As government rains money down on the economy, many astute AMG National Trust Bank clients are concerned that inflation could soon erode their financial futures.

While little reason exists to expect inflation to pick up speed soon, the risk is increasing. In coming months, intense price competition brought on by the recession and efforts to pare inventories will make it extremely difficult for businesses to make any price increase stick. That should keep inflation low in the near term. However, the Federal Reserve Bank also is likely to keep short-term interest rates near zero for an extended period. As a result, the money stock and excess bank reserves will grow considerably—which puts the economy at risk for future inflation.

Currently, households and businesses are content to sit on a mountain of cash because of their concerns about the severity of the recession and the lack of safety of other investments, financial or tangible, but this will not always be so. As the economy recovers and the gap between demand for goods and services and productive capacity diminishes, the Fed will have to shrink the excess of money and bank reserves, or we will have the classic cause for inflation—too much money chasing too few goods.

The Fed may not have an easy time shifting policy. Banks may not be eager to buy the non-Treasury private debt now held by the Fed, and the Fed may not have enough Treasury bonds to absorb the excess. Political pressures to maintain low interest rates, when they should be moving up, could also come into play. All indications are that Fed policy makers are attuned to the issue and determined to act—but success is far from guaranteed, and the time for investors to take protective measures is before inflation accelerates.

There is little reason to expect inflation to pick up speed any time soon. Intense price competition, brought on by the recession and efforts to pare inventories, will make it extremely difficult for businesses to make any price increase stick. Given the high current numbers of unemployed workers, the rate of increase in wages and benefits will likely remain quite modest, and businesses will be forced to absorb the effect of declining productivity in reduced profit margins. With demand weak and bloated oil inventories putting downward pressure on prices near term, several more months of declines in the CPI are possible this year.

A number of the media’s financial and economic pundits are now pointing to forecasts of large increases in federal debt, which they conclude will inevitably result in very high inflation. While we agree that high inflation is a serious risk in the intermediate to long term, it will not be because of the size of government deficits and debt per se. Post-World-War-II era periods associated with high levels of federal government debt have, in fact, been associated with lower average inflation than periods with low levels of debt. This does not mean that there is not a problem, but rather that high inflation is not predestined by large increases in federal debt.

The problem occurs because the Fed is likely to keep short-term interest rates near zero for an extended period. The money stock and excess bank reserves will thus grow considerably. The severity of the recession means there is no short-term inflation risk because the total demand for goods and services—and their factors of production, such as labor—is much lower than supply, and because households and businesses currently prefer to add to their cash reserves because of concerns about the safety of other investments, financial or tangible.

However, as the economy recovers, the Fed will have to shrink the excess of money and bank reserves. This may not be as easy as it seems. Banks may not be eager to buy the non-Treasury private debt now held by the Fed, and the Fed may not have enough Treasury bonds to absorb the excess. Political pressures to maintain low interest rates, when they should be moving up, could also come into play.

All indications are that Fed policy makers are sensitive to the issue and determined to act.

The Wall Street Journal identified a lack of checks and balances as “the most glaring red flag in the Madoff scandal” and recommended that investors pay close attention to the levels of internal and regulatory oversight their financial advisors receive.

AMG National Trust Bank is subject to stringent regulation and examination by the Office of the Comptroller of the Currency, a bureau of the U.S. Department of the Treasury. In addition, AMG routinely submits to rigorous financial audits and operational reviews by experienced, knowledgeable and reputable accounting firms. AMG has a full-time compliance officer on staff who reports to an audit committee consisting of independent members of AMG’s board of directors. AMG is well capitalized and has Federal Deposit Insurance Corporation insurance on bank deposits.

Annual audits and reviews independently verify a number of safeguards critical to the security of assets held at AMG; specifically:

• The separation of client assets held in securities accounts from corporate assets and independent confirmation of client-owned securities held at third-party custodians,
• Appropriate accounting for client assets and reporting of the assets to the client,
• The existence of, and adherence to, policies and procedures, including dual control over client assets,
• Detailed due diligence on recommended outside investment managers, brokers, and custodians,
• The scrupulous protection of client privacy.

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The fiscal deficit of the federal government is expanding rapidly. The impact of the economic downturn is evident in both receipts and outlays. The deficit will likely reach $1.9 trillion in the fiscal year ending September 30, 2009, setting a new record by a wide margin. A fiscal stimulus package, the ARRA, was enacted on February 17, 2009. That, along with recent Congressional responses to the President’s budget requests, virtually guarantees high levels of spending through fiscal 2010, while revenues will remain weak. This expansionary fiscal policy, if maintained beyond the recovery phase of the economy, could create financing difficulties. In the near term, however, there will be little or no adverse effects on the financial markets, and it should prove adequate growth.

During the first half of the current fiscal year, total federal government receipts were down 13.6% compared to the same period one year ago, while total outlays were up 33.2%. Individual income tax collections were off 15.3%, and corporate income tax receipts were down 56.6%. Spending on social insurance programs was up dramatically. Medicaid expenditures were up 17.0%, and unemployment benefits payments more than doubled. In addition, fiscal-year-to-date outlays for the purpose of stabilizing the credit markets and the banking system, along with support to automakers, totaled $350 billion.

The Congressional Budget Office estimates that spending associated with the ARRA will total a net $788 billion through fiscal 2019. The adjacent table shows the estimated composition of the stimulus package in calendar years 2009 and 2010. As we previously anticipated, the package is heavy on subsidies and transfer payments, short on infrastructure construction, and devoid of cuts in marginal tax rates.

Nevertheless, the ARRA will be moderately effective in filling the hole in aggregate demand that has developed in the private sector. We estimate that the package will have a multiplier effect of a little less than one. This implies that, on average, every dollar from the package will produce somewhat less than a dollar of additional economic output over the next few quarters. Still, the package should be adequate to pull the economy out of recession around year end 2009. We calculate that fourth quarter 2009 real GDP will be about 0.8% higher than it would have been without the package and that fourth quarter 2010 real GDP will be about 2.4% higher.

In addition to the ARRA, other legislation will increase the deficit both this year and next. When Congress completed the budget process for fiscal 2009, it boosted expenditures by about $40 billion more than anticipated. The Obama Administration submitted its proposed budget for fiscal year 2010, and it currently appears that Congress will pass something close to what the Administration has asked for-if not in exact detail, at least in total spending. Spending will rise significantly in both fiscal 2009 and 2010 while revenues remain suppressed by a weak economy, sending the deficit to a record in 2009 with only small improvement in 2010.

Total federal debt held by the public will increase to about two-thirds the level of the GDP, exceeding the peak of the 1990s but still well below that of the late 1940s and early 1950s. Although increased debt levels will create future difficulties, the size of the debt in the near term will not push the private sector needs out of the credit markets because private demand for credit is shrinking due to the recession while the demand for Treasury debt has grown due to its safe-haven status.