Don’t Fear Inflation – Yet

Friday, October 9, 2009

eagle balloon inflate-editGold is hitting new highs, oil is rising and the US dollar is falling – all amid a growing US government deficit. These movements have many investors fearing inflation and buying commodities and US Treasury Inflation-Protected Securities (TIPS). However, there is no need to worry (yet). Here’s why…

First, a quick explanation of what inflation is and what it is not. Starting with what inflation is not: price increases due to demand/supply issues. For example, steel prices rising due to economic growth (demand) or corn prices rising due to a drought (supply) are simply market price fluctuations. These price increases are a sign of a normally operating economy, not inflation.

“True” inflation, the kind to worry about, is best described by the term, “fiat money inflation.” This inflation occurs when the money supply increases faster than the economy’s rate of growth can support.

The underlying cause of fiat money inflation is usually government borrowing and spending substantially beyond its revenues and the country’s expected economic growth.  This inflation can turn into a vicious cycle of across-the-board price, wage and interest rate increases, leading to a weakened economy and dysfunctional income and resource distribution.

So, what about now? Many investors are using history (particularly the last inflationary cycle in the late 1970s and early 1980s) to support the notion that today’s government deficits will lead inexorably to high inflation. However, there are two key differences that are keeping inflationary risk low:

First, the knowledge among the people determining and evaluating government policies is much improved from the last inflationary period. There are many people in business, finance and the government with vivid memories of those traumatic times. In addition, current economic theories incorporate what happened then, diminishing the previous theories that the government could create growth through spending. (A good example is the health care debate’s focus on not increasing the deficit.)

Second, economists and investors understand that today’s government spending is aimed at stabilizing the financial markets and creating incentives for reestablishing economic growth. These are sound government roles that can be fulfilled in times of value declines and lending shrinkage. Importantly, these actions can be reversed as the markets and economy regain health. Debt issuance can cease as the need disappears, and the deficit can shrink as tax revenues grow.

So, there is no need to fret about inflation yet. But we do need to be watchful that the government heeds the past and quickly winds down its deficit activities as the economy winds up.

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