What's the outlook for inflation????

Many clients are asking, "How should we position our investments to guard against the coming high inflation?" This question presupposes that accelerating inflation is a certainty. Clients are hearing a drumbeat in the financial press and among pundits asserting that high levels of deficit spending, a weak dollar and mounting public debt will undoubtedly lead to an inflationary spiral. As long term observers of the gold and currency markets such conclusions do seem plausible. Gold has been in a multi-year uptrend stretching back to late 1999 and proclamations of the dollar’s imminent demise seem to be a daily headline. Public debt has doubled to roughly $12 trillion in the last 9 fiscal years. But what does the historical record tell us about the likely impact of the current fiscal and monetary trends in the US economy? Is the consensus that rising inflation and loss of the dollar’s reserve status are just around the corner supported by any empirical evidence?We attended the 2009 DFA Financial Advisor College in Santa Monica last week. Amid the usual avalanche of (incredibly detailed and useful) statistical information several presentations addressed these exact questions. The evidence presented was a bit surprising. The future may not be as certain as the pundits would have us believe. We’re going to summarize a few of the presentations that we feel may be of use to you when discussing these issues and others with clients in our next several posts.

The first presentation we'd like to highlight was delivered by Marlena Lee titled "Inflation Forecast". Marlena posed two questions: first, can inflation be accurately predicted and second, is the current monetary and fiscal environment likely to cause inflation?

Inflationary expectations on the part of consumers have in the past been the most accurate short-term predictors of inflation. This doesn't imply any particular predictive ability for consumers but if prices are rising and consumers expect them to rise further, inflation tends to become a self-fulfilling prophecy. Professional forecasters on the other hand seem to exhibit somewhat less skill. One year inflation forecasts by professionals (economists, etc. compiled by the Fed) in the period from the first quarter of 2000 through the third quarter of 2009 have a -.10 correlation with actual realized inflation rates. When the forecasts are compared with a one year lagged version of the actual CPI results the correlations rise to .83. This strongly suggests that professionals rely on current inflation rates to be the predictors of future inflation. While this is logical from an efficient market standpoint, the net effect is largely inaccurate and useless information from the predictions. For example, no professionals foresaw the steep drop in the CPI that began in mid-2007. It was not until mid 2008 that forecasters began to predict slowing inflation rates. Similarly, since the end of 2008, predictions have been for rising inflation while the CPI has continued a largely flat or negative rate. There is however, one empirical measure of inflation that does have predictive ability: the interest rate spread between the nominal 10-year Treasury bond and the 10-year TIPS. Since1999, the spread between these two instruments has averaged 2.23%. As of October 27, 2009 the spread was 2.24%. In late 2008 when deflation forces were strong, the spread narrowed to zero and for a brief period to a negative value. Given the remarkable consistency in the long term average spread between these instruments, a logical conclusion is that the credit markets do not envision an impending inflationary spiral.

There currently exists a large body of opinion that cites the explosion of the Federal budget deficit and the sharp rise in public debt as indicators that inflation must surely increase dramatically in the near future. Is this a reasonable expectation? On its face, an unprecedented level of national debt and previously unheard of annual budget shortfalls would seem to suggest inflation. Marlena examined both fiscal and monetary influences on past inflationary periods. Fiscal policy, in terms of the percentage of a country’s debt compared to its GDP in the conventional wisdom is thought to increase inflationary pressures in direct correlation with the increase in the percent of GDP represented by debt. Current debt levels and inflation rates argue otherwise. As of 2007, the outstanding US public debt stood at roughly 40% of GDP. As of June 2009, that level had climbed to 52%. This puts the US within a cluster of developed economies with roughly the same percentages of debt/GDP ratios. The annual inflation rates in these countries during 2008 fell in a range of roughly 2%-4%. This is hardly a severe number. We use a long term inflation average of 3.2% in our purchasing power studies. Within the group, Japan’s public debt level was at the high end of ratios at just over 160% of GDP in 2007. Japan’s annual inflation rate in 2008 however was the lowest of any country in the sample (<2%). Iceland registered the highest 2008 inflation rate in the group at more than 12% yet its debt/GDP ratio was a comfortable 20% in 2007. Clearly the efficacy of the link between high levels of debt and rising inflation rates is sketchy at best.

What about monetary policy? Surely unchecked creation of paper money will eventually translate into a collapse of purchasing power and a tsunami of inflation; or not. Examining data tracking the 12-month changes in the CPI and M2 (the broadest measure of the money supply) from the fourth quarter of 1959 through the second quarter of 2009 yields only a few instances when a strong uptrend in money creation is accompanied by a strong uptick in inflation. When the “output gap” (the difference between current and perceived maximum production levels in the economy divided by the perceived maximum) is overlain on the chart the reason becomes clear. It is only during periods of high capacity utilization that an acceleration of M2 growth is accompanied by an upturn in the CPI. Clearly capacity utilization is an important component when determining the potential inflationary impact of monetary aggregate growth. Capacity utilization in the US economy as measured by the Federal Reserve in October 2009 stood at 70.7%, well below the “maximum” in the upper 80%’s. With slack capacity utilization, strong growth in M2 should not be expected to be an inflation creator based on the historical record.

The final concern addressed in this presentation was the dollar. Myriad commentators and “experts” have been expressing concern that unbridled dollar creation to fund domestic spending will inexorably result in the abandonment of the dollar as the world’s reserve currency. Losing this designation would surely result in runaway inflation (in their expressed opinions). The facts in the currency markets suggest that this is not a likely scenario. The depth of the dollar markets dwarfs the Euro markets, which is the most likely substitute for the dollar as a reserve currency. Further, creating a hybrid “currency of currencies” would suffer the same handicap only worse. Despite the grumbling and lectures, the reality is that the Chinese and other US creditors have no real alternative to holding dollars. No other currency offers the liquidity available in the dollar markets.


The conclusions then are these:

There is great uncertainty about the inflationary future and professional predictions have proven largely inaccurate

The main components of inflation are expectations, money growth and capacity utilization

No one agrees on the relative importance of any of these components

There is no conclusive evidence that high inflation is imminent

There is currently little prospect of the dollar losing it reserve currency status


A link to the presentation slides is below.


https://sites.google.com/site/dkepartners/files