Is Significant Inflation Coming?

The Federal Reserve's massive injection of liquidity into economy has led many pundits to forecast that rapidly rising inflation would be the inevitable result. As I've mentioned before, this is a risk, but it's not a certainty.

So far, we haven't seen significant inflation because the increase in the monetary base has been offset by a sharp drop in the velocity of money. The increase in the monetary base will only result in future inflation if the Fed fails to unwind its prior injections of liquidity when the economy begins to recover and the velocity of money returns increases.

The Fed has already started unwinding some of its lending programs. It's reducing the Term Securities Lending Facility to $50 billion from $75 billion and the Term Auction Facility to $50 billion from $900 billion. In addition, banks have repaid roughly one-third of the Troubled Asset Relief Program funding.

Fed Chairman Ben Bernanke is well aware that the markets are watching to see if he repeats the mistake made by his predecessor who failed to tighten when the economy was recovering in 2003. The question is whether the Fed will be as aggressive in reversing its actions as it was when it was battling the crisis. Unfortunately, we don't have a clear crystal ball to answer that one.

Investors can address the risks of future inflation by purchasing Treasury inflation-protected securities (TIPS) in their tax-advantaged accounts and by avoiding longer-term bonds in their taxable accounts.

Further reading: For more on TIPS, see my post discussing how to guard against inflation using TIPS.