Inflation Friend or Foe

If you have been hoping to see higher interest rates on CDs and savings accounts you favor inflation.

Interest is the cost of money and the first thing a lender wants covered is inflation followed by an amount that is the lenders profit. The level of profit varies a little over time and is currently at depressed levels. The inflation component of interest rates varies a lot; remember 18% money market rates in the late 70s with a 16% inflation rate. Compare that today to short term interest rates that do not even cover the current rate of inflation which is around 1%.


Around 1%! Have you seen the price of food? This brings us to the question of how inflation is calculated which unfortunately is not standardized. There at least three main methods used in this country but the CPI/PPI survey method is the one most often quoted and it is also used to calculate the annual adjustment in Social Security. The survey looks at different things we consume and assigns them a weight. So medical costs might represent 15% of the index and housing/shelter might be another 20% of the survey. Yet what if you have very low housing cost and use very little medical care. Then 35% of the index may not apply to you. The problem is that we each have our own inflation rate that is based on what we consume. Recently a government economist was telling a group of senior citizens that the inflation rate is very low and they angrily yelled back asking if he ever shopped for groceries.


So how can the price of oil and food be rising so fast and there not be a significant rise in the inflation rate? Getting away from the method of calculation which is too painful to get into detail, there are other explanations for this situation. This has been a bad year for agriculture around the world. You might have heard of some very stormy weather and flooding in Australia or a heat wave in Northern Europe and Russia last year that significantly reduced production and thus raised food prices. If 2011 production rises with fairer weather the prices could fall later this year. Oil is a story of fear given the turmoil in Libya and Egypt as well as a story of speculation since there does not appear to be a shortage.

There is also another speculative element at work here that stems from the government borrowing too much money and printing the money to pay its bills. Quantitative Easing 2 which will end in June has been a process where the Federal Reserve prints money and uses it to buy bonds from the Treasury who then pushes the money into the economy through the banks. This is basically what is meant when you hear the phrase "running the printing press". It is an inflationary policy that was designed to help the economy recover but the question remains can the government stop the process without the economy slowing into another recession. On the other hand there is also the possibility that the amount of "money printing" that has occurred will cause inflation to spiral upward. This is behind the upward move in gold and other hard assets. We will have to wait and see which way the economy and inflation go. I hope it doesn't get too interesting this time.

Written by Wealth Management.