Inflation May Not Be On The Horizon

Includes: FXE
by: Wealthcompound

Everyone is worried about inflation. The financial pundits, analysts and even CEOs are warning about the high inflation environment that the U.S. is facing. Certainly there is precedent for their concern. Whenever governments have loosened the purse strings to easy money policies, high inflation has always reared its ugly head. The U.S., specifically the Federal Reserve, has definitely been guilty of easy money policies since the onset of the financial crisis.

Although the absolute 100% right thing to do considering the circumstances that the country (and the world) was facing was lowering the Fed Funds rate to zero, and instituting QE 1 and 2, although this would theoretically cause inflation to spike in the long run. However, according to the experts, inflation was going to hit by now anyway. All anyone has to do is go back and search through articles from as early as 2009 that were warning about inflation within the next few years. It could be argued that we are seeing signs of it. Food and gas prices are up. A trip to the pump or the grocery store is all the proof anyone needs to be convinced of this.

However, the cause of food and gas prices rising is not the Fed "printing money." The cause is primarily due to the emerging economies and the long-term market shifts. More and more countries will be consuming these commodities as the majority of their populations continue to migrate into the middle class. This is the current long term trajectory. It is by no means a certainty. Countries such as China and India have numerous structural, social and political problems that need to be addressed, and these are beyond the scope of this article. Currently, they are consuming, and as a result, prices have justifiably increased. Also, speculation has contributed to food and gas prices. With regards to gas prices, uncertainty in the Middle East, most notably geopolitical tensions with Iran, will continue to have an effect on gas prices until these tensions ease. If they don't, and Israel strikes Iran, oil will skyrocket, taking gas prices with them. Speculators in agricultural commodities however are betting on inflation. Although some commodities, such as corn, are off the highs that were seen over the last couple of years, prices are still higher than the historical average.

Since the volatility in food and gas prices is high, it is important to look at the CPI (consumer price index) excluding food and gas. Currently, the CPI ex food and gas is around 2%. This is the desired inflation rate by the Fed. As mentioned earlier, many believe that this rate is bound to spike. Generally, I would agree with this premise. However, my thesis is that most of the accepted financial and economic theories have been turned upside down, including the notion that inflation is inevitable due to easy money policies. Consider the economic recovery. Although the recovery has been sluggish, and at times anemic, there is no doubt that the economy is on a path towards health.

What has been unusual about this recovery is the fact that it has not been led by the housing market. In fact, the housing market is moribund. Many factors have contributed to this. First, housing was the underlying cause of the Great Recession. A massive bubble burst and the mess is still being cleaned up. As a result, housing can't lead the way in this recovery. Too many people are either underwater on their mortgage, in foreclosure or just can't get a loan if they are a willing buyer. This leads to my second point. The Federal Reserve does not print money. What they do is, at the press of the button, increase the amount in the accounts that banks have with them. Is this an increase in the money supply? Of course. Does this necessarily lead to inflation? No. The money is not in circulation. Banks are making sure of this. Lending for consumers is still very difficult to come by. The number of people unable to get financing for homes, cars, etc. is still quite large. Banks are being very conservative and while this has led to very healthy U.S. banks, even great credit risks are being heavily scrutinized before getting a loan. Plus, banks do not want to make a bunch of low yielding long term investments when they can invest short term and wait till the interest rate environment improves.

To Wall Street's dismay, the Fed looks to be signaling a higher rate environment soon. While Mr. Bernanke noted several months ago that rates would most likely stay the same until 2014, more recently the Fed disappointed, signaling that QE3 does not look to be on the horizon (in my opinion, it is not necessary). I think that Chairman Bernanke will eventually reconsider his time horizon of 2014 as well, especially if he pays attention to the economy instead of the stock market. The Fed will ultimately determine if I am right or wrong. If my guess is right, and the Fed raises rates before 2014, I think significant inflation, if it were to arise, could be managed. If the Fed decides to keep rates low into 2014, it would most likely also implement QE3, because such actions would indicate a weak or weakening economy. Unfortunately at that point, this theory goes out the window, because I think that such actions would almost certainly ensure high inflation by the latter part of the decade.

Although most of this analysis is quite qualitative, my last portion of this theory is qualitative possibly to the point of being abstract. Has anything over the past several years gone the way that economic theory or historical analysis would suggest? Think about it for a second. The U.S. dollar is inexplicably worth less than the euro. Yes, the U.S. is on a trajectory of devaluation, but Eurozone members are on toeing the line of default. Greece already technically defaulted. Plus, the U.S. economy is doing much better than any country in the Eurozone, including Germany, which is without a doubt the big kahuna in Europe. If we hold ourselves to what "should" happen, this doesn't make any sense. Why would anyone want to hold euros considering the various unknowns, even with current U.S. monetary policy? Second, it is very apparent that equity, and some bond markets, have decoupled themselves from fundamentals. Although I don't think this is a long term shift, it could continue for quite some time. Equity markets especially have been on a roller coaster ride of emotions over the past several years of the bull market, alternating between bouts of overemphasizing bad news and dismissing good news and vice versa in a somewhat familiar pattern of spring/summer sell-offs.

PIMCO coined the phrase "The New Normal." A one word summary of this theory would read: stagflation. I would disagree with this assessment. For me, "The New Normal" is representing a marked shift where accepted economic theory and historical precedent may not accurately predict the future. Part of this "New Normal" would include the notion that easy money leads to inflation. It could very well be different this time around.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.