Solid Foundation for Inflation Fears

So from my vantage point, inflation could be understated by 2% per year. If that's true, what practical effects does it have?

• Real GDP has grown 2% less annually than we've been led to believe.


• Productivity growth has been 2% less than stated.


• Depending on your point of view, monetary policy has been either too loose (encouraging inflation) or too tight (discouraging growth). I lean toward the former view because I don't believe that monetary policy, except at the extremes, has any effect on long-run economic growth. This is the widely held view of the Austrian school of economics, and also the Monetarist sub-school. Neo-Keynesians may differ, but I know of few Neo-Keynesian economists that believe that monetary policy can produce a significant amount of additional inflation-adjusted growth in the long run. In the short run, monetary policy can have an effect; it can certainly make the booms and busts smaller or larger; in the long run, economic actors react to relative prices, not the overall price level.


• The understatement of inflation encourages interest rates to be low, which induces lower return on equity projects to be successfully financed. This leads to overinvestment in marginal areas, such as the construction of too much residential housing.

The government has reasons to keep reported inflation low:

• It lowers entitlement payments, like social security.


• It allows the nominal coupon debt market to feel good about lending to the government at what seems like a positive real yield.


• It allows the government to pay less in the inflation-adjusted bond market (TIPS).


• It keeps the currency relatively stronger, if foreigners are fooled.

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Brave Words: 'Soft Patch'

These are not good reasons to underreport inflation. Bill Gross ends his piece in an impassioned manner that's different from his normal wry style. He's not primarily annoyed at the loss of income from TIPS, but at the misleading of the American people by telling them the economy is less productive and more inflationary than they have been led to believe. If we are growing, where are the jobs? If things are so wonderful, why the large debt load on the lower and middle classes? These are excellent questions to ask at a town hall meeting with the presidential candidates.

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At time of publication, Merkel was long TIPS, though positions may change at any time.

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.