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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 This commentary is for informational purposes only. The statements contained herein are solely based upon the opinions of Crawford Investment Counsel and the data available 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 we believe to be reliable but are not guaranteed as to their accuracy or completeness. This report contains no recommendations to buy or sell any specific securities and should not be considered investment advice of any kind. The securities discussed may not be held in a client’s portfolio at the time of receiving this commentary. Past performance is no guarantee of future results. In making an investment decision, individuals should utilize other information sources and the advice of their investment advisor. Crawford Investment Counsel is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Crawford’s advisory services can be found in its Form ADV which is available upon request. CRA-13-18