Saturday, September 22, 2007 0 comments ++[ CLICK TO COMMENT ]++

Criticism of the High Inflation Supporters

I recently posted a response on the Crow Bar rebutting those who think inflation is much higher than the officially reported number. I'll paraphrase that comment here.

To give some background, some people out there (mainly the goldbugs) believe that inflation is far higher than the reported number. Many actually think that inflation is way beyond 5% (officially full inflation is around 3% with core inflation around 2% (depends on period)). An argument for inflation being higher makes no sense whatsoever. My key arguments against such view are:

  1. The market, which is smarter and more nimble than any individual, central bank, or government, has not priced in such a high inflation.
  2. Depending on the number you pick, a high inflation number implies negative economic growth (i.e. contraction). There is zero real evidence of economic contraction.

We all believe in the free market (I hope). Given that, why hasn't the market, which is smarter than anyone including central banks, priced in high inflation if inflation was actually high? Stocks will get discounted more and even less people will be investing in bonds. Very few would find interest-sensitive assets like REITs attractive. But this hasn't happened. If those claiming that inflation is much higher than 3% (or whatever it is; 2% is the core) over the last 10 years were right, the market would have discounted all these assets. Yet, that isn't the case.

Furthermore, if inflation is much higher than what is reported, (real) GDP growth would be much lower. Depending on the number you pick, the implication would also be that (real) GDP growth may be negative (because real GDP is after discounting by inflation (PCE deflator)). For example, given that GDP growth has been around 3%, if you thought inflation was more than 3% higher than the reported number, you are basically saying the US economy has been contracting for years. Yet nothing is further from the truth. You don't need to listen to the government published numbers. Go and talk to anyone running a business. Talk to people looking for work. Look at capital spending by US corporations. Talk to lower class people who will feel economic contraction first. And so on. You will find that everyone would say that the economy has been expanding and doing well (except recently--we may actually go into a recession).

You can argue the economy is driven by debt, too much borrowing, and so on, but regardless of how the economy is being driven, a higher inflation number means real GDP growth is lower. Anyone that thinks inflation is higher than around 6% should realize that they are basically implying that the real GDP was contracting all these years. There is zero evidence of that (except in the last few months and maybe in the near future).

(Having said all that, I will admit that the recent Federal Reserve rate cut will put pressure on inflation if the cuts were unnecessary (i.e. cuts happened without the economy weakening). It looks like I sold out my gold (HMY) just before the massive rally recently but I'm still unsure that the inflationists are right. If the economy slows, it should be deflationary and the stock market rally in the last few weeks should falter. In any case, my comment is about the past, where people have been saying inflation is much higher than reported for years.)

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