The Fed is justifiably concerned about a serious deflationary cycle getting started in America. A deflationary cycle of declining demand, declining inflation, declining interest rates, and declining interest income for savers all leading to even lower demand as consumers wait for lower prices and save more to offset lower interest rates, that kind of deflationary cycle could be disastrous for an economy like ours that has so much fixed-rate mortgage debt and government debt that must be serviced. Bernanke and the Fed governors are smart enough to know how disastrous deflation could be and they know that it must be stopped, even at the risk of inflation rising to 3-4% in the US.
Prices of commodities will rise the most, but outside of food, gasoline, and natural gas, commodities are actually a very small part of the cost of all the other goods and services we buy. Except for food and energy, when you look all the way up the supply chain, personnel costs and corporate income taxes are more than 90% of the cost of everything we buy. So a fairly small devaluation of the dollar is not going to create serious general inflation, because productivity (output per worker) continues to rise while labor markets are extremely soft and labor costs are rising very slowly.
The Fed is doing exactly the right thing here, as long as they don’t overdo it and as long as they know when to stop. They’re working to create a wealth effect to boost consumer spending, home buying, and eventually employment and personal income. A deflationary cycle would be a nasty problem to solve if it became entrenched in the US economy. A deflationary cycle was just starting when the Fed made the decision to do more quantitative easing. You could see the deflationary cycle starting in the huge bond market rally in treasuries and investment grade corporate bonds. Those declining interest rates are great for corporations, but they’re not good for retirees who need more interest income and were being forced to cut back on spending or move savings into higher risk “junk” bonds. That’s not good for our economy—we don’t want interest rates going too low and forcing retirees to spend less and also forcing people saving for retirement to save more because of lower interest rates. The typical person saving for retirement has an income number in mind that he/she wants to have when retired, and most people are not going to adjust that number down because of lower inflation. So they would tend to save more and spend less when interest rates on bonds decline, thereby reducing demand in the economy and adding to the deflationary cycle.
We can go to lower inflation in the long run, but it’s dangerous to deflate rapidly and leave retired people trying to pay fixed rate mortgages with much lower income on their savings. The Fed is putting the brakes on deflation and creating a wealth effect to increase demand, all of which is exactly the right policy at this time. The next step we need is for congress, the White House, and the American people to develop a credible long-term plan to reduce federal budget deficits, including more realistic expectations for entitlement programs by all citizens. People have to understand that the blessing of longer life expectancy has also wrecked the finances of the Social Security program and that program cannot continue to pay out so much money to affluent retirees. Medicare costs are also out of control and have to be reduced substantially. Obamamcare will be a fiscal disaster if not repealed, and that disastrous legislation must be repealed or defunded as soon as possible by the new congress.
In theory, when interest rates decline and the interest income of retirees declines, people with fixed rate mortgages can refinance their mortgages at lower rates to offset the lower interest income. But the problem now is that so many home owners are upside down on their mortgages and cannot refinance without throwing in a large cash payment that they don’t have. So refinancing is very difficult for many people right now, and the Fed governors now this and know how much trouble declining interest income would cause for retirees. The Fed is run by very smart people. God bless ‘em, they’ve done a great job during this financial crisis.
No that does mean that companies can get less for the products they sell, which hurts businesses. But which businesses does it hurt? We import far more than we produce domestically. If we want to help businesses, and we definitely need to help businesses if we want our economy to recover, cut our insanely high corporate taxes by a bit.
A deflationary cycle of declining demand, declining inflation, declining interest rates, and declining interest income for savers all leading to even lower demand as consumers wait for lower prices and save more to offset lower interest rates, that kind of deflationary cycle could be disastrous for an economy like ours that has so much fixed-rate mortgage debt and government debt that must be serviced.
Deflation makes the money people have saved worth more. It increases their buying power. Inflation on the other had eats away at any returns on an investment. Even worse you still get taxed on the dollar gains even though inflation has made the dollar worse less. Deflation produces tax free gains in the value of savings. That's what the government really can't stand.
If we have 5% inflation, and you are earning 5% interest, you don't break even, because you end up paying taxes on that 5% interest you earned.
Prices of commodities will rise the most, but outside of food, gasoline, and natural gas, commodities are actually a very small part of the cost of all the other goods and services we buy. Except for food and energy, when you look all the way up the supply chain, personnel costs and corporate income taxes are more than 90% of the cost of everything we buy.
But the cost of living for those workers are highly dependent on those commodities, especially when their rent or mortgage are basically fixed costs, unless you think a lot of people are going to be refinancing mortgages at a lower rate some time soon.
The economy is bad. People are living from paycheck to paycheck. They need each paycheck to buy more. That is why they have been buying less. That is why demand is low. Deflation is the normal market correction. Government intervention that causes inflation might make borrowing money more attractive, but it might even help people pay back debt in the long term, but it increases their cost of living now, hurts people's savings, and devalues returns on investments.
What it increases are tax revenues, and makes it easier for our government to service it's debt. However it also makes it harder for the government to borrow more money at a low rate since lenders knows they are going to get paid back with money that we are intentionally devaluing.
That's why our government is having to keep borrowing money with a higher percentage of short term bonds. Lenders are losing faith in the long term strength of the dollar. That is a very bad thing, because we have a huge amount of national debt, and the cost of servicing it could easily balloon dramatically if the treasury can't continue to reissue bonds at low interest rates.