The Fed Remains on the Lookout for Deflation and Inflation

Most investors know that large budget deficits can lead to an increase in inflation. However, given the current price trend, to remove fiscal, or monetary, stimulus now would be precisely the wrong policy to follow: deflation, not inflation, remains the bigger threat to the economy. Most investors know that large budget deficits can lead to an increase in inflation. However, given the current price trend, to remove fiscal, or monetary, stimulus now would be precisely the wrong policy to follow: deflation, not inflation, remains the bigger threat to the economy.

Still, the above is not to say that the inflation hawks don't present reasonable concerns -- they do. The U.S. Federal Reserve must be ever-vigilant against the sometimes-sudden, sometimes-sneaky upward movement in prices.

Further, it's only natural to be concerned about a possible uptrend in prices and wages given the Fed's unprecedented increase in its balance sheet and the record fiscal stimulus injected into the U.S. economy. The Fed must always be at-the-ready to increase short-term interest rates and/or remove quantitative easing funds, if inflation sparks a price "forest fire."

Price Data Shows Inflation Remains Contained

But as of now, inflation is not only not smoldering, it's been drenched after a season of monsoonal rains. Consumer prices rose 0.1% in March and the core rate -- which excludes the often-volatile food and energy component -- was unchanged, according to data compiled by the U.S. Labor Department.

What's more, over the past 12 months, consumer prices have increased just 2.3%, with the core rate rising only 1.3%, or within the Fed's comfort zone for inflation. In other words, inflation, despite fiscal and monetary stimulus, is low: The Fed said as much in its latest Beige Book report on the U.S. economy. Moreover, the tame price environment isn't surprising given the large asset destruction that occurred during the financial crisis and the reduced demand for goods/services as a result of more than 8 million job lay-offs.

Do A Local Mini-Survey

However, if you need further evidence besides the Labor Department's and the Fed's comprehensive data, do a small survey where you live, regardless of whether you live in New York City or on the plains of Kansas. Have any of your friends talked about a large raise they got for the same job they were doing? How about home prices -- are they rising? And how about the price of items in the stores -- clothes, home goods, and other items you buy -- have any increased in price so much it's caused you to do a double-take? In sum, inflation is contained.

The Labor Department and the Fed's data documents it, most random samples in U.S. cities and towns would confirm it, so why even mention the inflation hawks?

The problem is, certain U.S. Congressmen and financial commentators want the Fed to raise interest rates -- and the U.S. government to taper its fiscal stimulus -- now, and that would be precisely the wrong thing to do. Moreover, it could lead to deflation.

Deflation, a sustained period of price and wage declines, would reduce corporate revenue and earnings as well as individual income. It would also undercut the U.S. economic expansion at the very moment that it's starting to gain some steam. Moreover, it could plunge the economy back into a recession.

U.S. Economy: Nearing The Harbor

Don't misunderstand, the large U.S. budget deficit and national debt are legitimate concerns, but also know that the way to pay off that debt is via rising government revenue. And an effective way to get federal revenue rising (outside of a tax increase) is to get the economy growing at a strong rate again -- in other words, by avoiding a recession, which means maintaining fiscal/monetary stimulus until the expansion is self-sustaining.

Further, more than likely, in the second half of 2010 the economic expansion will be self-sustaining, and policy makers can start withdrawing stimulus and raising rates then.

Put another way, removing stimulus now would be like pulling down the sails of a sailboat when you're a mile from your home harbor. The boat may drift in, or it may not. So if someone tells you it's time to remove the stimulus, tell them you're keeping the sails of this economic sailboat up, until the boat is in the harbor.

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