How the lack of price inflation could kill the economy

I know it might sound backwards, coming from someone who claims to be a fan of sound economics. But hear me out. After last weeks CPI-numbers, and lets ignore for a moment that this is the government fudge numbers (for a look at how the CPI would have looked without the Boskin Commission and other manipulations, check http://www.shadowstats.com/). What is the largest risk to the US economy? The Federal Reserve.

While the Federal Reserve policies as of this moment can hardly be called inflationary, since they have mostly consisted of allowing commercial banks to stockpile reserves, this could change quickly. The reason that the US Federal Reserve has so far failed to hyperinflate the US dollar is simply because the underlying factors are causing that much deflationary pressure to counteract their actions. People might argue that this makes their policies sound, but that is (in my view) a bit of a misnomer - a sound economy would have had rapidly falling consumer prices and accelerating debt deflation since the fall of 2008. You may think this sounds horrible (the latter part at least) but that was the easy way to get out of this hole. This is the hard way.

The problems will sooner or later emerge, although it's hard to pinpoint where. It could be (as Robert Wenzel has pointed out during this spring) that the Federal Reserve finds themselves in a situation where they have to buy more Treasury securities to keep the Fed Funds rate down. It could be a second collapse in the mortgage market. It could be the US trade deficit shrinking due to China changing their dollar peg, or some other policy shift. It could be inflation pressure rising either in Britain or Europe (unlikely sofar, but it could happen).

Any of these scenarios have one, and only one, solution. Monetization of debt. The Federal Reserve must crank up those printing presses and add an additional trillion or two to their balance sheet. It might not be that inflationary this time either - the commercial banks may fail to lend out any significant amount this time as well. They may very well park it all in US Treasuries just to be safe. But sooner or later, printing money MUST become inflationary. And this is where the problem is.

This article from Bloomberg is the second that I've seen that has declared inflation dead. There is talk about a "new normal", where inflation problems are no more. Due to the flawed government CPI numbers, we are experiencing something that looks like zero price inflation, and sooner or later the US Federal Reserve is going to take this as a cue to print their way out of each and every new obstacle ahead. What this basically means (and this is already partly true), is that the US monetary system is going to be wound up to contain an ever increasing amount of lagging price inflation, and this will be done to the point of no return. And then, one day, the water starts seeping in under the door of the Federal Reserve. And as Ben Bernanke & Co. realize that someone has to turn off the pump that is about to drown the US economy in a flood of paper money, it will already be too late.

It might happen next week. It might happen next year. Hell - it may even take half a decade. But when this chicken comes home to roost, it's game over for the US dollar. So instead of trying to be upbeat and saying "well, at least there is no inflation problem yet", you should be screaming in horror "for the love of god give us price inflation to prevent the Federal Reserve from destroying the economy!!!". Remember - if it wasn't for the Boskin commission, we would currently be saying that annual consumer price inflation in the US was between 5 and 6 percent. You be the judge of which measurement might be correct....