Introduction by Matthew A. Griffith

I was recently asked some questions about my prediction of very high inflation in coming years.  In response, I’ve asked Chris Norwood, CFA, to explain why inflation will become a problem for which businesses need to prepare today.  Chris is one of the smartest business thinkers I know, and you should value his opinions as much as I do.  Please enjoy Chris’ post and visit his site-   The Knowledgeable Investor.

Guest Post

By: Christopher R. Norwood, CFA
Biechele Royce Advisors, Inc.

Inflation is a monetary phenomenon. The world currently uses pieces of paper backed by nothing to facilitate exchange in goods and services. A dollar has no intrinsic value; it is just a piece of paper. A dollar is an IOU from our government that can currently be exchanged for goods and services; it is a liability of the U.S. government.

The Federal Reserve controls the number of dollars in circulation; they are a liability on the Fed’s balance sheet. The Fed holds assets as well that offset their dollar liability. The Fed’s balance sheet has grown from $871 billion on May 21, 2008 to $2,165 billion on May 20, 2009.  U.S. Treasuries were the main asset backing the dollar one year ago. Today, the Fed’s balance sheet contains $523 billion in toxic assets parked in its Maiden Lane LLC. Treasuries comprise only around $400 billion of the Fed’s total assets, down from around $700 billion last year.  Finally, the St. Louis Fed’s adjusted monetary base was up a record 113.4% from the same period last year.  The monetary base – basically currency plus bank reserves – is the Fed’s primary tool for affecting growth in the money supply.

Now here’s the important part. The general price level is a function of money supply and the velocity of money (how many times per year a dollar changes hands). Currently, money supply is exploding (dollars backed by toxic assets) but the velocity of money has been falling, leaving inflation at a low level for the time being. However, as soon as economic activity picks up (dollars start moving through the economy) inflation will rise sharply unless the Fed is able to remove dollars from the system very rapidly and in a timely manner. The Fed will need to find buyers for those toxic assets and/or remaining Treasuries at a time when the economy is expanding and inflation is rising. A very difficult assignment to say the least.

High levels of inflation are almost a given at this point. The only real question is the actual timing of the tragedy as it plays out.

Best Regards,

Christopher R. Norwood, CFA
Biechele Royce Advisors, Inc.
http://theknowledgeableinvestor.blogspot.com