Understanding Inflation

Jun 2010

Investors appropriately ask lots of “what if ” questions.  For example, what if countries don’t take better control of their finances?   Countries that don’t control their own currency (like Greece, which uses the Euro) or have borrowed funds denomi­nated in foreign currencies cannot inflate their way out of their fiscal problems.  Thus, either they practice fiscal discipline or they default on their debt (“restructure”)—which would lead to a lack of access to further borrowing, which would likely lead (finally) to market-enforced fiscal discipline.  Countries that do control their own currency (like Japan, the U.K. and the U.S.) can either practice fiscal discipline or print sufficient money to pay their debts.  Printing money, of course, would likely lead to inflation and possibly a 1980-style election where inflation concerns dominate the political agenda.  If we experience meaningful inflation again (something that hasn’t happened in about 25 years), that would likely increase nominal stock returns, home prices and energy prices; leave inflation-adjusted stock returns roughly the same; and decrease bond returns (potentially to the point of being negative).  Basically, inflation acts much like a tax that takes purchasing power from consumers.  As you would expect, we closely follow inflation trends.