The road to inflation is paved with good intentions…

On December 26th, 2004, an earthquake with a magnitude greater than 9.0 struck off the coast of Sumatra, Indonesia. Apparently it was the second largest earthquake ever recorded. One of the consequences of the earthquake was that a massive Tsunami was generated that killed hundreds of thousands of people. Measuring by lives lost and the scope of damages, it was one of the largest tragedies of our times.

There are several accounts and some video footage showing that prior to the Tsunamis strike, the sea retreated from the shore leaving vast areas of land previously covered with sea, exposed for the first time. Unaware of the danger, some people strolled out into the unexplored terrain. Of course once the wave rolled in, they were in serious trouble and had farther to run in order to avoid the wave. I am not a geologist or oceanographer but I understand that is how Tsunamis can manifest. All the water races away from the shore and then returns with a fury of… well, a Tsunami.

I am left wondering as I read article after article explaining the various stimuli(?) tallying now into almost $10T, are we headed into a financial equivalent of the Boxing Day Tsunami? If you replace the ocean with capital flows and the Tsunami being inflation, then I cannot help but draw an analogy. In fact, that is what some of my favorite analysts are saying in this Bloomberg article. In the article, it cites a commentary by PIMCO (you can read the note here) which states, ‘PIMCO believes that the policies of the Federal Reserve and the Obama administration, which are designed to avoid deflation, are likely to reflate the economy over the next three to five years. Breakeven inflation rates currently reflect expectations of nearly 3% deflation over the next five years. This is not PIMCO’s outlook and suggests that TIPS are significantly undervalued relative to nominal Treasuries. Although we expect growth to contract in 2009, government stimulus may reflate the economy as soon as 2010 and beyond that.’

In other words, PIMCO is saying  ‘get ready, all this stimulus may create inflation next year.’ There are several other well known pundits sounding the same warning. In a closed system, it is impossible for one action to not impact the entire system. And given that ‘decoupling’ has been shown as an ideal rather than a reality, I think it fair to start viewing the global economy as a closed system. The effects of the US’s massive stimulus programs combined with other economies worldwide following in lockstep, will be be manifest. The unknown is ‘in what way?’ Perhaps it will be a benign outcome and we will once again return to a ‘trees growing to the skies’ economy. But somehow, that seems like almost magical thinking that is too good to be true.

While the current situation is dire and the actions being taken by governments worldwide seem logical, there are always unintended consequences. It is fair to say that this financial crisis has plunged us into unexplored financial territory. Let us then recognize the risks we accept as we grapple with the current problems in front of us on a pragmatic basis. Let’s not be those caught unawares strolling into the fresh shoreline while a Tsunami races toward us.

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