Economy

Inflation vs. Deflation Which is it? by Thomas R. Lacey, Ph.D., May 14, 1999

Consumer prices came in stronger than expected today causing the stock market to falter. How valid a response is this?

If you believe, as has been suggested by some senators, that Kosovo is going to wind up costing the US government 100 billion dollars, then we should expect to see some upward pressure on prices. Of course, there are other conflicts the US is engaged in as well, such as Iraq.

This is likely to be a temporary effect. The long term economic trend is still deflation as we see tremendous increases in technological productivity and global economic competition, forestalling price collusion.

Although there are significant increases in wealth on paper as stocks reach into the stratosphere, these increases are not widely distributed. Most people still manage to lose money even as the market as a whole goes up. This is because they buy high and sell low obviously, which is the natural reaction to rapid price fluctuations, market volatility.

Most working people still own very little stock, and what they do own is tied up in IRA accounts, so stock market prices do not significantly push up inflation in general. Rising stock prices actually can keep wage demands down as more and more companies use stock option plans as part of their compensation package. Also, people have a tendency to retire earlier if they have significant increases in capital gains, thereby leading to lower labor force participation.

The significance of rising prices means more to the bond market than the stock market, raising long term interest rates and lowering bond prices. Since sector favorites have risen at much greater rates than bonds, there would have to be substantial inflation to cause a major crash in these sectors. The expectation in new technology and internet sectors is for multiple price expansion, so apart from temporary effects, rising inflation will still likely favor internet and technology sectors at the expense of older sectors.

There is a shift out of bonds as rates rise, hence the falling bond prices. The money is not likely to stay in cash or short term debt instruments for long. It is soon shifted back into stocks. After a business cycle slump, stocks recover faster than bonds. Bonds are a pure interest rate/inflation play. Stocks also reflect long term gains in technology. Obviously the place to be in the long run is in technology stocks.

Technology and internet sectors will be influenced less than more interest rate sensitive sectors, by increasing inflation, although in the short run they may fall a lot because they have a greater volatility and have risen a lot in recent times. Yet they have already corrected already.

The significance for working people is not that great unless the Federal Reserve raises short term interest rates, which always has a negative impact on spending and growth.

It would be much better for the Federal Reserve to keep a hands off policy with regard to the economy and only be concerned with ensuring an adequate supply of money for investment needs.

Given the rapid rates of technological change, there is always a demand for more investment, so a policy of low interest rates will produce the most investment and the lowest rate of unemployment, as well as a low long term rate of inflation.

The Federal Reserve should not be so concerned with short term changes in price indices, particularly when there is a war going on. Raising interest rates in war time only leads to less private investment and to stagflation.

More than likely however, the Federal Reserve can be counted on to do the wrong thing, so rising prices tend to limit expansion.

In a perfectly competitive economy, a modest rise in prices is considered healthy, a sign of economic expansion. If workers makes wage gains, all the better. However, Federal Reserve policy in past years has been designed to favor the stock market at the expense of wages, so there has been increasing income inequality.

Real incomes have increased however because of falling consumer prices, particularly in electronics, which make up an increasing part of everything.

Since the US agricultural sector is in depression, more effort should be given to increase competition in food distribution to hold down retail food prices. Raising interest rates only makes it worse for farmers and does not hold down food prices.

A much more structural approach to both prices and employment is needed by policy makers. Macroeconomic and monetary policy is no longer effective in today's world market economy. Tinkering is more likely to produce the wrong results and lead to increased volatility in financial markets.

Individuals cannot really survive any more just on wage income. Without capital gains, there is no long term wealth accumulation. Policies which favor capital gains, particularly for lower income groups could have a benefit for reducing income and educational inequality.