Is the Fed Creating an Inflationary Bubble – No

The Fed is not creating an inflationary bubble, rather it is working to avoid an outcome it considers much worse. The Federal Reserve has taken a look at Japan.

In Japan, for the past twenty years, living standards have fallen with the economy. Middle-aged people who once took lavish vacations and drove elegant cars have now tightened their belts and learned to live small.

Younger people, who have known no times but deflationary ones, live in tiny homes called (in translation) microhouses. Many pride themselves on their thrift, rather than on their elegant possessions.

In Japan, the economy is the same size as it was in 1981. It has not grown at all, according to a frightening article “Japan Goes from Dynamic to Disheartened,” written by Martin Fackler and published in the online New York Times. The average price of a home, according to Mr. Fackler, is the same as it was in 1983. The total value of the Japanese stock market, he says, is one quarter of what it was in 1983.

In the United States, the prices of homes, at least in less desirable areas, have fallen far. This is deflation, at least in home prices, that echoes the deflation in Japan.

In the United States, the stock markets have recovered somewhat, but at one point appeared to be reaching a rate of decline comparable to that of Japan.

The bond market has rallied to the point that many pundits speak of a bond bubble. Bond prices rise as their yields decline, of course. Falling yields can be taken as a sign of deflation, a deflation that resonates with a similar bond rally in Japan.

No one, not Ben Bernanke with his vast academic knowledge, not the Japanese with their lengthy experience, not even the bond market where bond traders invest their worshipful faith, knows what will happen next. It’s likeliest that this crisis will pass, as most crises do.

Fed action may in fact create inflation. The price action in precious metals appears at times to say it will. However, the Fed is not trying to create inflation, but rather to avoid its opposite. Whether Chairman Bernanke will be able to steer between the value-burying landslide of inflation and the steep plunge of deflation is yet to be seen.

One way to look at inflation is that it makes money less valuable. It takes more pennies to buy a loaf of bread because each penny is worth less. However, wages and pensions tend to go up with inflation, so pennies are easier to get.

Deflation, conversely, makes money more valuable. It takes fewer pennies to buy bread. On the other hand, the pennies are harder to get. As a penny grows in value, people are less willing to let loose of it, less willing to buy things today with money that will be worth more tomorrow. Consumers tighten their purse strings, so businesses see fewer sales, and tighten too. That is why deflation feeds upon itself, as frightened people spend less and less, and make less and less, and have less and less.

Dr. Ben Bernanke is a brilliant man, with great credentials. He is well equipped to deal with our problems, fortunately. As he walks a rocky and possibly narrowing path however, it is not inflation that he has most to fear.