A popular notion these days is that inflation will take off as central banks print money to buy up the debt of overleveraged governments. Many investors, in fact, are betting on this scenario. However, I fear they may end up disappointed.
For one thing, central banks are committed to inflation targets. The Bank of Canada is presently anchored to a range between 1 and 3 per cent. The Federal Reserve has an implicit target of 2 per cent and Ben Bernanke’s likely successor, Janet Yellen, wants it made explicit.
Even if central banks abandon their inflation targets, it’s unlikely they can inflate the debt away. The U.S. bond market is so big that any signs of resurgent inflation will induce a wave of selling that would cause bond yields to spike upward and collapse the economy.
“We believe that any attempt to inflate away the massive [debt] would create a panic in debt markets,” wrote Peter Gibson in a report a while ago. Mr. Gibson is the former CIBC World Markets portfolio strategist who regularly won No. 1 rankings in the annual Brendan Wood analyst survey.
The only real solution to a debt crisis is new breakthroughs in technology and productivity. “Only then can we generate faster non-inflationary growth in order to grow rapidly out of high debt-to-GDP levels without the inflationary fears that would drive bond yields up,” Mr. Gibson concluded.
Until the breakthroughs arrive, the U.S. Fed’s goal is to play for time. It can only guide the economy between the Scylla of deflation and Charybdis of inflation until new sources of real growth emerge (in this regard, the new fracking techniques for extracting natural gas are an encouraging step forward).
There are precedents. Canada faced a debt crisis in the early 1990s but was bailed out with the help of an economic boom fuelled in part by the birth of the Internet. In the late 1940s, the U.S. had very high levels of government debt (relative to gross domestic product), yet the 1950s were not inflationary.
While a non-inflationary future seems more likely, it still isn’t a good idea to put all of one’s investment eggs into that basket. Prudence requires diversifying over several baskets.
Larry MacDonald is a retired economist who manages his own portfolio and writes on investing topics. He tweets at @Larry_MacDonald
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