The inflation hawks circle: For U.S, it's cut the budget deficit, or else

By Money Matters Editors

Now the road gets a little bumpier. For years, the United States ran large deficits with near impunity - with low inflation and relatively low interest rates. That may be starting to change.

On Tuesday, investors bid-up the price of gold to a record high close of $1,033.90 per ounce. Gold had hit an intra-day high of $1,045 per ounce earlier in the day. (To view a price chart for gold click here.)

Historically, institutional investors (IIs), bid-up gold when they sense that inflation will re-heat in the quarters ahead. The culprit in Tuesday’s rally was the former, and also some chatter that there may be a move to price crude oil using a basket of currencies or a basket of currencies plus gold – either of which would be bearish for the dollar. Some major economic leaders are growing increasingly concerned about possible further weakness in the dollar and a rise in inflation, due to the U.S.’s large plus-$1 trillion budget deficit.

Up until now, IIs, including major U.S. bond holders, expressed little concern about the dollar or inflation: they were content to buy U.S. debt. But that was during a period of ‘relatively minor’ deficits of about $300 billion per year. The phrase ‘relatively minor’ is used because a $300 billion deficit in $1.5-2.0 trillion federal budget was still a large some of money. But it pales in comparison to the $1 trillion budget deficits precipitated by the bank bailout out and fiscal stimulus package.

In other words, during normal times, IIs were content to buy U.S. Treasuries, despite a world awash in dollars. That really benefited the U.S., despite its profligate ways: it kept the dollar artificially higher, and kept interest rates relatively low.

Gold, oil rise on inflation fears

But now, it appears, the United States has reached the limit of institutional investor patience regarding all those dollars floating around in the world. The price of oil and gold have risen this year, as both an inflation hedge and protection against further weakening in the dollar. The nascent economic recovery in emerging markets will also likely cause IIs to rotate some money out of U.S. Treasuries and into higher-return investments in the developing world, and if that occurs, long-term U.S. interest rates will rise – another hurdle for the U.S. economy, as it attempts to pull out of its pronounced recession.

What can Congress and other U.S. policy makers do to support the dollar, reduce the risk of inflation, and help keep long-term U.S. interest rates low? Cut needless federal spending and raise taxes to demonstrate to IIs that the U.S. fiscal condition will trend toward a balanced budget in less than 10 years. There are no easy, pain-free solutions to the U.S.'s fiscal problem. Underscoring, the U.S. must implement these difficult measures or face the wrath of the IIs: every nation must pay its bills. Or, as we say in the states, “There’s no such thing as a free lunch.”