Inflation: For and Against
by Red Delicious on June 25, 2009
The hot topic du jour is inflation, when it will rear its ugly head and to what extent we should be concerned. We have therefore put together the argument for and against inflation, along with some food for thought in conclusion.
- The argument for significant inflation: Let’s start with the fact that the budget deficit now stands at 13% of GDP. Then add the $100 trillion in unfunded liabilities of Fed programs, such as social security, civil service and military pensions, and the ballooning bills of Medicare and Medicaid. This lethal combination allegedly ensures dramatically higher interest rates, massive tax increases and puts into question many government promises made to date. Let’s contribute to this perfect storm Bernanke’s anti-deflationary monetary policies, which have dramatically increased the monetary base by almost $1 trillion beginning this last September. (Monetary base = currency in circulation + bank reserves + vault cash.) The New York Times has called this “the largest increase in the past 50 years by a factor of 10″, representing a 15% growth rate of money supply over the last 12 months alone. Basically, the Fed is buying debt from the government and private sector and paying for it by crediting banks with extra reserves. In the meantime, the demand for money is dropping due to decreased output and falling employment. So combine decreased demand for money plus its rapidly growing supply and the outcome is not rocket science: higher inflation and higher interest rates (which in turn further reduce the demand for money, exacerbating further inflationary pressures).
- The argument against significant inflation: First and foremost, there are no signs currently of inflationary pressures. Consumer prices are lower than they were last year and wage increases have come to a halt, both arguing for deflation rather than inflation as a potential culprit. Indeed, the Fed’s increase of bank reserves would generally encourage banks to increase their lending activity, which in turn would increase demand, thereby up pushing prices. But that’s not happening; banks are not lending their reserves for the most part and are instead sitting on them. As an example, between ’97 and ’03, the Bank of Japan purchased debt on a massive scale yet consumer prices fell. During the Great Depression, many were warning about the dangers of hyperinflation yet prices plummeted. Lastly, the current fears of hyper inflation if our debt exceeds 100% of GDP appears misplaced after looking at Japan, Canada and Belgium, all of which surpassed the 100% threshold while avoiding this dreaded pitfall. Even the US surpassed 120% after World War II without the “I” word destroying the economy.
- What we know: The question in the real estate world is whether a home is a good hedge against inflation. Keep in mind that housing returns have tracked inflation over time, not surpassed it. If you are waiting to buy now (from an inflation standpoint), you are basically betting that home prices will decrease more than will inflation will increase. [Pause and digest that for a second to see how that sits with your view.] Alternatively, if you are buying now as a hedge, you believe that inflation’s rise will surpass the fall in property values. Certainly some level of inflation will materialize over the next few years; how quickly and to what degree are both hotly debated questions. “What about the impact of foreign purchasers and their increasing purchasing power based on the anticipated devaluation of the dollar“, you ask? “What impact will that have on Manhattan prices?” Though this argument has merit, a closer look at the European and Japanese economies suggests that they are in worse shape than ours. Foreign investment would need to come from other parts of the world.
