Inflation’s Real Cause

According to Pimco’s new Chief Economist, Paul McCulley, the Fed’s war against inflation has been won!  But, before we get out our party hats and plan the tickertape parade, we have to ask ourselves – for the past 27 years have we really been at war with inflation?  Yes, during the late 1970’s and early 80’s a different Paul (Paul Volcker, Chairman of the Federal Reserve) waged a real battle against inflation.  Mr. Volcker painfully took the Fed Funds rate to near 20 percent in June of 1981.  The economy suffered a deep recession, it was a treacherous battle plan, but the Fed stayed the course because Volcker was correctly convinced that limiting the growth rate of the money supply was the key to popping asset bubbles, vanquishing inflation and establishing a sound economy. 

Fast forward six years, exit Paul Volker, and enter Alan Greenspan. For the back drop, it was the crash of 1987….and after declaring “mission accomplished” on the inflation war, Greenspan sought to fight a new war against falling stock prices.  Acting as the veritable Navy Seal of financial market defense, Greenspan valiantly leapt to shield markets from corrections.  This “special operation”, was affectionately referred to as the “Greenspan put”.  Over the years the “put” has remained, we have merely substituted Greenspan with Bernanke and now Yellen.  And so for the past 27 years, the only “war” the Federal Reserve has been waging has been to inflate asset bubbles.  These bubbles bring the economy to the brink of financial destruction, leading the central bank to intensify its efforts to fight deflation with each iteration.

McCulley goes on to say "For the last 15 years inflation has been incredibly absent…We've had our cyclical ups and downs but when you look at it on a chart, I think we've achieved the promised land of price stability over many cycles."

I have to assume that McCulley is affectionately gazing at the government-manipulated chart of CPI, where despite all the bureaucratic finessing of these figures, we still can find year over year inflation reaching more than 5 percent during that 15 year period.  But a 15 year chart of the NASDAQ and Home Price Indexes tells a more interesting story.  Perhaps McCulley dismisses the NASDAQ and Real Estate bubbles under the cover of seemingly innocuous “cyclical ups and downs”; mere speed bumps on the way to the “Promised Land”. 

McCulley also states that he and Bill Gross strongly support an increase in the minimum wage, giving celebration I’m sure to all the minimum wage bond traders in New Port Beach, CA. I find it ironic those who espouse the belief that inflation doesn’t exist would argue for increasing the   minimum wage.  After all, why should incomes have to rise in the face of price stability? 

Most importantly, Keynesians, like McCulley and Chairpersons of the Federal Reserve, believe inflation is caused by rising wages. They contend that without rising wages inflation cannot become a problem.

Let me explain something to McCulley and his fellow adherents to this Phillips Curve myth. Inflation is caused by a persistent and pervasive fall in the purchasing power of a currency. The market becomes convinced of substantial currency dilution and the value of paper money falls.

The fact that nearly every other central bank on the planet has followed in the footsteps of our Fed has masked much of the currency destruction against our trading partners. But the value of the dollar has fallen against most assets precisely because of massive money printing and artificially-low interest rates provided by the Fed.

Rapid money supply growth can and often does occur while real wages are falling because commodity and import prices respond first to the drop in the currency’s value, while median nominal wages merely lag in a futile attempt to keep pace with the falling purchasing power of the currency.

History is replete with examples of this fact, and the latest proof that inflation can become a problem without wage growth in the vanguard comes from Japan.  The Japanese Yen has lost 30% of its value since 2011 vs. its major trading partners. That’s bad news for an economy that needs to import 80% of its food and energy needs. At the same time, consumer inflation is up 3.7% YOY. In fact, Japan is experiencing the highest inflation rate in 32 years. However, real incomes are down 4.6% YOY and have been falling for 23 months in row.  This is just another example of how nominal wages lag inflation when a central bank pursues policies that promote currency destruction.

But the real problem is that these Keynesian misconceptions are not only held by McCulley and, his boss Bill Gross, they are also held by Janet Yellen and her cronies at the Federal Reserve.  And by continuing to focus on wage growth instead of the growth rate in the money supply, the Fed has put itself in the position where it will be perpetually behind the inflation curve and delayed in pricking the asset bubbles it is fighting so hard to recreate.

The simple truth is you can’t win a war you don’t fight. How can the Fed have conquered inflation if the only battle it has fought since 1987 is against deflation? Both Volcker and Keynesians cannot be correct. Inflation cannot be defeated by taking interest rates to 20 percent; and also through the process of keeping rates at zero percent for 6 years and counting. Inflation also cannot be declared dead by creating an additional $3.5 trillion of bank credit over the past few years. 

Unlike the prosperity induced by Volcker’s deflationary utopia, we now have the dystopia of massive economic imbalances created by central bankers that have completely replaced market forces in the determinations of interest rate and price levels. And it is central bankers’ complete incomprehension regarding the healing forces associated with deflation that will cause the next collapse to be exponentially worse than the financial crisis of 2008. Inflation has not been defeated at all, but rather it is any hope of deflation and economic stability that has been wiped out.

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Michael Pento is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”

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Michael Pento is the President and Founder of Pento Portfolio Strategies and Author of the book “The Coming Bond Market Collapse.”