Why the Fed Likes Inflation (and What It Means for You)
February 25, 2011, By Tyler Newton 0 comments
Why would the Federal Reserve Bank, who is holding interest rates at zero, be purposely trying to whittle away the purchasing power of savers in this country? Below are a few simple rules to understand how the Federal Reserve operates, why interest rates will likely remain low for a while, and why that’s good for stocks and commodities.
- Job #1 is to prevent deflation. The Fed was created back in the day when deflation, or falling prices caused by a collapse of demand, was the primary issue.
- Deflation is caused by financial crises. Deflation is generally a symptom of financial crises. Companies, consumers and banks load up on debt during boom times. When the eventual bust comes, certain companies or consumers do not pay their debts. If the assets (loans) of a bank run into trouble, banks tighten credit to preserve cash. If the creditors of the bank (depositors and other banks) become nervous about its asset quality, they withdraw their loans and the troubled bank suddenly collapses. Because banks lend to each other, bank collapses cascade through the system, leading to a collapse of demand as everyone scrambles for cash.
- The financial crisis of 2008 was deflationary. The collapse of the highly-leveraged Lehman Brothers (an unregulated bank) had started to cascade through the financial system, leading to the near collapse of AIG, Merrill Lynch, Citibank, Wachovia and other firms. During the crisis, the Fed lent to the financial system when private credit was being withdrawn.
- The Fed actually likes inflation. Because the Fed is afraid of deflation, it generally likes to promote moderately positive inflation of 2-3% on a regular basis to provide a cushion against deflation when the eventual crisis comes. I personally believe that this line of thinking is flawed, but it is how the Fed views it nonetheless.
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