Inflation, Deflation and Wealth Redistribution

The Federal Reserve has two mandates:
1. Price Stability (often read as low monetary inflation)
2. Maximum Employment (usually accomplished by a moderately growing economy)

Basically, the Fed would like to target a 1%-2% price inflation rate annually. This rate is (theoretically) where maximum sustainable economic growth occurs. More inflation than this can result in runaway asset price inflation (breaking Mandate #1) or an overheated economy that meets with a bust later on (breaking Mandate #2).

Throw all of the above in the recycle bin. This is worthless PR drivel meant for the consumption of the masses. I will give you a key to understanding politics and politicians:

Ignore what they say. Watch what they do.

In that regard, what is the true mandate of the Federal Reserve?

Protect the interests of the wealthy.

Does this occur because the wealthy run the government, or because the government creates wealthy people? Probably some of both. But I digress.

Why do I say that the Federal Reserve mandate is to protect the wealthy? Because of one simple thing: The Fed will always, in all ways and everywhere defer to the side of economic and monetary inflation over deflation.

Deflation strikes fear in the heart of all wealthy people. Why? Wealthy people have a majority of their wealth in assets. Assets produce income or store wealth in proportion to their price. If asset prices fall, their store of wealth, income produced, and relative standing all go down in large measure. Conversely, deflation (as long as it does not crush the economy) favors the working poor, who generally live off of a fixed income as they trade their time and labor for money. The “poor” generally don’t have assets to deflate, and their expenses form a greater percentage of their overall wealth, so the reduction in prices directly impacts their lifestyle. Basically, deflation has the net effect of transferring wealth from the rich to the poor.

Inflation strikes fear in the heart of all working “poor” people. Why? “Poor” people have a majority of their wealth in fixed income streams or cash. This income (job, pensions, etc) is relatively fixed in relation to prices. If asset prices rise, their store of wealth, income produced, and relative standing all go down in large measure. Conversely, inflation (as long as it does not crush the currency) favors the wealthy, who generally live off of income and assets that gain a greater value as prices rise. The wealthy generally don’t have problems with fixed income streams that are penalized by inflation, and their expenses form a smaller percentage of their overall wealth, so the rise in prices is offset in large measure by the rise in the value of their assets. Basically, inflation has the net effect of transferring wealth from the poor to the rich.

Back to the Federal Reserve–Ignore the rhetoric. Have the policies of the recent past, from Greenspan’s free money, to Bernanke’s rate slashing campaign, to the alphabet soup of toxic investment relief vehicles, buying Treasurys, increasing money supply in the face of global credit deflation–have they been using every tool in their arsenal to combat inflation or deflation? They always err on the side of inflation. ALWAYS. It’s simple to see why. Follow the money.

By my read, about half of the S&P’s ~40% gain since the March lows has been made up of inflationary pressures, leaving only ~20% in actual equity appreciation. Bears, shorts and other doomsayers have been annihilated in this latest wave, even though they may have been accurate in their prognostications for the economy. This is part of the reason why. Half green shoots, half green paper.

Of course, hyper-inflation is as damaging as mega-depression. I’m not arguing the extremes. Just pointing out that if you can’t dance the 1%-2% dance precisely, which side of the line do you think the Fed and other monetary and fiscal authorities will fall towards? The Fed will always choose inflation over deflation. The margin of safety will always be on the inflationary side of the line. Count on it, position for it, expect it.

Just know that the revolutionary socialists aren’t the only ones that pursue a policy of wealth redistribution.

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9 Responses to “Inflation, Deflation and Wealth Redistribution”

  1. Adrian C Says:

    Hi Pro,

    There are people that think that even if the Fed is printing a lot of money, increasing the money supply and hoping for the inflation to win over deflation, this is just not happening because the banks are not lending this extra money (from various reasons). Mish Shedlock has a very detailed description in his blog here: http://globaleconomicanalysis.blogspot.com/2008/12/humpty-dumpty-on-inflation.html

    Adrian

  2. Cuervos Laugh Says:

    Nice post. Not sure I agree with you but, your thesis is to view what is based on historical actions, then make monetary decisions based on reality as best you understand it.

    I call that “taking the trade in front of you”.

  3. Prospectus Says:

    I’d be interested in your point of view on it. I’m mostly trying to make sense of the recent bull run that seems absolutely unfounded. Plus, it’s more a thought experiment than any kind of factual argument. If you have the time, I’d love to hear your thoughts.

