Download inflation: danger ahead? - Crawford Investment Counsel

INFLATION: DANGER AHEAD?
NOVEMBER 2013
Inflation and inflation expectations may be the single most
many dollars chasing too few goods. The supply of dollars
important of all the economic variables. They hold a key
in the U.S. economy is managed by the FED. The FED
to the future and play a major role in interest rates, Federal
increases its balance sheet and the supply of dollars in the
Reserve policy, and confidence of consumers and corporate
system by purchasing bonds from financial institutions
executives. In this paper we attempt to provide broad
which will typically use those dollars to originate loans.
parameters as to what lies ahead on the inflation front.
Those loans are made to consumers and businesses to
As is the case with any forecast of the future, determining
purchase goods and services which can have the effect of
with precision what inflation will be is virtually impossible.
bidding up the prices of those goods and services. The
About the best one can hope for is get
dollars that were originally borrowed
the trend right and to understand what
are spent multiple times as more loans
the major factors are that are shaping the
are made from the deposits of goods
At some point in the
inflation picture.
and service providers.
Our forecast will focus on the Consumer
Price Index (CPI) excluding food and
energy, or core inflation. The reason core
readings are used is because food and
energy are notoriously volatile, and they
tend to wash themselves out over time as
supply/demand conditions shift.
future when capacity
is tight, consumption is
strong, employment is full,
productivity is low, and credit
is abundant, then inflation
can be a problem. We do not
foresee these conditions for the
next few years at least.
First, what is inflation? Inflation is
defined as a general increase in the level
of prices of goods and services. When a
general inflation exists, most economic
constituencies have the ability to raise prices or demand
higher wages. Commodities may be in short supply and
therefore producers can command higher prices. Labor
has the ability to demand higher wages, and businesses pass
along these costs to consumers. There is also a psychological
element to inflation. “Buy today, for tomorrow it will cost
more” becomes the watchphrase. Typically, these conditions
are associated with a supply and demand mix where there is
more demand than supply in most goods and services.
The most common measure of inflation is the Consumer
Price Index (CPI) which is produced monthly by the Bureau
of Labor Statistics. On a year-over-year basis, the CPI has
averaged around 4.0% over the last fifty years, reaching
a high of 14.8% in 1980 and a low of -1.3% in the last
recession. It is widely held that the Federal Reserve (FED)
prefers that inflation, excluding food and energy prices, not
exceed 2%.
Technically speaking, inflation occurs when there are too
Today the FED is rapidly expanding
its balance sheet through what is called
quantitative easing. This has many
people worried that all of the liquidity
(money available for loans) in the
system will eventually result in inflation.
Perhaps so, but until the liquidity is
moved out of bank reserves at the FED,
there is no adverse circumstance. Idle
liquidity is no threat.
We maintain that inflation is more than
anything a function of supply and demand. This leads us
to the conclusion that it will be very difficult for a general
inflation to develop, absent a much higher utilization of
resources.
Currently, both domestic and global supply far outweigh
demand. Economists like to speak of the output gap. This
is the difference between actual and potential economic
output. With unemployment still high at over 7%,
capacity utilization of under 80%, and a glut of cheap
money worldwide that is available to increase capacity, it is
difficult to see how a major or widespread inflation could
be ignited. Slack in the economic system is the antidote to
inflation. We have a long way to go before demand equals
supply. At some point in the future when capacity is tight,
consumption is strong, employment is full, productivity is
low, and credit is abundant, then inflation can be a problem.
We do not foresee these conditions for the next few years at
least.
• Exiting markets they have helped make liquid (including
the mortgage and asset-backed bond markets).
• Actually paying interest to banks on reserves held at the
FED.
We recognize that correctly reversing policy will be a
difficult process that will require precise timing and political
will. The strength of economic expansion and utilization
of resources, the interplay of global economics, and most
importantly, the actions of the Federal Reserve will play a
role in determining whether or not we enter a period of
rapid inflation.
Source: Congressional Budget Office
We are now in the third episode of quantitative easing,
or aggressive balance sheet expansion by the FED. We
recognize the risk of inflation over coming years based on
the enormous amount of liquidity currently being made
available to the economy. However, we do not believe that
serious inflation is a given as a result of these actions. Just
as the FED has injected liquidity into the system, it can take
equally dramatic steps to drain it. These steps could include:
• Increasing reserve requirements on banks to reduce the
amount of loans that can be made.
Our best judgment is that if inflation becomes an issue
it will not likely occur within the next few years. In our
opinion, the supply/demand imbalance is just too great.
Once the output gap is closed, the economy may be more
vulnerable to inflation.
Specifically, we forecast a core rate of inflation over the next
several years that averages around 2%. Longer term, as the
economic expansion finally gains traction at real growth
rates of 3% or more, inflation may drift upward. The
manner in which the Federal Reserve reverses some of its
liquidity measures will be very important to the inflation
outlook.
Our inflation forecast will be subject to revision as conditions
develop.
• Raising policy rates such as the Federal Funds target
and Discount rates to make borrowing less attractive.
Crawford Investment Counsel, Inc.
600 Galleria Parkway, Suite 1650, Atlanta, Georgia 30339
(770) 859-0045
www.CrawfordInvestment.com
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at the time of publication of this commentary, and there is no assurance that any predicted results will actually occur. Information was obtained from third party sources which
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