Falling Prices Are Natural

The following isexcerpted from a commentary originally posted at www.speculative-investor.com on 16^thMay 2013.

The USgovernment usually admits to "price inflation" of about 2%/year. Asfar as we can tell, the actual rate is probably at least 5%/year, but no morethan 7%/year. Let's say 5%/year for the sake of argument. Considering what theFed has been doing on the monetary front, 5%/year still seems low. It'scertainly a long way from the hyperinflation that some gold and commodity bullsexpected to happen by now due to the Fed's profligacy. Why?

In previous commentaries we've discussed the apparent discrepancy between whathas been happening to the money supply and what has been happening to"price inflation". We don't want to go back over this ground intoday's report, other than to note the following: First, there is plenty of"price inflation" if you know where to look for it. The new all-timenominal price high for the US stock market and the surging demand for junkbonds are two examples. Second, monetary inflation's effects on prices arealways non-uniform and can encompass large and variable time lags, making theexact price response impossible to predict and difficult to correctlyinterpret.

In today's report we want to make the additional point that the central bank'shistorical effect on the "general price level" is much greater thanmost people realise, for a reason that never occurs to most people: the naturaltendency in a market economy is for prices to trend downward over time.

Most people have been conditioned to believe that rising prices are the naturalway of things and that a strengthening economy leads to higher prices. Theopposite is actually true. Real economic growth involves producing more viagreater productivity and/or population. If more is produced within an economyand the money supply remains constant, then the so-called "general pricelevel" will have a downward bias. In other words, if the supply of moneyis stable then the increasing production of goods and services will lead tolower prices for most goods and services. The purchasing power of money willincrease over time.

An implication of the above is that to bring about a rising trend in consumerand producer prices the central bank must first engineer sufficient monetaryinflation to counter the natural downward trend in prices. In the US, forexample, increases in production due to productivity improvements andpopulation growth would probably result in an average rate of decline in the"general price level" of about 3%/year, so if prices are rising at5%/year it effectively means that monetary inflation is adding about 8%/year tothe price of the average good/service. It actually isn't that straightforward,but the general point is valid.

If you are having trouble imagining the combination of falling prices andstrong growth, just take a look at the computer industry. In this industry therate of real growth has been so rapid up until now that even the Bernankes ofthe world have been unable to prevent prices from falling.

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