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Rapid inflation in the future?

The consensus opinion of the public is that we have a big inflation problem in our future. This conclusion is reached because of the large amount of government debt which has been taken on to provide economic stimulus and end the most severe recession since World War II.

The collective opinion coincides with what we learned back in second-year economics, where a rapidly expanding debt load and money supply can lead to a declining currency value and rising interest rates which tend to make imported goods and services (like oil) cost more.

My issue with this opinion, which just about everyone agrees with, is that the majority is hardly ever right when it comes to economic and investment prognostications. The majority tends to buy stocks and real estate after they have risen in value and want to sell after they decline — the opposite behavior of buy low — sell high, which is how it is supposed to work.

So when I hear the majority predicting rampant inflation, I feel compelled to look at both sides, preferably in an unemotional way. Fortunately there is a mathematical way to measure the inflation expectations of professional investors who control hundreds of millions, and sometimes billions of investment capital.

The U.S Treasury issues two types of bonds. Traditional treasury bonds are issued with a $1,000 face value, pay interest at the quoted rate for the life of the bond (typically 5 – 20 years), and mature with the same $1,000 value. The second type is known as a treasury inflation protected security. This bond is issued with a $1,000 face value, but the principal value and interest payments are adjusted for the change in the Consumer Price Index.

If inflation picks up, the treasure inflation protected security will pay more interest and carry more inflation protection than a traditional bond which can actually lose principal value temporarily if inflation rises. The neat part is that we can compare the current yields of traditional treasuries and treasury inflation protected security with 5, 10, and 20 year maturities to get an indication of the implied inflation rate anticipated by large institutional investor who are buying and selling large amounts of bonds.

Currently, the traditional bond indicator is implying an inflation rate of between 1 and 2 percent over the next 5-10 years and a little over 2 percent over the next 20 years. The average rate of inflation for the last 80 years has been just a little over 3 percent.

I admit that these indicators could change as new information becomes known in the future, but inflation expectations today are running below what they were a year ago before the stimulus package and before the large run-up in the government deficit. Interestingly, the U.S. dollar is higher against most foreign currencies than it was as we entered the critical phase of the financial crisis last year.

No one knows for sure what the future holds, but following the crowd has generally not been the best way to go. I would be careful this time around as well.

Tom Breiter, president of Breiter Capital Management Inc. and a registered investment adviser, can be reached at (941) 778-1900.

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