The Inflation Debate Is Heating Up

By Andrew J. Willms, President & CEO

Federal Reserve Chairman Jerome Powell announced a major policy shift by the Federal Reserve on Thursday. Under the plan, called “flexible average inflation targeting”, the Fed will allow for inflation to rise moderately above 2% “for some time” following periods where inflation “has been running persistently” below its 2% target.

The reason for the change is that the Fed wants to have the flexibility to keep interest rates lower for longer. That policy adds to the existing downward pressure on the dollar, and a falling dollar is inflationary. Accordingly, a policy change was needed in order to avoid a rate hike necessitated by stimulus-triggered inflation.

In his statement Powell acknowledged that “many find it counterintuitive that the Fed would want to push up inflation.” The Fed is hoping that allowing inflation to drift higher will lead to higher wage growth, which has been slowed as technology has reduced the need for manual labor. And, while higher inflation will trigger price increases, the Fed is expecting the cost of living to grow more slowly than wages, in part because many U.S. consumer goods are imported, and technological advances help keep prices low.

It’s been a very long time since there were real concerns about inflation. The Fed’s new policy has added fuel to a fiery debate about whether inflation is about to awaken from its extended hibernation. The chasm between those who fear inflation and those who don’t has never been wider.

The inflationists point to the estimated $20 trillion that governments worldwide have pumped into their economies in an effort to keep another great recession (or worse) at bay. This massive increase in the money supply (the amount of currency and other liquid instruments circulating in an economy) means that there is more cash chasing the goods and services an economy produces, which can cause prices to rise.

In addition, the more dollars in circulation, the less valuable each dollar theoretically becomes. When the value of the dollar falls, it takes more dollars to purchase something, which is in essence the definition of inflation.

In short, if a nation’s money supply grows faster than its economic output, the expected result is inflation, all else being equal.

The deflationists, on the other hand, argue this time is different. That’s because much of the money used to stimulate the economy isn’t being spent. Rather, it is sitting in savings accounts, paying off credit card balances, and being invested in stocks and bonds. As a result, there is no reason to expect prices to rise so long as the “velocity” of money – the frequency with which it changes hands when goods and services are bought and sold – does not rise.

Perhaps the debate all boils down to one’s timeframe. In the short-run, the velocity of money is probably a better predicator of inflation than money supply. But sooner or later an increase in the money supply is likely to lead to more money being circulated, and therefore higher inflation.

So how concerned should you be about inflation? Like so many things, it depends on your investment horizon. If you have a short-term investment horizon or are an active trader, then inflation would not seem to be much of a threat at the moment. However, if you are a long-term investor, then it may make sense to inject some inflation protection into your portfolio, while the cost of that protection is still relatively cheap.

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