Our Inflation Problem

We have a problem with inflation, but it's not what you may think.

Inflation isn't too high. The problem is that it's too low.

The Bureau of Labor Statistics reported today that consumer prices, less energy and food, rose last month by only 0.2% compared to April. On a year-over-year basis, the growth rate came in at 1.7%.

You might be wondering why this is a problem. Isn't inflation bad?

The answer is both yes and no. It's bad if it gets out of control. Think the Weimar Republic in Germany between the world wars. People literally had to use wheelbarrows to ferry their paper money between home and the grocery store.

A less extreme example was our own economy at the end of the 1970s and the beginning of the 1980s, when the then-chairman of the Federal Reserve, Paul Volker, was forced to hike up short-term interest rates to stem the double-digit increase in consumer prices. While the move succeeded at its objective, it also sent the economy into a deep recession.

But inflation can be too low as well and it's particularly harmful if it crosses into deflation -- that is, where prices for goods fall. The United States' experience with this in the 1890s triggered civil strife and widespread bankruptcies throughout the largely agricultural economy, as farmers struggled to repay their increasingly burdensome debts with dearer and dearer dollars. More recently, Japan has been mired in a deflationary spiral for much of the last 20 years.

Just like Goldilocks' porridge, then, the ideal situation is when inflation is just right.

What constitutes "just right" is, of course, open to debate and largely informed by one's standing as either a debtor or a creditor. If you're a debtor, like the farmers in the 1890s or a mortgagee today, then the higher the rate, the better, as this lessens the burden of paying back your debt. But it's for this same reason that creditors prefer lower rates of consumer price appreciation.

For what it's worth, the Fed has targeted a 2% rate of inflation to use as a gauge for its monetary policy. Anything below that, as we have now, will presumably encourage it to stay the course when it comes to monetary easing.

This is good news for equity investors as the central bank's recent easy-money policies have fueled the stock market to all-time highs. It logically follows that this is probably one of the reasons that both the Dow Jones Industrial Average (DJINDICES: ^DJI  ) and the S&P 500 are rallying today on the heels of the BLS's announcement. Since QE3 began, these indexes have shot up by more than 16% each, and seemingly every time a rumor circulates about an abandonment of the policy, the indexes fall -- and often violently. Neither one, for example, has reclaimed its May high since Ben Bernanke testified on the 22nd of last month that a reduction in support could be decided upon at one of the next upcoming meetings.

Alternatively, a reading above that figure would most certainly induce the Fed to draw down its support, which would almost invariably lead to a reduction in stock prices. This is why Warren Buffett has said that the decision to taper QE3 will be akin to the "shot heard round the world."

To get back to the present, as you can see in the chart at the beginning of this article, the problem is that there's a clear downward trend in core consumer prices since the beginning of last year despite the Fed's massive monthly infusion of liquidity -- under QE3, it's buying $85 billion worth of federally insured securities a month. But while this is good for stock prices, it's horrible for the economy. And that's our inflation problem.

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