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Risks of Inflation

Many analysts state that we need to embrace the "new normal," predicting that the U.S. economy will grow at a rate of 2% for a while instead of its historical average of 3.6%.  With lackluster economic growth being a real possibility for several years, it may be surprising to hear that a big debate is going on regarding the prospect of higher inflation.  The concern over inflation arises from the dramatic increases in both the money supply and federal expenditures.  Ben Warwick of Quantitative Equity Strategies describes the situation as: "the Treasury keeps printing currency and the Fed keeps spending it in attempt to bolster the flagging economy." 

 

There are a number of reasons, however, to believe that high inflation is not imminent.  For one thing, according to Jerry Webman, chief economist at Oppenheimer Funds, the money being created is not being put to use - banks are not lending and consumers are not spending.  Money is sitting on the sidelines instead of creating economic activity.  Webman states that the rate at which money is flowing through the economy (velocity) is at a two-decade low.  Thus, the increased money supply is not pushing prices higher.

Another factor limiting potential inflation is the excess capacity of productivity and labor.  James Paulsen, Chief Investment Strategist at Wells Capital Management, notes that unemployment is around 10% and factory utilization rates are less than 68%.  This excess capacity can soak up a lot of economic growth before inflationary pressure occurs.  Ben Warwick opines that inflation will not exert itself until the economy turns around to its previous level of economic activity, but that we are a long way from that.  Prices are low because demand for goods and services is low.  Government spending has not picked up the slack.

On the other side, strategists at Morgan Stanley cite a number of reasons why increased inflation is likely in the coming decade.  They argue that an expansive global monetary policy (read: lots more money being pumped into the system) will inevitably cause inflation.  Productivity gains and increased globalization, which have limited inflation in past years, will slow down in the future and not act as a sufficient counter-balance. 

In the end, it is important to be vigilant.  But inflationary concerns still seem at least a couple of years away from being realized unless we see a rapid recovery in the economy.