I’ll readily admit that I don’t know much about inflation.  It’s hard for my generation to appreciate the concept since the majority of our wage earning years have been characterized by a general absence of an inflationary cycle.   Since I graduated from business school in 2000, inflation (as measured by the Consumer Price Index for all urban consumers (CPI-U)  has not breached 5%.   In fact, over the course of 2009, we experienced considerable deflation, with negative growth in the CPI-U for eight months of the year.

So why is it that I am holding inflation indexed bonds in my portfolio?  That is a good question.   The reason I went into TIPS six months ago, was my belief that inflation was inevitable.   The unprecedented amount of liquidity that has been injected by the U.S. government in an effort to stabilize and re-energize the economy requires it.   Or does it?

As a general rule, when excessive liquidity is injected into the market place with an rapidity it leads to an inflationary cycle.  The logic equation is that the recipients of that cash will find themselves with an excess inventory of funds and bid up the prices of goods and services.  The sellers of those goods and services find themselves cash rich and pass along the favor.  The declining value of the currency causes people to part with these excess funds as opposed to holding on to them.   As evidenced by the graphs below — M1 (the money supply) and a trade weight currency exchange index (DTWEXM) — these very conditions are in play right now.  The money supply expanded by more than $1.7 trillion in 2009, more money than is necessary for transaction purposes.

So why is it that we find ourselves with sustained low inflation despite excess liquidity?  Notably, the process of inflation is not precipitous, especially in a complex economy and during a period of economic decline.  It is not hard to fathom an entity, be it a person, business, fund, etc., holding excess liquidity (read: hoard cash) out of fear despite the erosion of value resulting from falling currency rates, because the alternatives are less attractive.   The media often refers to this as the “money on the sidelines”.   Despite a strong economic recovery as measured by the stock market, people remain fearful of future problems stemming from the bloated balance sheet of our economy, and, as a result, they continue to be more than happy to hold onto their monies, even if they are less precious tomorrow than today.    One only needs to look at consumer spending figures and read about wage stagnation to see evidence of this pattern of behavior.

Additionally, economic meddling exacerbates the realization of inflation by delaying capital outlays.  Bailouts of individuals and institutions mean they can postpone deleveraging events and calls on collateral.   Notably stimulus packages spread out spending over a longer time horizon which prolongs the effect.   Further, much of the current stimulus sits on bank balance sheets in the form of excess reserves — money that provides savers assurance that their collateral is safe.  Because this money is sitting idle, since banks are not lending, the drop in the velocity of money has offset the dramatic increase in the supply of funds.

Despite these realities, the conundrum will not last.  We are talking monetary physics here after all.   If one is to believe the great economist Milton Friedman, the peak effect of on economic growth of excess liquidity will be felt between 18 – 30 months after the rapid expansion of the money supply.  Further, the impact on consumer prices will then be felt a further 12 – 18 months downstream, meaning, in monetarist terms, the inevitable spike in inflation would occur sometime in late 2011.

Whether you subscribe to Freidman’s paradigm or not, it is easy to conclude that that when banks start to lend, the velocity of money will increase and inflation will follow as a result.  Since the recovery is expected to be slow and bumpy, it is not hard to envision that the velocity of money will remain low throughout 2010, keeping inflation in check until late 2011 at the earliest.   Further, high unemployment and excess production capacity will keep wage growth in check (not hard to imagine) further muting inflationary pressure.   Finally, if you believe Bernanke the government could, at its discretion, unwind the special lending programs, pull back the reserves and sell of the securities it has purchased, thereby avoiding the problem of monetary expansion all together.

However, in my opinion inflation will likely be realized sooner than Freidman would  have predicted.    Notably, the Fed cannot put the brakes on the program as contemplated without risking pushing us back into a recession.  This is highly political, so nothing will be done until it is clear that we are out of the woods.   As a result, the money will remain in the system allowing for velocity to increase sooner than anticipated.  Further, I expect there to be political pressure both from within and abroad for us to inflate our way out of our current deficit.   This would be achieved by the Fed allowing inflation to increase while holding interest rates low.  The net impact would be negative cost of borrowing on an inflation adjusted basis.  This would stimulate both borrowing and spending.  Further, wages would increase, which in turn would increase the tax base, thereby enabling the government to pay off its massive deficits.   This is too seductive a solution for politicos to keep their hands off, especially if the President’s approval ratings continue to dwindle.   However, this program is hard to enact in a periods of high unemployment, so the recipe is not ideal.

That all being said, it seems clear we are not headed for double digit inflation anytime soon.   Our current deflationary cycle is still in effect and the combination of other factors — falling commodity prices currency valuations, fear, low velocity of money, high unemployment, etc. — will insulate us from significant systemic shocks.  However, expect modest inflation to return in the medium term and be seen in markets were capacity is constrained first.