money, which has a tendency to drive up prices. We can call this scenario the positive consumer sentiment factor.
Although unemployment is gradually declining recently, the low levels of inflation in recent years can be attributed to the large number of unemployed people. Employers do not feel a need to increase wages and incentives when unemployment is high, thus there is little wage inflation. This is contributing to steady prices of goods and services because consumers are less inclined to pay higher prices with unemployment high and wages generally not rising.
One of the basic causes of changes in the rate of inflation is the economic principle of supply and demand. As demand increases, the supply of a good or service decreases, causing prices to increase, whether because of too little production or natural disaster. Sometimes price inflation rises as supplies decrease and demand increases due to the desirability of a product. Corporations may also take advantage of tight supplies to increase their profits.
On the surface, it may appear that consumers benefit little from inflation. However, it is necessary in the overall economic system, if for no other reason than psychological: everyone wants to get paid more; it makes us feel better and therefore makes us want to spend more money that feeds the economic cycle. And secondly, the basic principle of supply and demand balance allows a free market based capitalistic system to function at a peak performance level.
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Inflation: Economic Peak Performance – Part Two
By Mark Wendell
In Part One of this series, we defined inflation, and explained why a moderate level of inflation is a necessary component of a healthy, growing economy. Part Two applies this knowledge to several issues in today’s economy related to inflation, including consumer confidence, the effect of falling prices, and government intervention.
Consumer sentiment, which can be significantly influenced by the media, is one important driver of inflation. Economists have for many years correctly assumed that the Federal Reserve, the Treasury Department, Congress, and the President’s economic advisors, collectively referred to as policymakers, influence markets and economic activity. And this is done not just through financial channels, but also by directly shaping the public’s views about the future through deliberate press releases to the media.
For example, if the media report expectations for a slow economy or low inflation or higher taxes, consumers and businesses may be less inclined to spend, borrow or invest. And if the public anticipates that prices will decline, resulting in no inflation or deflation, and senses further delays in interest rate hikes, they will be less likely to buy houses or businesses, invest in plant and equipment, hire employees or increase wages. These actions - or lack of actions - in turn, contribute to slow growth or a stagnant economy. This scenario of stagnation persists in our economy today: For the ninth year in a row through 2014, the US economy has underperformed to the tune of an annual GDP (Growth Domestic Product) growth rate below 3% - the longest stretch of slow or negative growth since the early 1930s (Wall Street Journal, 02/01/15). However, recent media reports of labor market improvements may finally signal a long sought-after acceleration in the rate of inflation, average hourly wages, and economic growth in the face of a low labor force participation rate of 62.9%, (01/07/15 Bureau of Labor Statistics) remaining near the lowest rate since 1978 that may not yet signal optimism. A tax increase of $320 billion is being proposed at the same moment when GDP for 2014 is reported at an anemic rate of 2.4%, and for the fourth quarter at a lackluster 2.6%, of which only 1.9% is attributable to business investment (Bureau of Economic Analysis). Less business investment slows productivity and thus wage growth. Higher taxation of dividends and capital gains reduces the incentive for business investment that will ultimately contribute to economic stagnation.
Beyond the influence of the Federal Reserve, falling prices of goods and services can directly contribute to declining inflation. With the recent drop in energy prices, the cost of goods and services may fail to rise, or they may even decline. And the recent surge in the value of the dollar is resulting in suppression of inflation due to cheaper import prices. While this outcome may sound appealing to the public, a general price reduction can spread like a virus and become quite destructive to an economy. Price stability is a basic pillar of a strong economy and a deflationary cycle would cause the economic system to freeze up because purchases, lending and borrowing would come to a screeching halt and consumer prices may fall, causing businesses to fail and unemployment to rise, with each element reinforcing the other in a domino effect that is difficult to stop.
In addition, government intervention can certainly have an effect on inflation. The Federal Reserve has been artificially setting the price of credit by offering near-zero interest rates through the bond buying program known as quantitative easing or QE. As well, the Federal Reserve has been controlling the amount of bank credit that is available through regulatory policy and leverage standards. The effect of this policy has been to channel credit to the safest borrower - the wealthy, the government and corporations – who may not be the best job creators, at the expense of small savers, small businesses and moderate-income borrowers. These actions have distorted our normal market-based credit system because the program has had a tightening effect on credit by incenting banks to avoid their normal risk taking role of lending to the private sector and small business. The result of this excessively centrally controlled system, where risk is no longer incentivized and rewards are no longer prized, is slowed business activity, a stagnating economic cycle and almost nonexistent inflation.
Today’s policymakers who want to encourage growth in the standard of living and average wages paid must increase their country’s productive ability by encouraging a genuine incentivized risk and reward system where capital can flow freely and be put to work without excessive regulations or a punitive tax system interfering. Joseph Schumpeter, a legendary 20th century economist posited that the miracle of capitalism lies in its power to democratize wealth, that is, create a simple system to allow for business startups and mass-market-efficient production. He argued that capitalism sparks entrepreneurship. Mr. Schumpeter pointed out that entrepreneurs innovate not just by figuring out how to use inventions, but also by introducing new means of production, new products, and new forms of organization. Entrepreneurs and small businesses are the backbone of our country’s wealth, as measured by GDP. The general standard of living of its citizenry depend on its ability to welcome sparks of entrepreneurship and produce goods and services efficiently within a legal framework, a stable credit system and a predictable and fair taxation system, all combined that allow capital to flow freely, and therefore, allow the wealth of a country to multiply rather than stagnate. Economic growth is the single most powerful determinant of federal revenues and standards of living for all citizens. The CBO (Congressional Budget Office) projects that, if annual gross domestic product (GDP) were to average one percentage point higher, there would be an additional $2.9 trillion, inflation adjusted, in revenues over a decade (WSJ 02/03/2015).
Economists may differ in their opinions as to the proper role of the government in promoting a healthy economy. However, when our own financial system provides for more disincentives than incentives, whether by burdensome regulations, interest rate manipulations or excessive taxation and subsidies, the economy will eventually flounder under its own weight of unfairness and distortions, well-intended or not. And at the center of this dysfunction are attempts by policymakers to manage wages, prices and interest rates, under the guise of fairness and progress, in an effort to influence inflation and consumer spending. And recently, the term “middleclass” has been used by policymakers that provoke empathy and votes, but seldom does their policy actually benefit this group, and paradoxically it often feeds into the issue of economic stagnation since their efforts usually benefit ‘the few’ at the expense of ‘the many’. The movement to mandate equality by punishing the successful and talented in the name of fairness is counterproductive, since the real problem is the economic smothering effects of a leviathan-labyrinth empire of taxation that has been eroding our capitalistic system, including GDP. Overhaul! - is the only answer that will have the serendipitous bolstering effect of an economic stimulus for the economy and all citizens alike.
The monetary intervention we have been experiencing was originally initiated to prevent a banking system failure. Mission accomplished. But any ongoing excessive governmental involvement in a capitalistic free-market-based system, regardless of intentions, will distort results, impede growth to the point of fostering a self perpetuating cycle of stagnation, and ultimately lead to overwhelming governmental involvement in an effort to constantly try to prevent the failure that may have been of their own making due to futile manipulations of the economy. The success of one generation’s policymakers in learning and heeding these fundamental lessons about economic growth and inflation will determine what kind of world the next generation will inherit - peak performance or not.