Thoughts on Inflation

I believe that true inflation is higher than reported inflation in the US. The federal gov't has several reasons to under-report inflation, chief among them the benefits from artificially restricting COLA (cost of living) increases in Social Security payments, which are ruinous to the deficit. We can see this in real life, as the gov't practices "substitution," which embraces the fallacy (this is just a hypothetical example) that if milk is expensive, consumers will switch to orange juice instead (so the gov't drops high milk prices from the CPI). 

However, if consumers aren't buying goods and services, that exerts a downward force on inflation. Also, any government dealing with a deficit wants inflation very badly, as outstanding debts become cheaper (easier to repay) as a result of inflation.

So presently there are competing forces acting on inflation: gov't wants it higher (but reported artificially lower); and low demand pulls it down.

Here is a fascinating article arguing another reason that inflation is low:  http://seekingalpha.com/article/1448811-why-inflation-never-came

Summary:  

M x V = P x Q, where M is amount of money, V is velocity of money, P is price (inflation or deflation), and Q is quantity of all transactions. You can see that if V and Q are fixed, then an increase in Money supply will cause inflation. That is the classic model, and it's what I've been expecting for years now.

The author argues that while M has been moving up significantly (this is the fed's Quantitative Easing, which, classically, suggests that inflation will follow), in fact there has been subdued inflation because the velocity of money has fallen so much. There are new proxies to money (GLD and SLV and bitcoin), which have zero velocity and thus displace currency and thus reduce its average velocity. (I'm not smart enough to be able to confirm that these new forms of money have zero velocity.) Also, the big banks have more competition now in the creation of money, and the new forms of pseudo-money are arising from different financial institutions, and the quantity of paper money is lower now, compared to the past; this also prompts velocity to fall.

I'm going to nibble from all these cakes. I conclude:

a. Inflation is higher than as reported by our government;

b. But money velocity is low, which is a drag on inflation; and

c. Demand for goods and services is relatively low, which is a further drag on inflation.

Another point worth making is that with interest rates stuck so low, holding cash is likely a losing proposition (actual inflation rate is most likely much higher than the 0.1% or whatever that your bank is paying you), so the present economy is impoverishing savers, even with a low inflation rate! Solid dividend-paying stocks to the rescue!

My final point is that indeed who knows when rates will finally rise, but heaven help the folks holding long-term bonds, when they do.

My FINAL final point is this: No one can predict the future accurately. Even if we can see the WHAT (which, the above analysis shows, is doubtful due to complexities that we do not yet understand), we cannot know the WHEN, as there are just too many variables. So, diversify!