The great economist Milton Friedman once said that "inflation is always and everywhere a monetary phenomenon." His observation has been proven true many times.
Unless this time is different, so much cash sitting in banks plus a sudden change in lending standards could result in more loans being made and, eventually, a return of inflation.
In fact, the bond market already may be signaling that more loans — and more inflation — are within sight.
Escaping notice in the evening newscasts is the fact that the interest rate on the 10-year Treasury note has increased by almost 20 percent since the start of the year.
Bailout plan after bailout plan have flooded the economy with cash. The supply of money in the United States has never grown this fast for such an extended period of time.
Surprisingly to many at the Federal Reserve and the Treasury Department, the government may not be able to direct the private sector to spend money just by printing it as fast as they possibly can.
For now, most of that cash is sitting in banks. The financial crisis has forced banks to write down the value of many assets and, in order to meet regulatory requirements, they are holding very large amounts of cash to demonstrate that they are solvent.
Solvency, though, is largely an accounting concept. It means that banks have enough assets to meet their long-term obligations. With mortgages, car loans, and other bank assets suffering ever-increasing default rates, it is important for banks to have some safe assets on their balance sheet. Right now the only truly safe asset is cash.
Yet much of the losses that banks have taken are related to accounting rules. The losses may or not be real.
It is likely, then, that financial companies will get rule changes to lessen the impact of those theoretical losses. These rule changes will most likely allow them to increase the value of the loans on their balance sheet, based upon their best guesswork, and decrease the need to hold cash.
Traders who bet with real money instead of just expressing opinions on television may still harbor a little pessimism about the long-term economic trends. While they are enjoying their short-term gains in stocks, however, they have been selling bonds.
As bond prices decline, of course, interest rates must go higher.
It might be time to lock in that lower mortgage rate, or invest in an inverse bond mutual fund, to take advantage of coming higher inflation.
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