At present, inflation risks are hardly considered to be problematic by Wall Street. From the standpoint of the next few years, my impression is that this complacency is probably well-founded, but only because we are likely to observe a second wave of credit losses that will create fresh "safe-haven" demand for default-free government liabilities. From a longer-term perspective, however, I believe that inflation will be a major event in the latter part of the coming decade, with the consumer price index roughly doubling over the next ten years. As exchange rates and commodity prices tend to be more forward-looking and less "sticky" than the prices of goods and services, it is likely that these markets will move substantially well before the eventual peak in CPI inflation.
John Hussman says government spending growth is the key driver of inflation and presents us with this chart:
The past two years have seen an enormous issuance of new government liabilities. During the two years ended September 30, 2009, the amount of U.S Treasury debt held by the public (outside of agencies such as the Social Security Administration and the Federal Reserve) surged by more than 50%, from $5.05 trillion to $7.55 trillion. During that time, the Fed's holdings of U.S. Treasuries actually shrank by about $10 billion, yet the Fed has explosively increased U.S. monetary base from $850 billion to $2.02 trillion, fueled by massive purchases of Fannie Mae and Freddie Mac's mortgage-backed securities.I think that the doubling of the CPI over the next ten years is very unlikely. First, Hussman's scenario of inflationary fire after deflationary flood is too specific. It is difficult enough to identify the most probable events for the next few years and any additional specific details quickly diminish the probability forecast is correct. Second, by saying there is a huge risk of second wave of credit concerns, Hussman basically admits that the current fiscal and monetary policy stance is appropriate for the next few years.
Third, the return of significant inflation means that the intrinsic value of MBS is near par again, and the real budgetary cost of bailouts is low. Fourth, at the first sign of increased inflation in the actual data FOMC hawks will be able to tighten monetary policy. Timothy Geithner's extended Fannie and Freddie funding commitment will allow Fed to shrink the monetary base without big pain. Fifth, fiscal hawks in the Congress will prevent the worst forms of fiscal incontinence.
Sixth, Hussman has repeatedly stated he thinks Fed's monetary policy has no effect, because higher fed funds rates have no effect because they pressure monetary velocity higher. This is just a classic case of confusing correlation with causation.
Don't get me wrong - I completely agree with Hussman that the current stimulus is of the wrong kind. It is just that any stimulus is better than none when the risk of deflationary spiral is still looming ahead. And I am also confident that Hussman will wait for very attractive entry points for commodity positions needed to hedge the inflation risks he sees.