Why Inflation Is Good for the US

The US federal deficit is $14 trillion. The only way to pay back this kind of debt is to grow, inflate, or both. Inflation has been demonized by the investment industry. Sure, it's an unfair depreciation of assets and the stuff bad dreams are made of. It can take a dollar earned and cut its purchasing power in half over the typical 25 year investing cycle at the average 3% rate. Anyone remember “5 and 10” stores when it was about cents and not dollars? However, it is helping the United States, both competitively and fiscally. Inflation, for lack of a better word, is good! What's that you say? Inflation obviously will assist in the payback of our ever increasing federal deficit and help us honor our entitlements. It is also a competitive advantage with other countries, especially developing ones. Inflation helps the economy grow and will even help to support housing prices.

Our federal deficit is $14 trillion. The only way to pay back this kind of debt is to grow, inflate, or both. Our economy cannot just grow slowly and think of paying back our government bonds at 100 cents in today's dollars. Interest costs of higher deficits will take up a larger and larger portion of our budget, leading to a death spiral. With the largest economy facing the headwinds of an increasingly automated industrial complex and without the leading powers of past recoveries in housing, finance, and autos, our goal should be to maintain our growth rate of about 3%. In this scenario, a payback without a restructuring can only be achieved with less powerful dollars in the future. Paying our debt will be difficult, but possible. With inflation it's almost manageable. As for entitlements; sure they need to be adjusted but the COLA or cost-of-living-adjustment that retirees look forward to is actually a “government baked” version of inflation. It is not your everyday gas pump and food bag prices. The actual cost of living has been going up far higher than reported CPI which was reconstituted several times over the years. That way the government can arbitrage the difference, pay a small fraction of the real cost increase, and pocket the difference. Commodity prices have risen due to increased demand and limited supply. Commodities are a small part of our country's input with our service sector comprising over two thirds of US economic activity. That is our competitive advantage. In services, wages matter more. However, in emerging countries commodity price increases are a much larger part of everyday lives and an increasing source of unrest and social friction. Over half of developing economy inflation rates comes from the prices of commodities. In this ever flattening world where labor can be accessed via Internet networks, the large unemployed and under-employed labor force will keep wage gains in check.

We are not returning to the 1970's price spirals. That style of inflation was “cost push”; wages and commodities were both rising together, pushing prices higher. Today it is more “demand pull” where strong demand for scarce raw materials will pull prices up but without demand, prices can also fall. With wage gains so moderate, and unemployed labor around the world so accessible, the US has a competitive advantage in this commodity versus wage price increases. Price increases also create a healthy incentive to buy things. Do you buy something now or wait until later at a higher price? Why buy something today that's going to be cheaper tomorrow? Deflation is damaging because of the resulting power of psychology and prices. It builds momentum of non-buying. Some price increases are actually good. Now about housing. Since the cost of raw materials is an important component of home construction, inflation will benefit the housing market. Almost half of the cost of constructing a home can be in industrial commodities and finished goods. With input costs rising, building new homes becomes more expensive. The lack of new home building will over time eliminate unsold millions of existing homes already for sale. Inflation will help the housing market put a “floor” under the replacement cost of a home and in turn create more chance of a construction jobs recovery later.

Finally, investing for the growth and the maintenance of purchasing power is the goal of all financial advisors. Stock market performance is determined not only by company earnings but also the price versus earnings multiple that investors are willing to pay. Stock market performance usually doesn't like inflationary times, as P/E ratios generally decline with high levels of inflation. The market knows that the reported earnings are not real. Stocks, however, do like “moderate” price gains. In fact, with inflation between 0-5%, the stock market has enjoyed its highest multiples versus earnings. It is when inflation gets over a 5% rate that the stock market usually tosses the penalty flag and puts a discount on “un-real” earnings. P/E expansion will be vital from this point forward as companies will not be able to squeeze out more earnings on less employees and higher input costs. The productivity gains from the rebound years after 2008 are decreasing. Earnings growth is bound to slow. Inflation rising from 2% to 5%, still moderate, can pave the way for higher multiples on earnings and higher stock prices. So it's good for us; it's medicine that doesn't taste good, but in the right amount it's OK! So how do we create inflation? As it has been said, inflation is always and everywhere a monetary phenomenon. The Federal Reserve is doing its best to create money by injecting it into the economy, but without a multiplier and without money changing hands, it has been a weak antidote. With money earning next to nothing, why take any risk at all? Higher money rates will eventually bring a faster velocity of money. Inflation is good. It's better than the alternative.