inflation–what’s important to know (i)

It strikes me that the important topic that the financial press is most clueless about when it comments is inflation. That’s even though inflation is a central financial issue, because of its key role in determining the level of interest rates–and thereby the level of nominal yields on bonds and the PE on the stock market.

the basics

Inflation is a general rise in the price level in an economy. In the US over the past twenty years, prices have risen at about a 2% annual rate, as measured by the Consumer Price Index (CPI). The CPI is constructed in a way that mildly overstates inflation, but that’s more a quibble than anything else for the US. Mild inflation with no acceleration to the upside is the way most advanced economies work today.

The opposite of inflation is deflation, or a general decline in the price level.

worrisome developments

Deflation is generally bad. Think the Great Depression of the 1930s, where unemployment in the US peaked at 25% of the workforce (compared with 10% during the 2008-09 financial crisis). Washington’s tariff wars, restrictive fiscal policy and tight money all made the situation worse. Deflation feeds on itself. As potential buyers realized that prices were falling, they began to postpone purchases. Also, any company that had issued bonds or taken out a bank loan –both fixed rate instruments–found that as sales revenue began to dry up it was increasingly difficult to generate enough cash flow to repay borrowings. Eventually, many firms went bankrupt, deepening the economic slump.

One of the biggest themes of modern macroeconomics has been to figure out how to stop this from happening again.

Inflation can turn into something bad, if it is high and rising. As a result of persistent, excessive government stimulation in the 1970s, the US exited that decade with inflation at 14% and rising. Unemployment, at 7.5%, was expanding as well, as US companies began to direct cash flows to tangible assets, like real estate and mines, to preserve the real value of their assets.

There’s also hyperinflation, which appears to be defined as price level rises of 50% a month, or 130x a year. Think Weimar Germany or South America.

A change in inflationary expectations (Americans currently expect the current 2% or so to continue, I think) is another possible cause for concern. More about that tomorrow.

nominal vs. real

GDP, or GDP growth rates, or interest rates, or stock and bond prices that we encounter in ordinary life are recorded in dollars of the day, or nominal quantities. Economists break these figures into two components: the results of inflation, and the real (meaning ex inflation) quantities.

A two-year Treasury bill, for example, has a nominal yield today of 0.16%. If inflation in 2021 is expected to be +2%, then the real yield on the two-year is -1.84%. In other words, a holder to maturity will lose 3.5% or so of the purchasing power of his money by buying one today and holding to maturity. Similarly, the holder of a 10-year Treasury note, which yields 1.53%, will lose about half a percent of his purchasing power each year.

More tomorrow.

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