  4. Cuervos Laugh Says:

    Well, I suppose the biggest question I have for you re: your thesis that deflation is the adversary of the wealthy is to look at the Hamptons crowd in the US during the Great Depression.

    Pretty much unaffected. I think JFK said one time that it wasn’t until he was much older that he became aware that there was a crisis.

    So, I am not so certain that the upper classes are really feeling the pinch right about now. I think the bankers are as well as anyone that just put their money in equities and didn’t think about it much.

    OK – you know what? Perhaps from a top down classical fundamentalist point of view being a short loving bear is the only conclusion.

    On the other side of the coin however, is the fact that central bankers everywhere know that their actions affect the real world of factories, warehouses, etc etc.

    So, some of the actions were geared towards solving some of those issues and taking stands that let the man in the street feel like the folks on Pennsylvania Ave feel their pain.

    The unintended consequence of many of the actions following the dotcom bust was that people were trying to still make their first million so they could retire and were heavily leveraged either in their home or in the market.

    Some sad folks probably both.

    And how many 401k account deaths have happened? Wouldn’t it be sensible to provide some kind of stability to those markets before everyone that lost their shirts began to get really desperate?

    If the market is being manipulated by bots, well – then it should be easier to trade no?

    And there are two general rules which I think typify reality a whole lot more than reductionism:

    1. The law of unintended consequences
    2. The role of emergent behaviour in the markets and in complex organisations in general.

    With regards to #2 – I believe we as humans have a tendency to want a narrative to events when perhaps the best, most objective means of understanding them would be a series of unfortunate incidents (to borrow a book title).

  5. Prospectus Says:

    Cuervos,

    Thanks for those thoughts. I didn’t know about the Hamptons after the depression. That’s interesting. And I agree that the damage has thus far been mostly confined to equity markets and real estate, though once Obama turns up the tax wick and we get more effects of the recession, I imagine things will spread more.

    My analysis is overly simplistic, I agree. And I also agree that unintended consequences are huge. We think we have everything under control, but we really don’t have a clue, no matter how many Nobel prizes or computer models we have.

    I guess my biggest point is that even though we should probably default a lot of the bad debt and deflate things, the Fed will fight that to the death. Maybe strong medicine would do more harm than good, and it’s easy to be an armchair economist.

    Thanks for your excellent thoughts!

  6. MFoster Says:

    What you are saying is of course correct, but there are some finer points to it that some of people commenting obviously don’t understand, and they generalize far to much.

    Firstly, the wealthy are wealthy through assets, not through money. No one holds money because even if you earn interest on it, you get taxed and inflation pulls down its buying power, and combined your net worth decreased. So instead they all hold assets. This is why they like inflation. Inflation means the the debts they took out to buy the assets can be repaid with less wealth, and it also means the money the asset will make (eg. rent) will increase and give then increased wealth. If you follow almost any rich person the first thing you will notice is that they almost never ‘save’ and buy, they also loan and let inflation increase the incoming money and value of the asset. And secondly they focus on earning wealth streams from assets (like rent or businesses), as these wealth streams will increase with inflation.

    Deflation of course is the opposite. In this case both the asset and their income will devalue. They will have to pay more wealth to pay off debts incurred to obtain the assets, and the income from the assets will go down.

    However the real reason isn’t so much because rich powerful people are in charge – its because that the worst inflation does is slowly steal from every person in credit (who doesn’t hold assets, such as retiries with their 401k account), this is just as bad, but because it happens slowly many people don’t notice it. While the worst deflation can do is completely collapse the economy from everyone holding onto cash – cash becomes the appreciating asset.

  7. Jr Deputy Accountant Says:

    so what do you think about SF Fed President Janet Yellen saying she feels most comfortable with a 2% inflation rate recently? That seems odd to me. It *all* feels odd to me.

    now I’m no expert but I *do* spend slightly more time chasing the Fed than most and in my humble opinion, the Board of Governors is happily throwing the regional banks under the bus. This, of course, is good news for the rest of us because it shows that the Fed is under considerable strain, leaving PLENTY of room for apt criticism.

    The curtain has been pulled and I think we know who the wizard is at this point.

  8. For Debate: The Government Should Be Overthrown - The Liberty Lounge Political Forums Says:

    […] […]

  9. The REAL Role of the Fed - 38 Atoms Says:

    […] Excellent article on what the Federal Reserve is really in business to do. Key point, “pay attention to what they do, not to what they say.” […]

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