INFLATIONARY DELUSIONS

Lex
The great reflation will come with a nasty debt hangover. But the notion, mooted by some, that postponing the exit strategy from easy money and allowing some beneficial inflation to boost growth and reduce borrowing in real terms, is both dangerous and misguided.
In a simple world, inflation lifts nominal output while debt remains static. But the world is not simple. UBS economists looked at developed economies from 1971 through 2008 and found that government debt to output was five times as likely to be stable or rise than to fall if inflation rose above 5 per cent. By contrast, debt fell three times as often with low inflation. One reason for this is that much government debt is short-term, and markets adjust quickly. The US will roll over half its government borrowing in the next two years. A similar proportion of eurozone debt matures in the next five. The popularity of inflation- linked securities also offsets any gain from inflation. About 10 per cent of US and 23 per cent of UK government debt is indexed. So inflation would boost those borrowing costs.
Global imbalances add another complication. A perception that US policymakers desire inflation could dampen foreign demand for Treasurys and weaken the dollar, so importing inflation. Losing credibility on inflation would be costly indeed. In the quarter century since Paul Volcker's triumph, excess yields required to insure against future inflation have shrunk by 100 to 150 basis points. Squandering this legacy would be foolish.
Inflation is also tantamount to generational theft. Young people with large, fixed mortgages and much of their meagre savings in equities would benefit, while those near retirement with little mortgage debt and more substantial savings in bonds and annuities suffer. If this crisis has taught anything it should be that there are no free lunches.
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