Fed Seeks Ingredients for the Perfect Inflation

By Joseph A. Clark

NEW YORK (AdviceIQ) -- Most people think inflation is bad on its face. But one school of economic thought holds that a little inflation is a good thing, if it is confined to assets such as stocks and real estate. It's when it spills over to the supermarket or gas station that no one is an inflation fan.

Our central bank's policy is to goose asset prices, thus getting the sluggish economy finally moving, but that kind of precision is a tall order and there are other factors in inflation -- such as the weather distortions this year, which created more than just travel and meeting interruptions. The extreme drought in the West led to the loss of cattle and crops. This in turn spurred commodity prices higher.

The bill at the grocery store is rising faster than many household budgets are prepared to absorb. I asked my wife what she thought about inflation, and her response was less than positive.

The Consumer Price Index overall rose 1.1% in February, and food was up 0.4% four times the rate of the month before. Prior months were 0.1% or zero. U.S.-grown food inflation is worst among meat and dairy, and coffee is way up thanks to a drought in Brazil.

True enough, inflation raises the price of goods and services, but that in itself does not make inflation all bad. Again, I asked my wife if she wanted assets such as the value of our house and investments to appreciate. She replied: Sure, but what about food costs?

The history for the 2014 equity and bond markets will feature such short-term influences as Russia, debt ceilings, elections and things we can't yet forecast, but at the end of the year the story will be about the Federal Reserve and its chairwoman, Janet Yellen. The massive amount of Fed bond buying, a stimulus program called quantitative easing, flooded the markets with cash, all in the name of creating what my wife seems to despise -- inflation.

While it seeks mild inflation, around 2% yearly, the Federal Reserve is eager to avoid higher numbers such as 5% or more. It remembers how it had to drag the nation through a bad recession to wring out the virulent double-digit inflation of the 1970s.

But the Fed governors do need battered home values to rise. Real estate is a key part of the economy: Its slump triggered the 2008-09 financial crisis and almost wrecked the banking system, which functions as the economy's blood supply. Banks lend more money for houses than they lend for family vacations. They charge greater interest for a personal loan than a home loan.

Why? While you return from vacation with great memories, the bank has no asset to protect future repayment of the vacation loan. In contrast, the house historically furnishes solid collateral if you fail to make good on the promise to pay. That's provided the house appreciates or at least remains stable in value.

If the value of the house falls -- think 2008 -- the asset is worthless as collateral. The value falling is considered deflationary. The Federal Reserve put on a full court economic press with QE, adding more than $3 trillion to its balance sheet, aiming to keep asset prices higher and avoid deflation. Yes, it wanted job growth too, but it mostly needed asset prices to move higher. It needed to create inflation and did.

Spurring benign mild inflation is very difficult, an imprecise exercise. The Fed acknowledges that its actions can lead to bubbles (irrationally high asset prices that must decline eventually), but also notes that it can't completely control where the money goes.

Is there a bubble in U.S. Treasuries? Is it in farmland, or in the stock market? Worse yet, is it in grocery prices? One vexing characteristic of a bubble is you aren't aware it's a bubble as you participate in the excitement. Conversely, you can't comprehend how distorted prices can become before a crash.

Sudden surprises in things such as weather can amplify inflation. Rising food costs are part of the economic cycle. So is rising population growth. Unfortunately, we must take the good with the bad to see appreciation in our portfolios and house values.

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-- Joseph "Big Joe" Clark, CFP, is managing partner of Financial Enhancement Group, an SEC-registered investment advisory firm in Indiana. He teaches financial planning at Purdue University and is the host of "Consider This with Big Joe Clark," found on WQME and iTunes. He is a registered principal offering securities and registered investment advisory services through World Equity Group, member FINRA/SIPC. Big Joe can be reached at bigjoe@yourlifeafterwork.com, or (765) 640-1524. Follow him on Twitter at @Big Joe Clark and on Facebook at here.

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