There is a great deal of concern amongst the various pundits that the huge stimulus package will soon spark an inflation surge not seen since the late 70’s. While there is little debate that the stimulus package is potentially inflationary, I don’t share the prediction that we’ll see a huge jump in inflation down the road.

The first reason is that I believe we were already inflated and the stimulus is merely replacing money that was already in the system to begin with. Through the huge mortgage borrowing that took place over the last decade we added a massive supply of money to the system. The prevalence of cash out refinancing and existing housing stock being sold at higher and higher prices effectively added enormously to the money supply. Under normal circumstances that lending would have been restricted by bank reserve requirements but in the mortgage lending madness of the past five to ten years most loans were sold to outside investors, many from abroad who contributed to this influx of money without the normal restraints. Today, as those mortgage loans default the loss of this capital helps offset the new money being pumped back into the system by the Federal Reserve. In essence we are merely monetizing some of the debt that was added to the system over the prior decade.

A second reason inflation is no sure thing is that we are saving more. When times were good a dollar earned was soon to be a dollar spent. Because our savings rate was so low, every new dollar added to the monetary system got spent multiple times creating ample opportunity to drive prices higher. Today spending habits are vastly different and that same dollar finds it’s way into savings or to pay down debt much quicker than just a year or two ago. In economic terms the velocity of money has dramatically decreased which means new dollars introduced into the monetary system are far less effective at increasing inflation. Unless we suddenly revert to our old mega-consumer ways, this will have a dramatic effect in lowering the potential inflation rate.

A final reason inflation may be lower than we think is that a good portion of the stimulus is actually being used to buy debt that can be easily resold. By purchasing preferred stock and bonds the Fed puts new cash into the monetary system. When the economy begins to recover they can easily, and very rapidly, sell those securities and drain the cash back out. As an added bonus those sales would likely be at a profit as the recovering economy makes the risk of holding many of these securities more attractive to investors.

Understand that I am not suggesting there will be no inflation but rather that it could be substantially less than many people think. There are two important caveats to keep in mind. First, we are currently in a period of virtually zero inflation and while the inflation rate will likely return to the average target rate of two to three percent, it could track higher than the target rate for a period of time as it offsets some of the unusually low periods. Couple that with a reasonable expectation that the Fed will tend to err on the side of letting the economy run a bit to assure they don’t tighten too early and it’s probably fair to expect some above average inflation for a year or so. The second caveat is that although all this works on paper, the real world is not quite so easy and the potential for mismanagement is real. Fortunately the Fed has had considerable experience in managing inflation and the money supply so I would expect that the odds for good management are in our favor.

Inflation is clearly worth keeping an eye on but be careful before you completely adjust your investment strategy in anticipation of prolonged, high inflation. There is a very good chance we won’t get there.

Randy Gridley

April, 2009