newjerseynewsroom.com

BY GERALD J. ROBINSON

NEWJERSEYNEWSROOM.COM

When British General Cornwallis surrendered his army to George Washington at Yorktown in 1781, legend has it that the British army band played "The World Turned Upside Down." That tune might justifiably have accompanied this week's announcement by the Fed of a bond purchase plan that will increase inflation.

For decades one of the Federal Reserve's principal objectives has been to keep inflation low. Now, with anemic growth and high unemployment, it thinks a little more inflation would help cure those ills. In Fed-speak it said, "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."

Come again?

What it means is that pushing inflation up closer to its traditional 2 percent target rate would help stimulate the economy. Why? Its theory is that just as a fear of deflation and falling prices causes households and businesses to delay purchases in the hope of getting goods at lower prices, inflation and its fear of rising prices causes households and businesses to accelerate purchases in the hope of getting goods before prices rise. By creating expectations of higher inflation, the Fed hopes it will encourage purchases, boosting demand and growth.

For example, if you're thinking of buying a new car next year but become convinced that car prices will be five percent higher next year, there's a good chance you'll go ahead and make the purchase now instead of waiting. This is what the Fed wants — to bring purchases forward in time to increase current demand.

Another reason for wanting inflation to rise somewhat is to reduce the burden on households of the heavy debt they're carrying. Higher wages usually accompany higher inflation, making it easier for households to pay down debt. In addition, rising wages also tend to enhance consumer confidence that also translates into increased purchases, raising demand.

The Fed has room to maneuver. Inflation has been running just a whisker over 1 percent recently and some pundits are arguing that we are headed for deflation and the economic malaise that has afflicted the deflating Japanese economy for years. Besides, with capacity utilization low and unemployment high, inflation seems a distant threat at best. So making inflationary moves may head off the danger of deflation as well as produce some increase in demand.

But it's not without risk. Once the cork is pulled from the bottle holding the inflation genie, it may not be so easy to get the genie back inside. And if increasing inflation doesn't work, it could resuscitate our old nemesis, stagflation, the unhappy situation where both the inflation and unemployment rates are high.

Another risk is that increasing inflation will further discourage already slow lending, further reducing economic activity. Lenders are less anxious to lend when they think they will be repaid in inflation's cheaper dollars.

That a large number of investors fear the Fed's move will release the inflation genie was demonstrated last week by the Treasury's sale of five-year Treasury Inflation Protected Securities (TIPS). The demand for these inflation hedges was so great that they were sold out at a price producing a potentially negative return. In effect, if inflation is not high enough, TIPS investors could end up paying to lend money to the government.

Investor's fear of inflation was again demonstrated last week when the price of gold bounced up in anticipation of inflation and a decline in the dollar that the Fed move seemed to threaten.

The Fed, exercising its role as the arbiter of the nation's monetary policy, will induce increased inflation by pushing more money into the economy. It will do so by buying up U.S. securities, so-called "quantitative easing," better known as printing money. While the immediate objective of the purchases is to put downward pressure on long-term interest rates by driving up the price of debt, an inflationary side effect is widely anticipated.

What does all this high finance maneuvering mean to the average investor?

Not much in the short term. Capacity under utilization and high unemployment mean that inflation is not imminent, so that investors' panicky response last week probably was unwarranted. Moreover, inflation is unlikely to occur without giving advance warning through inflation indicators such as a tightening labor market, rising wages and increasing capacity utilization.

When these indicators begin to flash yellow, it's time to give increased attention to inflation hedges, such as TIPS, emerging market mutual funds, commodities and even a little gold. We've discussed these hedges in previous columns.

Comments and questions are welcome. Contact Gerald J. Robinson at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .