Why is Inflation Low?

Inflation

The Obama economy has been a controversial topic. While the President and the Democrats have been bragging about the economy, many warn that it is not as good as the numbers appear. One of these numbers is inflation. Obama has bragged that the inflation number has been low. However, the Consumer Price Index (CPI) does not give an accurate representation of inflation in the US economy.

When people talk about inflation they are often talking about price inflation. Price inflation is the increase in price of goods consumers buy. This is what the CPI measures. The CPI calculated by measuring the price of 80,000 goods month by month. The CPI is currently under the 2% goal the Federal Reserve has for the CPI. You can see the current CPI trend below.

CPI

The textbook definition of inflation is an increase in the money supply. In the US, this is measured by the  M2 monetary supply number. For the past year, this number has been around 6% with a  range between 6% and 11% over the past 5 years. Meaning every year the number of US dollars that exist increases by 6-11%.

Economic theory predicts that when you inflate the monetary supply it should result in price inflation. This is because of supply and demand. When the money supply is inflated, people have more dollars. When people have more dollars they buy more products. As people spend those new dollars they increase demand which leads to an increase in price. So why then is the CPI measuring inflation at 1% while the amount of US dollars that exist is increasing at 6-11%?

The first cause of this is the CPI is inaccurate. The CPI measures the cost of around 80,000 products and averages these cost by using weighted averages. The price is the only measure used in the CPI. The CPI ignores changes in size to packaging. If a package of flour shrinks from 16 oz to 12 oz, but the price stays the same, then no change will be shown in CPI. While the CPI should show a 25% increase in price, as you are getting 25% less flour for the same price.

The second cause is price inflation is occurring, but is hidden from the CPI. When new money is created by the Federal Reserve Bank, a lot of that money is loaned out to banks. This money that is being lent to banks is at a very low interest rate, between 0-0.25%. This allows banks to lend that money at very low interest rates and still make a profit. The banks are lending this money to large corporations. These corporations are using this money to buyback their own stocks.  You can see this in the graph below.

buybacks1

The large amount of buybacks has lead to a huge price increase in stocks. All three major US stock indexes are up over 100% since 2009. While it is often thought that increases in stock prices are good, this is not always true. When the price of stocks go up because companies have created a new technology, increased sales, or build more infrastructure, this is a good sign for the economy. When this occurs the price increase in stock reflects real wealth creation by the companies. When prices of stock increase because companies are buying back their own stock, this is not a good sign. When this occurs, the price increase is because of increased demand, but there is no real wealth creation. In the US economy, the buybacks are occurring because of the low interest rates that companies can borrow at, not wealth creation. 

The inflation in the US economy is in stock prices. The price of stocks is not in represented in the CPI, which is how those who support Obama can say inflation is at or near 0%. However, the stock prices will crash back down. Once the Federal Reserve Bank starts to raise interest rates, then companies will not be able to borrow money at a low interest rate. This will prevent companies from being able to borrow money to buyback their own stocks. This will remove the demand from the market that increased stock prices up so high. Stocks will fall to a level to reflect the real wealth of the company. As stock prices fall, the money that was causing the stock prices to be inflated will leak into the rest of the economy causing inflation in the rest of the economy. Inflation is low and stocks are high now, but polices that create money today will cause inflation in the future.

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