this is the first of several posts about inflation, which may turn into an important investment issue this year or next.
what it is
Inflation is a sustained rise in the level of prices in general. An environment of modest inflation–the Fed’s target is an average 2% yearly increase–is the desired mode of operation for Western economies. It’s what people are used to. Government and university economists feel they understand how inflation operates and know what to do if it starts to get out of control. They all agree, moreover, that inflation is a lot better than deflation, a sustained fall in the price level, whose effects have historically been devastating and for which there’s no tried-and-true cure.
what’s bad about inflation
Inflation has two bad characteristics, last seen in the US in the 1970s, that make it an object of concern:
If goods or services are in plentiful supply and if prices don’t change very much, buyers will purchase things when they need them. If buyers think that prices are rising in a sustained and significant way, they’ll begin to buy ahead of time. Some will buy more than they’ll ever need, either with the intention of selling later at a profit or simply viewing their purchases as a store of wealth.
Once ingrained in individuals and companies, as it became in the Seventies, this behavior is hard to change. But it sends crazy signals to the providers of goods and services, who rev up production as fast as they can to meet this new demand.
Once convinced that inflation is here to stay, the economy begins to distort itself. Interest swings toward the production/acquisition of items whose chief/only merit is that they are perceived as inflation hedges (think: gold, diamonds, real estate, oil and gas). In the late Seventies, for example, industrial companies leveraged themselves to the sky to buy coal mines or hotels–things they knew nothing about, and whose purchase they would soon come to rue, but which they thought defended themselves against accelerating inflation. If they could borrow from banks at fixed rates–which was the general practice back then–they figured that the real cost of their debt would soon turn negative, giving them further gains. Once the Fed stepped in to halt the inflationary spiral, these firms (and their banks) were ruined.
In short, once inflationary psychology develops, an economy begins to go off the rails.
a tendency to “run away”
Three factors cause inflation to accelerate–and economic craziness to get out of control. They are:
–Inflationary psychology tends to feed on itself. Once you see the hundred pounds of pig iron you have in your basement has gone up 50% in price, you buy more …as time goes on, a lot more. As companies/individuals realize that “buy now” is a successful strategy, they expand the depth and scope of their activity.
–Some price rises are automatic, adding to the price rise momentum. Labor contracts, for example, may have clauses that adjust wages for inflation. Traditional pensions, too—and Social Security. Utility companies typically are allowed to pass increased costs directly on to consumers. In addition, these institutionalized price increases often use escalation formulas that overstate inflation (think: Social Security).
–Some parties may systematically underestimate inflation and inadvertently throw gasoline on the fire. For most of the 1970s, for example, the Fed set money policy that was much too loose, based on faulty inflation projections. Banks typically didn’t protect themselves by lending at variable rates, either. Potential borrowers soon learned that they could do a lucrative arbitrage by taking out a long-term loan at a rate that would soon turn negative and use the money to buy “hard” assets that would appreciate in value. This became the focal point of many firms’ capital spending plans.
1970s vs. 2010s
A generation ago, the “runaway” factor was extremely powerful in the US. That was partly because of bank activity and partly because a large portion of the labor force worked under multi-year collective bargaining agreements with inflation adjustment factors. Much more so in Europe.
Today’s banks lend at variable ares and are no longer a pro-inflation force. Labor arrangements have changed a lot in the US over the past forty years, though not in continental Europe.
As a result, my guess is that the tendency for inflation to accelerate is considerably lower in the US now than it was the last time we had an inflation problem. One offset: the early Volcker years, during which the Fed was successfully breaking an upward inflation spiral through super-high interest rates, were ones of severe economic hardship. The memory of that pain was enough to engender a “never again” attitude toward too-loose money that lasted for almost twenty years–until the latter days of Alan Greenspan. I think that mindset is gone now, not only from the Fed but from popular consciousness as well.