The Return of Inflation

November 19th, 2009

Those of us old enough to remember the 1970s recall, with a shudder, the last great American inflation. Recent events – the financial collapse resulting in a huge increase in indebtedness and money creation by the federal government – have stimulated predictions of future inflation. But inflation is already back, in a new and unfamiliar form.

 What Is Inflation?

Prices rise and fall constantly, but inflation traditionally describes the case where all or most prices rise simultaneously. We diagnose it using a price index, a kind of “average price” calculated using data on thousands of goods and services. The best-known price index is the Consumer Price Index.

 Inflation harms people on fixed incomes, such as retired pensioners. Because some prices rise by more or less than average, the structure of relative prices also changes. This makes valuation of companies very difficult, since it is hard to distinguish whether a company’s success is due to inflation or its internal efficiency. Creditors and holders of bonds and annuities receive fixed nominal payments whose purchasing power is reduced by inflation. While debtors and a few others gain from inflation, almost nobody views it as a good thing.

 What Causes Inflation?

Governments cause inflation by increasing the quantity of money in circulation. In all countries in the world today, government controls the quantity of money, altering it to suit the policy aims of the authorities. Governments today do not print currency and spend it. Instead, they create bank reserves – money – that the banking system uses to create more money.

 The money reaches the general public. They spend it. Productivity hasn’t increased; no increase in the supply of goods and services has occurred. Hence, the increase in consumer demand bids up prices. Presto – inflation.

 Why is the Current Inflation Different from Past Inflations?

Today, the world’s capital markets are fully integrated. That means that US dollars can be used to fund a mortgage in Europe or start-up companies in Southeast Asia. The federal government can issue debt that is bought by investors in China.

 Starting in 2001 and continuing until 2006, the Federal Reserve increased the money supply through a policy of lowering the Fed Funds rate. In 2001 alone, the rate was lowered 12 times. Much of the newly-created money found its way overseas through the international capital markets. En route, this increase in the supply of dollars lowered the dollar’s value relative to foreign currencies.

 The implications of this loose monetary policy were enormous. For one thing, it helped to fuel a worldwide real-estate bubble; foreign countries experienced the same pattern of sub-prime and alt-A mortgage delinquencies and defaults that have plagued the U.S. Another ramification was the unusual type of energy-price inflation that occurred in the U.S.

 The New Inflation

All oil transactions in the world are invoiced in dollars, even if the U.S. is not one of the transacting countries. In effect, oil is a “U.S. good,” even though most of the world’s oil is produced and sold outside the U.S. When the U.S. dollar depreciated, that made all U.S. goods – and oil – cheaper in foreign currencies. (This excluded those foreign countries whose currency value was pegged to the U.S. dollar.) With oil now on sale at bargain prices abroad, foreign countries increased their oil purchases.

 A tremendous boom in economic growth was already underway in Southeast Asia, India and China. Because energy use in those countries was much less efficient than in the U.S., it required huge amounts of oil. The oil-price reduction resulting from U.S. dollar depreciation sent the worldwide demand for oil into overdrive, eventually driving up the nominal, dollar-denominated price to new heights. This, and not the “speculation” blamed in the U.S. news media, was responsible for the Great Oil-Price Spike of 2007-08. (Various supply-related factors inside and outside of the U.S. also contributed to price increases of oil and derivative products, such as gasoline.)

 We are used to seeing inflation widely dispersed among thousands of prices. International capital markets channeled the government-created money into two sectors – real estate and energy – and concentrated the inflation effects into those sectors.

 How Can We Verify the Accuracy of This Analysis?

It’s happening again. In late 2008 and early 2009, Federal Reserve Chairman Ben Bernanke supervised an open-floodgate monetary policy that left the U.S. financial sector awash in dollars. Since U.S. banks weren’t keen on making domestic loans at the time, much of this money eventually flowed into the international capital market, where it began to depreciate the U.S. dollar. As before, this made the foreign-currency price of oil cheaper. Economic recovery is somewhat farther along in many foreign countries and their increased purchases of oil have begun to drive up its price. We are starting to see these effects at the gas pump.

 Will Indexation Protect Us from the Effects of This New Inflation?

No. It is true that investors have for some years been able to buy government bonds that are indexed to the CPI. It is also true that two of America’s leading fund groups now offer inflation-indexed annuities, akin to the “real annuities” that have been offered in Europe. Unfortunately, these indexed financial products are somewhat limited in their ability to inoculate us against conventional inflation and virtually impotent against this new variety.

 Generally speaking, indexed products carry an extra benefit – the ability to increase the real return of the asset in response to measured inflation. That benefit is not free. Buyers are willing to pay a higher price to get it, and the higher price negates some of the benefit. The value of indexation is really that it insures against higher-than-expected inflation, or hyperinflation, which is not capitalized into the price of the asset.

 The new inflation is poorly reflected in price indices such as the CPI, since it is concentrated in one or two sectors. Price indexes are deliberately weighted to prevent the effects of one or two prices from predominating. Indexation only counteracts inflation that is measured by the relevant price index.

 What Protection Can the Average Person Erect Against the New Inflation?

Probably none. The only genuine protection would be a true hedge – an asset whose value increased commensurate with increases in oil and derivative-product prices. Alas, construction of a portfolio asset fitting this description is beyond the capabilities of most people.

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