What is Likely to Cause Inflation?

There are three major causes of price increases: wage growth, lower supply or higher demand for a good or service, and a depressed currency.

For the next few years, wage growth is likely to remain fairly static, as a persistently high unemployment rate reduces the bargaining position of employees asking for raises.

If one believes, as I do, that we are unlikely to experience robust economic growth anytime soon, prices on discretionary items are unlikely to jump. With higher living standards in China and India in particular, it is quite probable that food and energy prices will rise more than American wages, thus reducing our purchasing power. Energy in particular is a topic of utmost importance that I will address in future blog posts.

Barring a huge shock to food or energy prices, I believe the biggest inflation risk we face is the devaluation of the dollar. Individuals and foreign governments invest trillions of dollars in Treasury bonds at fairly low interest rates. These bonds are backed by the full faith and credit of the U.S. government, and investors believe that despite its problems, America remains the safest place in the world to invest in government bonds. Investors purchase Treasuries with U.S. dollars, and coupled with the safety of our debt, that makes the dollar the world's reserve currency. Anytime investors get spooked about riskier assets, they typically flock to Treasury bonds, a process that increases the value of the dollar and reduces interest rates.

We are huge beneficiaries of having the world's reserve currency, because our government is able to borrow money cheaply, which makes it possible to finance our deficits.

However, our fiscal trajectory is nightmarish, with deficits projected to exceed $1,000 billion each year over the next decade. At some point, investors (e.g. mutual funds, pension funds, individuals, China, Japan, etc.) could scale back their holdings of U.S. government bonds. They could demand to receive a higher interest rate for the increased risk that the U.S. will have trouble paying its debts.

If this occurs, the dollar would lose value and it would become more expensive for consumers to purchase goods sold in the world market. Not only could the dollar weaken relative to foreign currencies, but it could undergo devaluation domestically if enough people question the creditworthiness of our government. This would produce significant inflation without sizeable economic growth, which could be likened to the stagflation period of the late 1970s.

Inflation is often accompanied by economic growth, where increased productivity and a mobile workforce induce employers to give their employees raises, which in turn contributes to price increases. However, stagflation results from dollar-denominated goods and services getting more expensive without the economic growth to support it. This outcome is very worrisome, as it would make society poorer and destroy incentives to save and invest, which is the key to future growth prospects.

Unfortunately I believe stagflation – or worse – is a very likely outcome of damaging fiscal policies that our nation has engaged in for many years. A future post will dive into inflation and illustrate why it is more ruinous to your personal finances than you might suspect. 

Source: http://online.wsj.com/article/SB10001424052702304410504575560711579850350.html