## Inflation or Deflation in 2002?

### by Fred E. Foldvary, Senior Editor

The prosperity of the American and global economy will be affected by whether there will be inflation or deflation this year, 2002. In analyzing inflation, we need to keep in mind that there are two types of inflation. Monetary inflation is the excessive growth of the money supply. Price inflation is an on-going increase in the price level, or overall prices, measured by a price index.

Deflation is the opposite of inflation. Monetary deflation is a growth of the money supply that is less than the rate of growth of the demand for money. So even if the money supply is increasing, if the output of the economy is increasing even faster, there can be monetary deflation if the demand for money grows at the same rate as output. We can then get price deflation, a decrease in the level of prices during some time interval.

There is another complication: velocity. Since money circulates, the frequency of the turnover of money is as important as the amount of money. Suppose you get paid once a month and spend all your money. We can call that a velocity of 1 (one). If instead you get paid the same total amount in two payments of half the amount each, then the average amount of money you hold is half, but it now turns over twice as often, for a velocity of 2. The effective money supply is MV, M being the amount of money and V being the velocity. MV would be the same in both cases.

Usually, price inflation is caused by monetary inflation. If the money supply, M, grows faster than the demand for money, there will be price inflation if there is no change in velocity. Actually, at high levels of monetary inflation, the velocity increases and folks try to get rid of cash as soon as possible. That is why prices escalate exponentially.

So the question is, what is more likely for 2002, inflation or deflation? If we have deflation, that is bad for business, since the prices of goods will fall faster and farther than the prices of their inputs, especially labor. Profits will be low, and therefore there will be little growth, and unemployment will be high. It's not that deflation is always a bad thing; the reason for deflation is what matters.

There have been articles, such as that in the January 4, 2002 Business Week Online, which are forecasting deflation. The deflationists argue that the prices of imports are falling, oil and gas are now cheap, technology is making many produces less expensive, and a depressed economy reduces the demand for goods.

The counter argument is that the U.S. has been experiencing high monetary inflation. There are various ways of measuring the money supply. The best measure is called MZM, which stands for "money zero maturity," i.e. excluding time deposits such as certificates of deposit that have a maturity date at which you may get your money back with no penalty. MZM includes cash and checking accounts and money-market funds that you may spend immediately.

The Federal Reserve Bank of St. Louis reports that MZM has been growing at an annual rate of about 20%. There was an especially large increase in September. Even if the velocity has decreased, that is a high rate of money growth, and the money has to go someplace. Much of it has gone to money-market funds, money that gets lent to business. The high rate of money growth has prevented what otherwise would have been substantial deflation.

It seems to me that we can get a general picture of inflation by looking at the prices of several typical consumer goods. In a supermarket near me, the price of fancy cans of cat food has risen by a dime. I also noticed that a large bottle of distilled water has gone up by 10 cents. Postage in the U.S. will most likely rise this summer, the first-class rate from 34¢ to 37¢. If we were really experiencing deflation, the prices of these common items, reflecting a broad set of inputs and also general demand, would be falling, not rising. Sure, gasoline is cheap, and that helps keep costs from rising, but that has not been enough to keep prices down.

My forecast is that prices will go up, not down, in 2002 for two reasons. First, the war on terror is raising the costs of production. One reason why postage will go up is that the postal service now has to check and treat mail for anthrax and other attacks. Travel is likewise more costly. These costs get passed on. Secondly, the expansion of the money supply offsets the deflationary effects of greater productivity and cheap imports. Third, the economy will improve in 2002, raising the demand for goods, thus preventing many prices from falling.

A mild inflation will favor business owners at the expense of workers, and borrowers at the expense of those with savings and money holdings. Funds in taxable savings and money-market accounts will most likely have a negative return, since the income tax taxes nominal gains that include inflation. In my judgment, the best investment strategy will continue to be a portfolio of diverse mutual funds, with perhaps long-term market-index put options as a hedge against a decline caused by terror attacks.

The long-term trend of the U.S. dollar since it was cut off from gold in the 1930s has been inflation, and that will most likely continue until we go back to using gold as money, combined with free-market banking freed from central-bank controls. Meanwhile, watch as your dollars buy less a year from now than they do now. At least, they will buy fewer first-class stamps.

Copyright 2001 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.