Prudent Money
Why the Worry of Inflation is Overblown  E-mail

Inflation is a big story.  It seems like you cannot turn Fox Business News on at any time without someone telling you to buy gold because inflation is coming..

There are prices definitely rising in various sectors of the economy.  In fact, everyone should have a real concern about the cost of gas as we watch what happens in the Middle East

The argument for inflation centers on the enormous amount of money that the Federal Reserve Board is pumping into the economy.  You can also see commodities rise, such as the enormous increase in the price of cotton as another example. 

However, there are some counter arguments you might want to consider. 

The Federal Reserve Board can pump in as much money as it wants without an inflation worry for two reasons.  First, the money is being hoarded by banks and not getting into the hands of consumers for purposes of spending.  You can see this in the chart below.  This is a chart that shows the velocity of money, which is the rate at which money circulates through the economy through spending.  People aren’t buying big screen televisions today and money is not circulating through the system to the point where inflation is a concern.  You can see the dramatic drop in the velocity of money that started before 2000. 

Second, this money that the Federal Reserve is pumping into the economy is being absorbed to replace losses and money that is normally there.  It is being spent in federal aid, unemployment benefits, to make up for other losses, etc.  Once again, it is not being used to purchase big screen televisions. 

The other reason is simply supply and demand.  Yes, the costs of making widgets is going up.  However, the consumer is tapped out.  Although companies have increased costs, they are unable to pass those costs onto the consumer.  The consumer will simply cut back.

The CEO of Best Western was on CNBC talking about this very problem.  He says that the rise in cotton has caused the prices of pillows to rise.  However, he has to eat that cost because he cannot raise his room rates because of lack of consumer demand.

As an investor, it is always important to take what everyone says is going to happen and try to determine why it might not happen. Typically the crowd ends up being wrong.

A lack of price inflation doesn’t necessarily mean we are out of the woods.  If we aren’t dealing with inflation, deflation or stagflation is more likely the end result.