I discussed deflation fears in my recent column. But as if the one worry wasn't enough, we frequently see its polar opposite too. Echoing Gerald Ford's 1970s "Whip Inflation Now" campaign slogan, headlines frequently flog future hyperinflation. Only problem is, we don't even have average inflation, and the last thing we want to do is get rid of it. So before anyone issues campaign buttons, let's consider the current state of affairs.
We Aren't Weimar Republic, Part Deux
First, a definition: Inflation is broadly increasing prices on a basket of newly created goods and services. Some inflation is normal and even desirable in expansionary times (as opposed to deflation). But hyperinflation is rising prices on steroids and hugely destructive.
For many, hearing "hyperinflation" may conjure images of Germans pushing wheelbarrows stuffed with marks to their local Deutsche-Piggly Wiggly to shop in the 1920s. (Or, if not, sensationalist authors are happy to remind you.) As commonly told, Weimar-Germany hyperinflation is a tale of the printing press gone wild. But the specifics are frequently forgotten or left out altogether. And that's a shame—because while the Fed (and other central banks globally) may have vastly increased the monetary base recently, the comparison ends there.
The Weimar Republic was a delicate coalition government formed in Germany following World War I. Weimar was saddled with a big wartime debt and outrageous reparations due to the Allies under the Treaty of Versailles. Access to sovereign debt markets was extremely limited—so money printing was the primary means of finance, even as they sent gold and supplies to the Allies (domestic currency was not accepted). As the money supply grew, production shrank—economic capacity had been ravaged by war. Additionally, France forced the Weimar government to give over thousands of transport vessels and tons of coal. Britain and France also erected punitive trade barriers, making import prices spike (on top of increased costs to transport goods). Ultimately, Weimar defaulted on reparations due, and the Allies seized valuable industrialized land—decreasing production capacity further. The result was much more money chasing far fewer goods and hyperinflation. In 1921, prices reportedly increased 50% monthly, which quickly increased to 1000% monthly by 1923.* Domestic government debt was wiped out, but so too were the savings of millions. Despite all of these challenges, Weimar's government feared a fractured coalition (or revolution) more than a nearly worthless currency and did little at first to stem the tide. When they ultimately replaced marks with a new currency in1923, the damage was done.
Today's US little resembles Weimar Germany. (When I last checked, we're not ceding New York to Canada.) We have plenty of spare production capacity, high unemployment (not positive, but also labor capacity), increasing productivity, and easy access to debt markets. Currently the Consumer Price Index reflects this—CPI has increased a modest 1.2% in the past year (through July).
Most inflationary alarmists know this very well—it's the future they're worried about. But looking forward, devout capitalists (like me) believe free markets are the best guide. And long-term bond yields show market expectations for near-term future inflation trends are benign—10-year Treasuries yield about 3% and haven't spiked recently. Similarly low rates can be found in developed countries around the world. The lack of a spike is telling—it shows investors are not currently seeking to be compensated for faster than average inflation today, or the risk of it in the near future. That's in stark contrast to double-digit long bond yields of the late 1970s and early 1980s—shortly after Ford's call for price-level corporal punishment. Of course, bond yields are driven by more than just inflation expectations and aren't a perfect window into future price increases—but nothing is, necessitating a look at underlying drivers. Faster than average inflation is possible moving forward. But keep in mind the long-term average is 3.2%—about 2% higher than today's rate and in line with long bonds. The 1970s? Weimar? Today's inflation and inflation expectations are simply microscopic by comparison.
Fighting Fear With Fear?
Now, it's true in the past two years the Fed has increased money supply quite a bit to counter deflationary pressures associated with 2008's bank panic. But recall, inflation is not driven solely by the stock of money. Today, spare labor and production capacity and still-recovering velocity (frequently feared by deflationists) are countering the enlarged monetary base (frequently feared by inflationists) and resulting, thus far, in benign inflation. These fears focus on one end of the equation without factoring in the other, but when taken together, they basically cancel.
Ultimately, economic recovery will likely drive more lending and spending, reduce idle capacity, and increase employment—increasing inflationary pressures. But this won't happen overnight, and central banks have time and tools to match the economy. The Fed may eventually use open market operations and short-term interest rates to battle inflation. But first, we'll likely see it sell long-term investments purchased in quantitative easing. It may also continue using a tool developed in the panic to slow lending activity—payment of interest on excess bank reserves. This tool compensates banks for keeping funds that could otherwise be lent on deposit at the Fed. If a bank receives compensation above what they could earn lending the funds, they'll likely do it—dampening money movement and inflation.
The economy has its own, free market set of tools to control inflation as well—in the recent recession, companies who were able to increase production with lower costs fared best. From Q2 2009 to Q2 2010, US non-farm businesses have increased productivity by 3.7%—with far greater gains in the manufacturing industry. This increased productivity is a deflationary pressure.
All too often, attention-grabbing headlines cause investors to skew towards highly improbable extremes. Inflation may accelerate down the line, but extreme inflation is not a foregone conclusion. Rather than acquiring wheelbarrows for worthless cash or a cat o' nine tails to "whip" rising prices, investors should prepare their portfolios for inflation's probable long-term outcome—moderately rising prices.
* Barry Eichengreen. Golden Fetters. Oxford University Press, New York, NY, 1992.