inflation? maybe? …gold? no way!

I turned on CNBC in the middle of the day to look at the stock prices crawling across the screen below the talking heads.  I happened to hear the discussion, as well.

The topic was gold as an inflation hedge.  The back and forth sounded kind of like one of those Time Life infomercials selling the Greatest Hits of the (1960s, 1970s…) …or maybe the commercials that let you know you can get the same auto insurance as Snoop Dogg even if you have a bad driving record.

Even though the participants didn’t know much about gold (what a surprise), I find their unstated premise very interesting.  What do we do as investors if inflation comes back?

no sign of garden variety inflation 

The standard analysis of inflation is that it arises in an advanced economy during an employment boom when money/fiscal conditions are too loose.  Government policy stimulates firms to expand.  But there are no more unemployed workers.  So companies poach from each other, offering ever higher wages to lure workers from rivals.  Not the case, at least right now, in the US, where the administration’s white racism and anti-science stance have leading firms, if anything, figuring out how to leave.

developing world variety, though…

This is the situation where a corrupt or inept government favors politically powerful industries of the past, borrows heavily–especially from foreigners–and shows itself unwilling or unable to repay what it owes.  The local currency begins to slip as this picture becomes clearer–evidenced by government budget deficits–and foreign investors head start to pull their money out.  This raises the price of imported goods and starts an inflationary spiral.

Trump has recently invited this framing of the US situation by hinting that he will punish China by defaulting on a portion of the $1 trillion+ Beijing has lent to Washington.  He also seems to have suggested the possibility of a more general default  during his presidential campaign.

In the case of the US, past bouts of inflation have been fueled by domestic fixed income investors fleeing Treasuries much faster than foreigners.  My guess is that this would already be happening, except for two factors:

–the gigantic amount of debt the Fed is buying, and

–there’s no obvious other place to go.  Japan is a basket case, the EU isn’t much better, Brexit dysfunction rules the UK out and the renminbi isn’t a fully convertible currency.

guarding against inflation

For currency-induced inflation, the winning equity stance is to have revenues in the strong currencies and costs in the weak.  For wage-cost inflation, the economic remedy is to tighten government policy, that is, raise interest rates.  That hurts all financial instruments.  Least badly hurt would be traditional defensives.









what’s bad about inflation?

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:

inflationary psychology

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.

More tomorrow.





the late 1970s: the last real inflationary period in the US

inflation in the 1970s

The most recent US experience with a real inflationary spiral came in the late 1970s.  In early 1977, prices were rising at a 5% annual rate.  A year later, inflation was running at 7%.  A year after that, the number was 9%, with 14% posted in early 1980.  Then Paul Volcker was appointed as Fed chairman.  He pushed the Fed Funds rate from 11% to 20%, creating a deep recession but breaking the back of the inflationary psychology that was feeding the accelerating rate of price rises.

There’s an academic debate, itself with political dimensions, as to what caused the spiral in the first place.  One side says it was a series of mistakes by the Fed, whose inflation forecasts were systematically too low–that therefore its setting of short-term interest rates(the main tool it used to regulate the economy) was, too.  The other side says it was Washington’s political meddling.

who lived through it?

If you were in your mid-twenties in 1975, when the world was just emerging from a horrible recession (the UK had to call in the IMF to rescue its economy), and the subsequent inflation problem was just being ignited, you’d be in your sixties now.

In other words, virtually all commentators about the perils of inflation today have no practical experience with the phenomenon.  Most of them are clueless.

two parts to runaway inflation

In my view, for what it’s worth, runaway inflation has two characteristics:

1.  money policy that’s too accommodative (read:  interest rates are too low), and that stays that way in the face of rising inflation, and

2.  a resulting mindset change that accepts rising inflation as a fact of life and seeks to benefit from it.

how people deal with rising inflation

I’ve seen this behavior in the US in the late 1970s, and also in high-inflation emerging economies around the world since then:

1.  The price of everything is going to be higher tomorrow than it is today. So you should buy now, rather than wait.  That’s true of everything …houses, cars, clothes, appliances.  If you have to borrow, do it!  In fact, if you can borrow at a fixed rate, inflation will probably soon make the loan look like a gift from the lender and you’ll profit from that, too.

Companies will load up on extra raw materials inventories, expecting to profit from holding them while prices rise.

2.  Workers will look for protection from inflation through contracts where wages are indexed for inflation (wages will rise in lockstep with the general price level). Companies will look for the same in multi-year sales agreements. Many contracts signed in the 1970s had prices indexed to the CPI or other indices that overstate inflation.  Good for the seller, but this also added to the inflation problem.

3.  Economists talk a lot about “money illusion,” the idea that most people can’t figure out how fast prices are rising.  So they’re satisfied with, say, a 5% raise when prices are going up by 8%.  In reality, that’s a 3% wage cut, after inflation.  Of course, once you’re aware of this possibility, you’ll ask for a 10% pay increase–fueling the inflationary fires.

4.  Investors of all stripes will look for assets that will protect them from rising prices.  Typically, these would be physical things, like property, oil and gas or metals.  At the same time, they’ll shun financial assets.  Investors may even short financial assets by borrowing heavily, at fixed rates when possible.

In fact, in the late 1970s many companies made what turned out to be disastrous acquisitions as they tried to work the inflation game, with, say, an industrial parts maker borrowing heavily to buy a coal mine or a chain of hotels.  These turned into almost certain recipes for Chapter 11 after inflation was tamed.

At one time in Brazil, investors bought used cars and stacked them up in their back yards as inflation hedges.  Sounded good at the time, but…

5.  Stock market investors will look for hard-asset companies or firms that can grow their profits at a faster rate than nominal GDP.  This excludes most defensive industries, like telecom or gas/electric utilities, where rates of return on investment are regulated, or like staples, where large price increases cause consumers to look for cheaper substitutes.

an alternate reality

Sounds like an alternate reality?  I think so.

But that’s the point.  It shows how far away from an inflationary environment we are today.