Worried About Inflation?

FIRST THINGS FIRST

With the economy at death's door last fall, the federal government prescribed the strongest medicines in its pharmacy. The bursting credit bubble bled the economy of money, so the Federal Reserve and U.S. Treasury started pumping in cash. The Fed is buying more than $1 trillion worth of mortgage-backed securities and debt of various government agencies, and it will buy hundreds of billions in Treasury bonds.

That's not all. The Fed effectively cut short-term interest rates to zero, a move that also boosts the money supply. Meanwhile, the economic-stimulus program enacted in February will feed almost $800 billion into the economy over the next two years through lower payroll taxes, higher jobless benefits and spending on such things as health care, education and energy projects.

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Economics 101 tells you that a flood of money can result in dramatic price increases. And the resulting high inflation is detrimental to the health of the economy, to say the least. It erodes the value of money -- particularly bad for people on fixed incomes -- and makes the economy run in fits and starts. Eventually, the government takes steps to rein in inflation by slowing the economy, a move that often causes recessions and havoc in the financial markets. As Robert Samuelson says in The Great Inflation and Its Aftermath, which analyzes the 20 years of tenacious inflation that began in the 1960s: "The inflationary episode was a deeply disturbing and disillusioning experience that eroded Americans' confidence in their future and their leaders."

WHAT'S KEEPING PRICES DOWN

Inflation is not a problem now because of the weak economy. "One thing recessions are really good at is keeping inflation low," says Standard & Poor's chief economist David Wyss. The most obvious impact of a recession is a drop in retail spending, which takes pressure off prices. Retail spending in April was down $38 billion from the same month a year earlier.

Although measures of consumer confidence increased dramatically in the spring, the figures are still well below historical averages.Unemployment is one reason that spending is weak and confidence is low. As of May, 14.5 million Americans, or 9.4% of the workforce, were jobless. The number could rise to 15.5 million if the unemployment rate hits 10%, as many economists predict it will. Even the employed tend to cut back on spending when they fear that they, too, may lose their jobs.

Declining wealth -- the result of falling home prices and the stock-market crash -- also suppresses the urge to splurge. "We've lost a lot of wealth as the value of our houses has decreased and the value of investments in the stock market has plummeted," says Ann Owen, a former economist at the Fed and now a professor at Hamilton College, in Clinton, N.Y. In addition, the decline in the availability of consumer credit dampens spending, as does the increase in the savings rate. Owen says that the rise in the supply of money hasn't "caused inflation yet because people haven't started spending it yet."

Even if the economy starts to grow in the fourth quarter, as Kiplinger's forecasts it will, unemployment will probably continue to rise for a while, keeping a lid on prices in 2010. In addition, productivity, another anti-inflationary force, tends to improve at the beginning of a recovery. Says economist Ed Yardeni, of Yardeni Research: "You almost never have inflation for the first year of a recovery. You usually have big unemployment and get a big pop in productivity. And that productivity bump actually brings down labor costs." For all those reasons, most economists agree with Yardeni that inflation won't be a problem for at least another year.

WHAT COULD GO WRONG

Quiescent inflation is by no means a sure thing. The uncertainty is due primarily to rising commodity prices and fear of a falling dollar.

Commodity prices have begun to perk up. The S&P GSCI commodity index, which dropped 46% in 2008, gained 9% year-to-date through June 5. Analysts say that much of the gain stems from buying in emerging nations, particularly in China, whose economy has continued to grow through the worldwide recession. Once a global recovery begins, manufacturers everywhere will need more raw materials, and their buying will push up commodity prices still further. And, of course, the price of oil could spike if Middle East tensions heat up. Ignoring such possibilities is causing "complacency about inflation risk," says Alan Levenson, T. Rowe Price's chief economist.

A diving dollar would make imports much more expensive -- which would obviously fuel inflation. What's more, because oil, gold and other stuff are priced in dollars, a falling greenback usually means higher commodity prices. Although the dollar held strong during the financial crisis as investors around the world sought the safety of Treasuries, big budget and trade deficits and generally low interest rates in the U.S. suggest that the greenback's long-term trend is down.

Meanwhile, long-term interest rates have surged this year, perhaps because of growing inflation fears. From a record low of 2% on December 18, the yield on the benchmark ten-year Treasury note stood at 3.9% on June 5. Because 30-year mortgage rates track the ten-year Treasury, rising bond yields threaten to lift housing costs. But economist Yardeni insists that bond investors are reacting to expected inflation, not actual inflation. In any case, a little bit of inflation isn't a bad thing, because it shows the economy has a pulse.

PUTTING ON THE BRAKES

William McChesney Martin Jr., Federal Reserve Board chairman in the 1950s and '60s, once famously observed that the Fed's job is to "take away the punch bowl just as the party gets going." Eventually, the Fed will have to withdraw all the money that it has injected into the economy. If it acts prematurely to reduce the money supply, the Fed could stifle the recovery. If it waits too long, it could contribute to a jump in inflation. "Its timing is going to have to be perfect," says former Fed economist Owen.

Vanguard chief economist Joe Davis concurs: "Deciding when to remove the punch bowl from the party will not be easy." But Davis says that if the Fed honors its own Ten Commandments, controlling both inflation and inflation expectations is "probably number one" on its priority list.