Inflate in haste, repent at leisure: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own.)

By James Saft

LONDON (Reuters) - Inflating our way out of trouble is tempting but it's another buy now, pay later strategy, both for the economy and investors.

Inflationary pressure is building globally, and consumers' expectations of future price rises are growing in a way reminiscent of the 1970s, pushed by surging commodity and energy prices and at least partly underwritten by U.S. interest rates designed to rescue a country experiencing a popping debt bubble.

In the year through March, overall U.S. consumer inflation rose by 4.0 percent, well above the Federal Reserve's comfort zone, though the core measure excluding food and energy on which the Fed traditionally concentrates rose only 2.4 percent. More to the point, inflation expectations are hardening. Consumers surveyed by the University of Michigan now expect prices to rise 4.3 percent in the next year.

From one perspective a bout of inflation is just what the doctor ordered: it will make paying back or writing off all those unwise loans far easier.

"America is a country that owes money. It is natural when you are a debtor that you lean in the direction of inflation, because it makes paying it back so much easier," said Philippa Malmgren, a former economic advisor to the current Bush administration who is now president of the Canonbury Group, a policy and political risk consultancy based in London.

Seems simple: rather than cutting consumption and upping savings, thereby touching off a nasty recession, let inflation do its magic and watch the debts melt away.

But though inflation may be an easier sell to America's voters, if not its creditors, make no mistake: it is toxic to investors, makes overall economic growth structurally lower, and ultimately is likely to boil over.

"There are terrible costs associated with inflation, but all the costs are later," said Malmgren.

The Fed has slashed rates to 2.0 percent from 5.25 since last September, though investors are now betting that rates stay on hold for several months and may next rise.

Tim Bond, global head of asset allocation at Barclays Capital in London, sees a possibility of higher inflation becoming entrenched in the United States and ultimately ending with a deep "policy recession" in several years' time, when the Fed is forced to raise rates and stomp on growth and employment in order to rein in price rises.

So, how bad would inflation be for investors? Pretty bad. From the end of 1969 to the end of 1979 the average annualized total return after inflation was minus 0.9 percent for U.S. stocks, according to Barclays, and a loss of 1.6 percent yearly for bonds.

DURING INFLATION, BUY THINGS THAT INFLATE

Bond has looked in detail at the way the 1970s played out for investors, and though he thinks this time might be slightly different, the message is clear: put your money in assets whose yields can reset rapidly to keep pace with inflation.

"If you have the freedom, you go for cash," he said. "Both bond yields and equity yields are going to go up. But otherwise you go in with more of an equity tilt than a bond tilt."