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Deflation is the Monster in Little Janet's Closet

Monday, August 10, 2015

Anyone who's had kids knows that the closet at the foot of the bed is the source of much nighttime dread. (I think I might be channeling Dr. Seuss here.)

And we know as well that the solution is actually pretty simple: Open the closet and show little Janet that there is nothing to fear. (Oh well, I tried.)

We are on the cusp of what some believe will be the first of many drawn out interest rate hikes, starting in mid-September.  But each time the news suggests this is coming, the stock market takes a prolonged hit. It's like it is bedtime and 'deflation' (or at least 'disinflation' - more on these terms in a moment) is the monster in little Janet's closet.  So someone has to come out and say something like:
The interesting situation in which we are is that employment has been rising pretty fast relative to previous performance and yet inflation is very low. And the concern about the situation is not to move before we see inflation as well as employment returning to more normal levels.
Imagine you were to try to pull off something like this with little Janet who cannot sleep because she fears the monster in her closet.  Federal Reserve Vice Chair Stanley Fischer - who made the comment above to Bloomberg - is thought to be trying to walk back the sense that the interest rate hike is 'baked in'.  This doesn't quite amount to opening the closet to show little Janet that there is nothing to fear.

So I'll try to tuck little Janet into bed.

But before I do that, let's get our heads wrapped around this thing called 'deflation'. When we believe prices are going down, we naturally hold on to our money.  Why buy today when you can buy for less tomorrow? The problem is that those who make consumer goods then have extras on hand, and in order to move the product, they lower their price. (See discount stores' and Amazon's "Black Friday" in July for a recent example.)

"Aha!" we say. "I knew it! If I hold on a little longer, prices might go down some more."

And so we end up in an economic death spiral.  Our esteemed central bankers will tell us this is what caused the Great Depression.  There is some debate among economists about that, but that debate is not what really matters here.  What matters is the complete absence of two forms of expertise and experience among the Board of Governors of the Federal Reserve.  The first of these is actual 'supply chain management'.  The second is information technology.

As an information technology professional, I will start there.  The most glaring difference between today and the Great Depression - one that is so glaring it flabbergasts me that the people who are making monetary decisions do not see this - is the computer.  The two things the computer does for us that matter in this discussion are: 1) the computer gives us a far more accurate sense of the actual money supply; and 2) the computer gives us a tool for 'supply chain management'. So that brings us to the second lack at the Fed: experience in supply chain management.

The two companies which are legendary in my field of information technology are WalMart (in the brick-and-mortar space) and Amazon (in the online space).  Among information technology professionals, they are legendary for how they employ the IT field know as 'knowledge management' to manage their supply chain.  In the case of Amazon, they are now offering same-day delivery in select markets (including my hometown of San Diego, California).  They can do this because they have studied the market so thoroughly (using 'knowledge management') that they can predict what will be ordered, have those products pre-staged in town, and then deliver them in one day.  It is a spectacular example of using the computer to manage a supply chain.  Where Amazon sets itself apart with same-day delivery, WalMart sets itself apart with low prices - by employing the exact same technologies.

(If you are about to fall asleep right now with all this gobbly-gook about knowledge management, that's because this is my bedtime story as I try to tuck little Janet into bed.)

If the Fed were to have actual experience in supply chain management - or to put this another way, if they had anyone who has actually run a large business - it just might alleviate some of their overblown fears about deflation.  If we go back and look at what that is - my decision to hold on to my money and the resulting excess of supply - we see that deflation is essentially a supply chain management problem - not a monetary problem.

But when all you have is a hammer, every problem looks like a nail.

And in the Great Depression, to a large extent all they had was a hammer.  But this is not the case today.  We have computers and we have companies like Amazon and WalMart who know how to use them to calibrate supply to demand as it increases and decreases.

This, then, brings us to the reality we face today.  The idea of 'free money' is an oxymoron: If you make money free, then as more money sloshes about the economy prices will eventually rise. But if prices rise, the 'purchasing power' of your money goes down.  In order to protect from this loss of purchasing power, a lender has to charge interest - and money isn't free anymore.  If interest rates do not rise from what economists call the 'zero-level boundary' (or ZLB), the whole idea of money - and banking - begins to lose its very meaning and purpose.  So if money is 'free', it will eventually destroy itself and take the banking industry with it.

But, because 'deflation' is the monster in little Janet's closet, the Fed want to hold off on ending the days of free money. So how do we open the closet to show little Janet that monsters aren't real?  Or at least that deflation isn't quite the monster she thinks it is? First, we have to acquire a healthy skepticism for some of what is being passed off as 'data'.

The Fed gets its 'inflation' data from the Department of Labor's Bureau of Labor Statistics.  During the Gingrich/Clinton years these stats were gimmicked to suppress the growth of entitlement spending, producing the much-vaunted 'budget surplusses' of 1998-2001.  The gimmicks continue by removing 'volatile' prices like food and energy, and substituting cheaper equivalents from more expensive ones, in the Consumer Price Index.

Before getting into that a little deeper, this exposes the fiction of an independent Federal Reserve.  The Fed cannot possibly be independent when it tells us that its decisions are 'data-driven', and it then gets that data from the Executive branch - whose political interests in how the Consumer Price Index is calculated are obvious to anyone who has been paying attention. (This holds true across administrations and the major political parties.)

The underlying idea of 'inflation' is that when you have more money sloshing about in the economy (or when you 'ease' the restrictions on the 'quantity' of money - Quantitative Easing) a rise in prices will follow.  But the Fed is wondering why, with all this free money, 'inflation' has not risen.

It has. We have already seen this numerous times in the stock market and real estate: These are the first two places this easy money goes, so stocks are at historic highs and real estate is almost back where it was before the last financial crisis. In the context of the minimum wage debate we are constantly reminded of how the price of milk and eggs has risen.  But none of these things are counted in the CPI.

It is ridiculous, then, to hear Fischer complain that 'inflation' is not where the Fed would like to see it.  All one has to do is look at the Shiller PE Ratio to see that stocks are historically inflated.  A similar picture can be seen in real estate. And anyone who has made dinner lately knows the truth - which is hitting minimum wage employees the hardest.

Probably the most pressing question - from a policy-making standpoint - is whether Ms. Yellen, Mr. Fischer, and their colleagues at the Fed actually believe the inflation numbers they are fed by the Executive branch.  And if they do, why do they believe them?

If inflation is actually more along the lines of four to five percent (as would be seen using the pre-Gingrich/Clinton calculation methods) then there really isn't a monster in the closet after all.  And if the Fed had people who actually understand how information technology is used in supply chain management, the inevitable deflation which has to follow the end of free money will not be quite the monster that keeps little Janet up at night quaking under her blankie.

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