Inflation Seems Like a Safe Prediction, but It's Hardly So Simple
Wall Street's penchant for overreaction aside, it's understandable why many investors might be bracing for scorching inflation ahead. Already posting a stronger rebound than many commentators had expected, the U.S. economy shows signs of picking up yet more steam. Some high-profile economists are expecting growth rates as high as 6% in the year ahead, and bellwether companies like Caterpillar (CAT) continue to report strong global demand.
That by itself is often enough to result into inflationary pressure. But lately, fears of a conflagration in prices have been exacerbated by the vast easing measures the Fed continues to take in response to the financial crisis.
The reasons to count on major inflation under these circumstances seem straightforward enough. But much like the actual impact of spiking commodity prices, the way inflation plays out is far more complicated. And while the usual pressures get plenty of press, countervailing forces can be far easier to overlook.
Restarting Idled Resources
While U.S. GDP may be ready to deliver impressive gains, measures like industrial production, which took a major hit during the recession, still have a ways to go. Indeed, industrial production remains 6% below its pre-recession peak, analysts at TD Economics wrote in a research note this week, and it will take another year to close the gap even at the present three-month average growth rate.
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"Throughout the post-recession expansion, growth in [industrial production] has stemmed not from the generation of new productive capacity, but from increased utilization of existing resources that had lain idle during the downturn," analysts at TD Economics wrote in a research note.
That means plenty of spare capacity can still be brought on-line, and that should help dampen inflationary forces. "With industry operating below potential, we believe inflation will stay subdued for now," the analysts wrote. "And with a fair amount of slack to absorb, the Fed will be in no rush to tighten monetary policy soon."
All that money the Fed created, meanwhile, might not lead to inflation as directly as some of Ben Bernanke's most strident critics claim. Along with the raw supply of money, the amount of that cash put into circulation -- sometimes called the velocity of money -- plays an equally important role.
Dormant Cash Isn't So Dangerous
And that leads to a much more complicated relationship to inflation than the constant howling about the obviously dire consequences of the Fed's money-printing would suggest.
"In order for any monetary variable to be reliable, the so-called 'velocity' of money in circulation needs to be stable, which is not often the case," Jim O'Neill, the high-profile head of Goldman Sachs Asset Management wrote in a research note. More money supply, in other words, doesn't simply translate into inflation. Cash laying dormant doesn't bid up the value of prices.
It's also natural for investors to think back to times when inflation ravaged the economy, like during the 1970s, when assessing risks. But things have changed dramatically since then, and the fact is that inflation has remained at benign levels for decades since that awful time. A combination of many fundamental shifts in the economy is often credited for this.
"Originating with the tough anti-inflationary policies of Paul Volcker at the Federal Reserve in the U.S., the widespread introduction of deregulated markets, globalization, and the introduction of the Internet have all been huge forces to bring the inflation process to where we broadly sit in current times," O'Neill wrote.
Given an economy now gaining steam and a vast expansion in the money supply, it's easy to assume inflation is up next. The causes of inflation, however, are anything but straightforward. And investors are better off keeping a close eye on incoming data than blindly believing the pundits who have a simplistic view of inflation.
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