Those who fear high inflation should consider two key economic factors that are commonly ignored: capacity utilization and monetary velocity. Both indicators do not warrant concern at their current levels. Given the concurrent failure of policymakers to stimulate demand and the semi-invalid Phillips Curve, there's not a high likelihood that inflation will hike significantly in the near future.
At the present moment, inflation is held in check by lower than normal capacity utilization, which expresses the percentage of a firm's actual output relative to its hypothetical total output. Total industry capacity utilization is currently just south of 79%, as seen in an excerpt from the St. Louis Fed report below. It dropped as low as 67% in June 2009, the depths of the crisis. Said differently, at that time the US economy was producing only two thirds of what it could have. In contrast, right before the crisis this indicator hovered around 80%.
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Low capacity utilization means there is plenty of room to increase profit margins, because firms can hire workers without raising wages. But at full capacity, more output will lower margins because wages have to rise. At the current level of idle capacity, there's not enough competitive pressure for labor. We should worry about inflation when capacity comes back to about 82%.
Velocity of M2 Money Stock, or the number of times one dollar is used to buy a good or service, was just below 1.6 for Q1 2012, from another St. Louis Fred report. This marks a decline from 2011's dismally low levels. To give you a context, money used to change hands almost 20% faster a decade ago.
According to these indicators, we're unlikely to see inflation for a while. Even if monetary velocity were to accelerate, wages won't rise because of high idle capacity. Moreover, policymakers have been unable to solve the problem of stimulating demand. Operation Twist, the government's attempt to tamper with the credit system, was recently extended. Another thwarted attempt was quantitative easing, which flooded the banks with massive amounts of liquidity but accomplished little else.
Unfortunately, the reason people aren't pouncing is not that interest rates are too high, or that there's not enough liquidity. Lower interest rates won't help; they're already low enough and the money isn't moving. The real reason is too much of the US population remains under/unemployed.
Keep in mind that the government has tried unsuccessfully to create inflation for years, and has failed because it has lost the power to stimulate demand. There aren't that many levers left to pull. We can't push rates any lower. The other two options are lowering taxes or injecting more money into the system through QE. No matter what they say during the campaign, neither the Republican nor the Democratic candidate is going to be able to lower taxes after getting elected. QE3 will be as ineffective as the first two rounds.
Given the lack of a viable stimulus and the partially functional Phillips Curve, I'm not convinced that the US is going to be turning into the next Weimar Germany anytime soon. The bigger concern for US investors should be the Eurozone crisis. The absence of rising inflation bodes well for high-quality, long-duration bonds as a tactical, short term hedge against international volatility.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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