From the July 2009 issue of Wealth Manager Web • Subscribe!

A High-Class Problem

Layoffs, mounting debt and housing prices in a freefall are but three items on a long list of economic troubles the U.S. is facing. Unfortunately, inflation is one concern that doesn't make the short list.

Most "inflationistas" point to the ever-increasing amount of cash floating around the economy as a sign that higher prices are inevitable. Indeed, both M1 (which includes all cash in circulation and money in checking accounts) and M2 (M1 plus savings and money market funds) are soaring. As the Treasury keeps printing currency and the Fed keeps spending it in an attempt to bolster the flagging economy, the supply of money keeps increasing.

Indeed, recent gains in the energy complex seem to suggest that the formerly moribund crude oil market is the beneficiary of all this new cash sloshing around the economy.

But inflation will not be an issue until the economy turns around, and the world is far from where it was in terms of economic activity. Costs are low because demand for all types of goods has dropped off. Even though the world's governments are fighting the persistent unwinding of leverage, total government lending and security purchases have offset only a fraction of the drop in private sector lending.

The shape of the American household is also a concern. Consumers drive about 70% of economic growth, yet the average family is still considerably overextended. Although corporate balance sheets are in good shape, too many folks remain mortgaged to the hilt.

There are signs that the recession is near a tipping point, however. Housing starts, jobless claims and consumer sentiment--the top three leading economic indicators--are improving, according to Decision Economics, a Toronto-based consulting firm. This likely portends better times by year end, assuming another shoe doesn't drop.

And don't worry about M1 and M2. Although both measures are rapidly expanding, the rate of money supply growth is far from that experienced in 1972 through 1982, a period known for runaway inflation. And historically, inflation doesn't expand until the economy starts to recover, which should give the Fed a long enough runway to ease back on the monetary throttle.

Deflation is a larger current threat than its pernicious alter ego. Although the Fed can run rates up as much as needed to keep prices down, rates can be pushed down only so far in a deflationary scenario. If easier money fails to stimulate demand, falling prices can persist (Japan in the 1990s). And in a scenario where prices are thought to drop, consumers will hold onto their cash, thinking that the costs of goods and services will continue to fall. This would severely hamper economic growth.

Fortunately, we are nowhere near this scenario. More has been done to address the banking issues in the U.S. in the last few months than in 10 years in Japan. But we aren't out of the storm yet, so inflation shouldn't be a concern until visibility improves.

Ben Warwick (ben@qesinvest.com) is chief investment officer of Quantitative Equity Strategies LLC, in Denver, and Memphis-based Sovereign Wealth Management, Inc.

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