AIER's essay on "A World of Persistent Inflation"

Last week, the venerable American Institute for Economic Research (AIER) published a clear and comprehensive study of monetary policy in the post-WWII United States, entitled "A World of Persistent Inflation," by Stephen R. Cunningham and Polina Vlasenko.  While somewhat long and involved, it provides an excellent discussion of an absolutely critical topic for investors, as well as some much-needed historical perspective to frame the shorter-term news that can monopolize one's attention in this "information age."

The essay's conclusions are stark and fairly straightforward:  increased government expenditures can be covered by increased taxes or by increased government borrowing, both of which can create increased public resentment. Most people understand how increased taxes can create resentment.  Increased government borrowing creates resentment by driving up interest rates on government debt, which then drives up interest rates on everything else, increasing borrowing costs for individuals, families, and businesses. By creating new money to buy up debt, however, interest rates can be kept low, masking the cost of borrowing. The study shows that this method has become the preferred method in the US since 1940.

By creating money in order to keep borrowing rates lower, however, the cost of those increased government expenditures are not erased, but transformed into a different kind of cost, one that can be less noticeable and cause less public resentment than exorbitant taxes or exorbitant borrowing costs.  As you might guess, this new cost is inflation, and it can be thought of as a sort of "stealth tax."  While extremely high inflation does cause widespread anger among the populace, steady but less elevated inflation rates can cost individuals just as much as taxes over the years (perhaps even more, depending on one's individual situation) without many people even noticing what is going on.

This subject is one on which the AIER has a long history of producing outstanding research, most notably in their essential study entitled "Stand still, little lambs, to be shorn."  We recommend that all our readers go back and revisit our comments on that essay, and the essay itself (which AIER has updated in the interim since we discussed it -- the latest version can be found here).

The newer "World of Persistent Inflation" essay is timely, as the Fed announced yesterday that it will continue buying mortgage securities at a rate of $40 billion per month, and that it will continue buying long term Treasury securities at a rate of about $45 billion per month.  Both of these measures had been enacted in order to keep interest rates lower, for the reasons described above.

Additionally, the Fed had previously been selling shorter-term securities in the same amount as it was buying longer-term securities (known as Operation Twist).  It announced yesterday that it will discontinue this selling, which marks a major step in further expanding its balance sheet.

While some investors may fear that these expansionary and accommodative policies by the Fed will lead to out-of-control hyperinflation, an understanding of the thesis of this latest AIER essay by Dr. Cunningham and Dr. Vlasenko points to a different conclusion.

As explained in that essay and outlined above, the cost of ever-expanding government spending can be passed on to the citizens of a country in three ways: it's a case of "pick your poison."  The cost can be passed on in the form of taxation (unpopular and acutely painful), in the form of higher borrowing costs (unpopular and acutely painful), or in the form of a long-term policy of inflation (much more difficult to detect, because the poison is subtle and slow to act, and when administered properly it causes some grumbling but after decades of such treatment the people generally accept it as part of the way things are supposed to be).

Based on this analysis, hyperinflation (which is unpopular and acutely painful) is less likely than a policy of persistent inflation, which is exactly what the authors titled their article, and exactly what the policies we see from the Fed are likely to create in the long run.

In other words, "Stand still, little lambs, to be shorn."

This subject is very important for investors to understand, as they weigh their strategies for the protection of their purchasing power into the future.  It is part of the reason why we recently reiterated our conviction that "we continue to believe that the best course for investors is to diligently seek out well-run, innovative companies in whose growth they can participate through equity ownership -- something that becomes all the more important during periods in which such growth is more difficult to find."

The search for growing innovative companies in which to invest is not a luxury in a "World of Persistent Inflation" -- it is a necessity.