Where Did Inflation Go?

For those concerned about incipient inflation resulting from the gargantuan monetary expansion we had over the past 18 months and the budget deficits we are still running, the lack of inflation is confounding.

One explanation is that the Consumer Price Index is inaccurate and misleading. For example, a third of the consumer price index is Owners' Equivalent Rent, an artificial addition put into the CPI in 1980. In the go-go years of housing, real estate prices were up much more than the Owners Equivalent Rent, and the actual cost of living went up by about 7%. The CPI did not reflect that.

Remove housing costs from the CPI, and inflation is back. In January the CPI was up 5.8% on an annualized basis, excluding owners-equivalent rent.

Another important explanation is that historically, inflation lags growth in the money supply by at least a year. By that measure, we should expect inflation by the end of 2010.

This happens because in a recession, demand falls and business activity declines. Businesses cut prices and reduce their borrowings. The Fed expands the money supply aggressively as a way to counter the recession. Inflation is the result of money supply growing at a higher rate than the goods and services in the economy.

Right now commodity prices are starting to rise again, and it seems businesses are done lowering prices. The economy hasn't caught up yet with the past decline. The slack left over from the recession is keeping inflationary pressures in check. This is why inflation lags.

During the early stages of the business cycle, government deficits actually coincide with lower interest rates. Currently, the Federal Reserve set short term interest rates at almost zero. But this is temporary.

Companies have become much more lean and competitive with the wave of streamlining that was forced on them by this deep recession. And as the economy begins to recover, both business and individual borrowing will increase, putting upward pressure on interest rates and fueling inflation. And if low interest rates trigger higher housing prices, inflation will be demonstrably higher.

It isn't all bad. Higher inflation might shrink the mountain of debt: Nonfederal government debt, now about $27 trillion, is almost four times as large as federal government debt (about $7.2 trillion).

After all, it worked before. In 1946, post World War II, US national debt was 122% of GDP. Ten years of 4% average inflation later, it was half that.

Inflation seems subdued now, but in light of the political constraints facing Social Security, Medicare and other entitlement spending, it is an inescapable certainty. At some point we will have to deal with the pernicious effects of a credit system flush with cash. Either we sharply reduce the growth in government spending or witness a steep rise in inflation.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at aschram@wellcappartners.com.

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