Some thoughts on inflation and the economy

Here is an insightful commentary from one of our favorite economists, Brian Wesbury, entitled "Inflation Now and Later."

In it, Mr. Wesbury explains how the Fed's mistaken belief that inflation is caused by high employment and strong economic growth is leading them to stay too easy for too long and introducing inflationary pressures into the economy. He notes that the Consumer Price Index (or CPI, a measure of inflation that looks at the price of a hypothetical "basket of goods and services" and compares it to previous prices for the same hypothetical basket) for the first six months of 2011 is up at an annual rate of 5.1%.

We discussed the CPI and inflation in this previous post from 2008 and in a series of other posts listed at the bottom of that one, pointing out the damage inflation does to purchasing power. A good or service whose price rises at an annual rate of 5% will double in price in about fourteen years.

We have also discussed the erroneous thinking that leads the Fed (and many other economists from a similar school of thought) to believe that inflation is influenced by strong or weak economic growth and employment, which is sometimes known as "Phillips Curve thinking." The counter to Phillips Curve thinking is the belief that inflation is caused by monetary policy, rather than by slower or faster economic growth, and it is typified by the work of economist Milton Friedman and Professor Friedman's quotation, cited by Mr. Wesbury, that "inflation is always and everywhere a monetary phenomenon."

On the other hand, note that while Mr. Wesbury believes that the Fed is too loose and allowing inflationary pressures, this is a far cry from saying that 1970s-style hyperinflation is right around the corner. He does not predict hyperinflation, and gives cogent reasons why not.

We believe that, while the Fed and the government have hurt the recovery by some of the policies they adopted in their attempts to help the economy, nevertheless businesses in general are in better shape than almost any time in economic history, with strong balance sheets and with productivity and efficiency at all-time highs.

Inflation has remained a threat to investors' purchasing power for several decades now, a scenario that is unlikely to change in the future. We believe the antidote, however, is the same as it has been in the past: participation through the investment of capital in well-run businesses positioned in front of fertile fields for future growth. There are many businesses out there today that meet that description, if investors know where to look.