Inflation has become the financial wolf that never came. But the danger is still there. And it may come in sheep's clothing.
I'll sum up my point upfront: The most likely form of coming inflation is not high official CPI or interest rates, but high food and energy prices that are invisible to policy makers and their think-tanks.
Now on to the long version.
What the western governments have done in 08/09 are primarily two things:
1. Massive injection of liquidity and expansion of money supply, to partly compensate for financial deliveraging.
2. Massive transfer of private debt to public, to temporarily lessen the perception of credit risk in the system.
With the rapid expansion and democratization of FX trading, raising interest rates is losing its conventional effect of shrinking money supply. Carry trades quickly drive up the exchange rate of high interest rate currency which leads to a massive inflow of hot money, effectively increasing money supply of the currency in the global context. We've seen numerous examples of such an effect in several countries (China, India, and Australia among others) in the few years prior to 08. Even in the U.S., the market answered the Fed's steady increase of interest rates from 04 to 07 with relentless increase of credit. I don't know if the Fed has realized this fundamental paradigm shift. But if they haven't and prescribe the conventional antidote, we'd surely have another massive bubble.
Furthermore, global commerce has changed the mechanism of inflation. Asia and Germany will gladly offer practically unlimited supply of any manufactured goods to meet the demand, wherever it may be. Demand-driven inflation is impossible as long as this global structure remains.
Commodities
But the massive increase of money supply in the system will have its effects if/when the system recovers and leverage rebounds. A natural outlet for this excess money supply, in fact the only one since people will be scared of U.S. real estate for at least a few years, is commodities. Unlike the seemingly unlimited willingness of Asian and German workers to make stuff, natural resources are finite and agricultural commodities are subject to many non-financial, hard constraints.
Commodity-based inflation will be largely stealth to policy makers and their think-tanks since food and energy are excluded from the "Real CPI", and it gives them a perfect cover to dodge the painful decision to tighten money. But we all pay for it every day. And it hurts the lower-income population more, both domestically and globally.
Moreover, commodity-based inflation, coupled with the determination of export-driven economies to remain export-driven, will cause a further decline of manufacturing in the U.S. Increasing commodity prices squeeze the profit margin of export-driven economies as well as domestic manufacturers. In this game of who-can-take-more-pain, domestic manufacturers have no chance. Germany still has a large supply of former East Germany's underclass. China and India still have a supply of hungry people that constitute at least 1/3 of world population. We only have illegal immigrants.
In fact, I'd argue the Great Stealth Inflation is already underway. See below for 1-year price history for gasoline and oil. Food is more complicated but you can check out wheat/corn/beef/pork/egg/milk prices to convince yourself. I'm not including gold here only because it's not a direct necessity for most people, although husbands having bought gifts in the past few weeks will probably disagree. Some may be tempted to say "but every market has gone up". But you don't have to pay for stocks. The point here is not about relative performance of different markets.
Actually this type of stealth inflation was here in 05-08. But nobody minded because we were all busy flipping houses and counting money. This time around, most of us will have a lot more time to feel the pain.
Now a real challenge to policy makers and think-tanks: if interest rates are ineffective or even counter-productive, how do you shrink money supply?
But more importantly, if the cost of living (never mind the CPI) increases by 10%, your 30% return on investment plus 1% increase in income all of a sudden becomes much less comforting.
