It’s hard to get worried about either inflation or deflation in the industrialized world at the moment.
Serious inflation seems impossible, given that there is so much slack in the major economies of the U.S., Europe and Japan. At the same time, the huge amount of liquidity that the U.S. is pumping into its financial system pretty much guarantees that general deflation won’t occur.
Yet the possibility of one or the other can’t be dismissed. Inflation is already rising in the emerging world, due to a combination of strong domestic demand, high and rising commodities prices, and investment inflows from the industrialized world. If not curbed, this inflation could spill over into the developed world — particularly the U.S., should growth be stronger than expected.
Deflation is less of a risk because of the obvious determination of the U.S. Federal Reserve Board to avoid it. That’s the point of the current round of quantitative easing — known as QE2 — to reflate the value of assets, including equities, by pouring in so much money that prices get bid up.
So far, all the liquidity isn’t doing much. The banks are taking the money the Fed gives them for the bonds they are buying up but they aren’t lending much of it. So, there’s very little velocity in economic growth. Normally, money frequently changes hands as Entity A lends to Entity B, which in turn spends the money on a variety of things, including wages for workers, who then spend as well.
Thus, all it’s going to take is for the banks to lend more to cause velocity to increase. If the Fed doesn’t start withdrawing liquidity the moment this growth kicks in, the seeds of inflation will be sown.
Further complicating the situation is the fact that the U.S. government — indeed, any governments that have a lot of debt — will not be unhappy with high inflation because it will make paying off the debt easier. If an entity owes $100 million, it will be easier to pay that back if revenue rises by 4% a year instead of by 2%.
You and your clients need to keep the threat of inflation in mind and ensure you have investments that will protect purchasing power if inflation rises. Fixed-income is no help except for real-return bonds. However, equities have a built-in inflation hedge because the revenue of many companies rises at least in line with inflation. IE
Inflation not a big worry
The U.S. Federal Reserve Board is commited to avoiding deflation, but inflation could creep up
- By: Catherine Harris
- January 24, 2011 November 5, 2019
- 12:21