It happened again... just as the market expected it would.
On Sept. 13, the Federal Reserve announced a new plan for quantitative easing (QE3). The plan -- which started on Sept. 14 -- is for the Fed to buy $40 billion of mortgage-backed securities each month until it sees a substantial improvement in the labor market.
The idea here is simple. By buying up mortgage-back securities and other financial assets, the Fed is hoping to keep interest rates low in order to spur additional borrowing, with the hope of stimulating economic activity.
The problem is, every time the Fed embarks on another round of quantitative easing, it's injecting billions of dollars of additional cash into the money supply. And as any first-year economics student would know, if the money supply starts to outstrip the supply of goods and services, prices can rise.
It's no wonder then that as soon as the market made the announcement, inflation hawks started pounding the table.
But don't be fooled by the headlines. While the argument makes sense in theory, it could be a while before we see any real inflation threats start to emerge. Let me explain...
In order for there to be inflation, two things need to happen. One, money needs to be cheap. And two, there needs to be a strong demand for goods and services. When money is cheap and demand for goods and services are high, it can create an environment where too much money is chasing too few goods. The only natural remedy is for prices to increase.
With the 10-year treasury currently yielding 1.6% money certainly qualifies as cheap. But it's the latter part of the equation -- high demand for goods and services -- that looks suspect right now.
All across the world, demand for goods and services appears to be slowing. Although central banks the world over are trying to stimulate their economies, governments are frantically slashing their budgets, which weighs on economic growth.
In Europe, unemployment current sits at 11.3%, the highest it's been since its formation. Even Germany -- considered better off than its euro peers -- has seen its unemployment rise in each of the past six months. You can't blame them if they don't feel like spending or borrowing, even at rock-bottom interest rates.
In Japan, the situation looks even worse. During the past several years, Japan has been furiously pumping money into its economy... but to no avail. In fact, in July, Japan's core consumer prices dropped 0.3% -- the third straight month of deflation.
And then there's the United States. While the economy is undoubtedly plugging along, we are not exactly breaking any growth records. The latest data estimates that U.S. economy grew at a lackluster 1.3% in the second-quarter.
To top it off, the United States is also about to embark on a program of fiscal austerity. Whether the federal budget gets cut in an orderly fashion or via across-the-board budget cuts -- triggered by a failure to meet the conditions of the 2011 Budget Control Act -- is yet to be known. But cuts are coming.
Don't get me wrong, inflation is certainly something to fear. In periods of rising inflation, there are few winners. For income investors, inflation can be especially devastating as existing fixed income assets take it on the chin when new fixed income assets get issued at higher interest rates.
Action to Take --> But right now we're lacking the demand to really bake the inflation cake. It looks like fiscal austerity and economic uncertainty seem to be keeping it in check. As a result, it looks like your fixed-income investments are safe... at least for the time being.