Rising national debt raises prospects of eventual inflation

"In this environment, we anticipate that inflation will remain low," Fed Chairman Ben Bernanke said in testimony on June 3. "The slack in resource utilization remains sizable, and notwithstanding recent increases in the prices of oil and other commodities, cost pressures generally remain subdued. As a consequence, inflation is likely to move down some over the next year relative to its pace in 2008."

But later

The government's plan is to fight the sour economy now by spending money, and worry about the debt problem later. "If that's the price to keep from having the second Great Depression, it's a bargain," say Ken Goldstein, economist at The Conference Board.

Even ardent supporters of the government's plan, however, worry that massive U.S. debt could be inflationary. Every day, for example, the U.S. needs to borrow $15 billion to fund the deficit, says Axel Merk, portfolio manager of the Merk Hard Currency fund. "Someone has to buy all that," he says. More important, the U.S. has to repay it.

Inflation is a tempting choice to pay the nation's staggering debt, especially because the alternatives are to raise taxes or cut spending. Already, some economists are suggesting letting inflation take some of the bite out of government spending.

Kenneth Rogoff, chief economist at the International Monetary Fund, gently told Bloomberg News that a bit of inflation might be a good thing. "I'm advocating 6% inflation for at least a couple of years," said Rogoff, now a professor at Harvard University. "It would ameliorate the debt bomb and help us work through the deleveraging process."

The effects of inflation are cumulative. After five years of 6% inflation, $1 trillion would be worth $734 billion, a 27% drop. Even a 2% inflation rate would be a cumulative devaluation of 81% over 30 years.

And, at least initially, a bit of inflation would be welcome. "If you have debt, you love inflation," says Merk. Workers would get bigger raises, home prices would increase, and 30-year fixed-rate mortgage payments would remain the same.

Not-so-good long view

But any sustained burst of inflation would have some ugly long-term effects:

•Higher interest rates.The Federal Reserve typically raises short-term interest rates to cool off the economy and tamp down inflation. Even if inflation remains tame, the Fed will eventually have to return short-term rates to normal — about 3% to 5%.

Other interest rates would rise, too. Bond traders, for example, loathe inflation, which eats away at the spending power of bonds' fixed interest payments. When inflation looks likely, bond traders demand higher bond yields — and higher long-term rates can also act as a brake on the economy, raising payments on everything from corporate borrowing to home loans.

•A lower dollar. The value of the dollar on the international currency exchanges is another measure of inflation. If foreign investors think the U.S. is inflating its currency, they will demand more dollars in exchange for other currency — say, the euro or the yen.

A declining dollar makes imported goods more expensive, although it makes U.S. exports more attractive.

"There's likely to be long-term decline in the dollar; that's generally inflationary," says Mihir Worah, head of inflation-linked bond trading at Pimco, the West Coast bond powerhouse.

The nightmare scenario is that the dollar loses its pre-eminence as a world currency.

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