Inflation, Deflation, and Stagflation (in defense of the Fed)

The secular cycle...

(A) When there is more demand than supply, there is inflation as buyers out bid each other. The increased profits normally spark competition, which increases supply.

(B) Eventually there is more supply than demand, and prices drop off. Suppliers are driven out of business. Supply decreases.

Repeat cycle…

That, in simplest terms, is the secular cycle. Part (A) is the secular bull, and part (B) is the secular bear. If there were no Fed, that would be all there was to it.

The Fed interrupts the normal pattern of long term supply and demand, which creates a counter-intuitive climate for investors. Although the Fed gets a lot of criticism, the alternative would be mass suffering. People can starve to death in secular bear markets. By pumping money into the system (i.e. Quantitative Easing), the Fed creates an artificial form of inflation – stagflation – that effectively taxes everyone’s net worth (rather than mere income) by devaluing everything they own. And while savvy investors can ride the inflation wave, they’ll find their capital “gains” taxed in the end.

Thus, if the currency falls to 50% of its value against gold, gold would rise by 100% -- merely holding its original value. But a 1000 investment in gold that merely rode inflation to 2000 dollars would find 1000 of that “value” taxable in the end.

While there seems to be no escape for people with incomes and investments, stagflation tends to finance public relief to keep those on the bottom rung of the economy from starving or freezing to death. People still suffer, but it’s spread more evenly.

(more later)