Tuesday, June 16, 2009

And yet again - inflation

I clearly subscribe to the view that inflation is everywhere a monetary phenomenon. Too much money chasing too few goods leads to higher prices. Obviously central banks have created some more money (but again as described in an earlier post – Is inflation just around the corner? - it is central bank money and not broad-based credit which is increasing). But on the other side, the drop in demand for goods is just truly astonishing. And it is this drop in demand which is deflationary. Today’s release of the US capacity ratio shows just how weak demand is at the moment. Not only did the capacity utilization rate fall further, it continued to come in below expectations (even if only slightly) and at 68.3% showed another record low (see chart). This per se shows how strong the demand-destruction has been.

The second chart highlights how closely the change in capacity utilization is mirrored in changes in inflation (i.e. when capacity utilization falls, inflation falls as well even though a bit later). Even during the inflationary 70s, this cyclical relationship held.

Second, it also underlines that the money being created by the central bank does not (yet) find its way into the consumers’ pockets (rather US banks’ excess reserves have grown) and the stimulus injected by the government does not get spent (as households restore their savings ratio).

In the end, if the additional central bank money is not being used to finance additional goods-purchasing transactions, then there is not too much money and if demand-destruction continues to be faster than supply destruction (via existing capacity being closed or becoming outdated), then there will be too many goods. In turn, we have too little money chasing too many goods resulting in downward pressure on prices remains. So far, I am not overly worried about upward price pressures in the US and the Eurozone (the UK is a different animal though).

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