Tuesday, April 19, 2011

Why the Pessimists Are Wrong About Inflation

Alexander Green

Everywhere I go these days, investors keep telling me the same thing. They're adjusting their portfolios for the leap in inflation that lies just ahead.
These investors are probably right about inflation. It'll almost certainly tick higher in coming months. After all, it was only 1.2 percent in the fourth quarter. But all this investment capital flooding into gold and silver, inflation-adjusted Treasuries and commodities may well prove to be spectacularly ill-timed.
Let me explain why.

I'll start by making my usual caveat. I don't know what the future inflation rate will be and neither does anyone else. But, in my experience, when the overwhelming majority of investors are thinking the same thing, they're usually not thinking at all. Instead they're simply repeating the conventional wisdom.

What is that? That a sharp increase in the CPI lies just ahead thanks to a weak dollar, sharply higher commodity prices and budget-busting spending by Uncle Sam. These symptoms are obvious, of course. The dollar has spent much of the last decade wilting like last week's roses. Agricultural commodities, energy prices and metals have all rocketed higher. And Congress - the recent budget compromise notwithstanding - continues to spend our tax receipts like sailors with four hours of shore leave.

So why isn't hyperinflation dead ahead? Let's start with Milton Friedman. The Nobel Prize-winning economist famously observed that inflation is always and everywhere a monetary phenomenon. In the inflationary spiral of the 1970's and 80's, for instance, the money supply, wages and U.S. gross domestic product all rose at double-digit annual rates.

But today economic growth is tepid. Wages are stagnant. (And will remain so with unemployment high.) And the money-supply gauge known as M2, which includes cash, bank deposits, and money market funds, rose just 3.4 percent in February.
How about higher commodity prices? Chances are good that these are nearing an end. As I've often explained, high prices always sew the seeds of their own destruction. Take oil, for example. The higher it goes, the more competition (and therefore supply) it attracts. Properties that aren't economically feasible (think oil sands) suddenly become so. And consumers and businesses cut back, by conserving or buying more fuel-efficient vehicles.

Just this week, Goldman Sachs - a long-time commodity bull - reversed its position on raw materials. The firm expects the hot money going into commodities to cool down. I agree. We're likely to see lower prices for energy, grains and especially metals in the months ahead.
How about the humongous federal budget deficit? Certainly there's no way that that isn't going to be inflationary, the pessimists insist. Hmm. If only we had a modern-day example of a major, developed country that ran a persistently high deficit so we could see what happens.
And, fortunately, we do. Japan's government has been wasting (excuse me, spending) ridiculous amounts of money for more than two decades now. Its federal debt as a percentage of GDP has now hit 200%. That's more than double our rate and much more than even bankrupt Greece and Ireland's.

Has Japan suffered from hyperinflation? No. It has the opposite problem. For more than twenty years, it's been battling a persistent and debilitating deflation.
That doesn't mean we're going to have disinflation here, of course. But it certainly ought make you stop and consider whether we're in for a head-spinning rise in prices.
Yes, I know. Food prices, gasoline, health insurance costs and college tuition are already rising much faster than the official inflation rate. But consider too that appliances, cell phones, computers, consumer electronics, cars, furniture and (ahem) home prices are coming decidedly down.

The bottom line is this. Inflation may or may not become a problem. You should certainly own oil stocks, precious metals and inflation-adjusted Treasuries, but only as part of a reasonable asset allocation.

In short, don't overdo it. Because the hyperinflation that everyone keeps crowing about may be late to the party. And it may not show up at all.

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