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Tuesday, June 28, 2011

Inflation, Deflation, and Stagflation: What’s the difference? - Published in the SB News Press in May of 2011

We often hear economic and financial terms like inflation, CPI, opportunity cost, derivative, option, and the like, with economists, analysts and market pundits rattling them off as if we are all supposed to know what these words mean and how all of these concepts interact to drive our economy and financial markets.  The reality is that few of these so-called experts really understand these concepts, especially their practical implications and real-world impact on our daily lives.  A discussion of inflation, deflation, and stagflation, although probably a bit dry for most readers, can offer insights into the risks we face with the U.S. economy and investment portfolios.

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.  As prices rise, (assuming the value of the local currency does not change), consumers receive less value for each dollar spent.  A simple example would be if a gallon of milk initial costs $4 and then prices doubled to $8 for a gallon, the consumer would only get a half-gallon for the same $4 that previously got them a full gallon.  Another way to look at inflation is that consumers have to work harder and earn more to be able to buy the same amount of goods and services. 

Some inflation is fine.  In fact, a relatively low level of inflation is the most common economic condition for most countries, including the U.S.  Over the very long-term, the U.S. economy has experienced, on average, about 3 percent annual inflation.  A reasonable level of inflation can typically be offset by a rise in incomes.  We are all familiar with the “cost of living” pay raise.  This type of pay increase is intended to offset inflation—to maintain the employee’s buying power as the general level of prices rises.

Problems begin to occur when inflation rises at more than the normal pace.  The most basic negative impact is on consumers, as stated above.  Things begin to go progressively worse as inflation accelerates.  By definition, inflation means that the value of the currency weakens—you get less stuff for each dollar spent, so the dollar, (if we are talking about the U.S. economy), becomes progressively weaker as inflation increases.  A weakening currency can offer some positives, especially for companies that export—it makes their goods less expensive to foreign buyers.  However, as the currency weakens further and further, serious problems begin to arise.

Foreign investors will no longer want to invest in the U.S. as the dollar weakens, because their returns are denominated in dollars, which means that, when they try to bring their money back to their home country, they will have to convert their dollars to their home currency at a less and less favorable exchange rate.  At the moment, China holds something like $1.25 trillion (some say more than $2 trillion) is U.S. treasuries.  Imagine the negative impact on our economy if the Chinese should decide not to buy our debt anymore.  How would we replace that $2 trillion?

Another negative impact of a weakening dollar (as the result of inflation), is that consumers, who are receiving less and less for their dollars, just stop buying much of anything, other than necessities.  This can crush economic growth.  If the dollar weakens past a certain point, consumers will no longer want to hold dollars, and will resort to gold or even foreign currencies as a substitute.  Often, when currencies devalue, consumers resort to a barter system—trading goods and services directly, rather than using money.  This is an extreme situation, but it has happened in plenty of other countries. 

Hyperinflation is a condition where the currency of a country devalues to the point where it becomes virtually worthless, typically resulting in a complete collapse of the country’s economy.  In fact, we have had two instances of hyperinflation in the U.S:

1.)   The Continental Congress issued paper currency during the Revolutionary War, which was widely counterfeited, leading to the expression “not worth a continental;”
2.)  During the Civil War, the Confederate side printed currency which also devalued dramatically as their prospects dwindled towards the end of the war.

Deflation is the opposite of inflation—price levels decrease, usually as a result of weak demand.  Deflation is generally associated with recessions and depressions—consumers, worried about the economy, or who are out of work, stop spending money.  The result is a decline in demand for goods and services.  Less demand means that producers must lower prices to entice consumers to buy their goods and services.  The lower demand goes, the lower prices must go to generate sales.  If the price of goods falls below the cost to produce them, the economy could collapse. 

A deflationary spiral is a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.  This vicious cycle can continue until the economy spirals down into a depression, such as the Great Depression.

Typically, when deflation occurs, (when we have a recession), the Federal Reserve will lower interest rates, as they did in the most recent recession, to stimulate demand.  By lowering the cost of money (the cost to borrow), usually (not always) more people will borrow and then spend, resulting in increasing demand and a stabilization of prices.  Low interest rates can cause inflation though, because lower rates usually end up causing demand to increase until prices begin to increase, and cause currencies to fall in value, etc. etc. 

Stagflation is probably the most serious possibility of the three discussed.  Stagflation occurs when the economy is stagnant, but still experiences high inflation.  This presents a conundrum for policymakers because the tools they would typically use to fight inflation—namely raising interest rates—will make the economy even worse.  The tools they would use to improve economic growth—namely lowering interest rates, increasing the money supply by printing more dollars, and open market operations, such as buying treasury securities, etc.—will result in even higher inflation. 

Stagflation can result when the productive capacity of an economy is reduced by an unfavorable supply shock, such as an increase in the price of oil. Such an unfavorable supply shock tends to raise prices at the same time that it slows the economy by making production more costly and less profitable.  Both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply, which we have seen in the U.S. recently, as a result of the recession.  The government can also cause stagnation by excessive regulation of goods and labor markets.

In the 1970s, the U.S. economy experienced stagflation, which resulted from a big spike in oil prices.  Problems continued when the Fed used excessively stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral. 

Federal Reserve chairman Paul Volcker very sharply increased interest rates from 1979-1983 in what was called a "disinflationary scenario." After U.S. prime interest rates had soared into the double-digits, inflation did come down.  Rates skyrocketed to the highest levels in modern history.  Volcker is often credited with having stopped at least the inflationary side of stagflation, although the American economy also dipped into a deep recession.  Unemployment remained at elevated levels for six years, although the economy began to recover in 1983, after the double-dip recession.  This was one of the darkest times in U.S. economic history. 

There are certainly some signs of possible stagflation developing today.  We have extraordinarily high commodity prices, including a big spike in energy prices.  We do have economic growth, although the pace is fairly slow and we could easily dip back into recession.  The dollar is incredibly weak, which could lead to more inflation, although inflation is tame at the moment.  Rates are at historically low levels, as a result of the Fed holding short rates at basically zero for a prolonged period of time, which is pressuring the dollar, and they have increased the money supply dramatically. 

My concern is that, if the Fed does not act quickly to begin raising rates, it could be too late for them to do so at a moderate pace.  What we don’t want to see happen is the Fed jumping rates up by a substantial amount in a short period of time, which would almost certainly crush the recovery and could set us up for stagflation.  I believe the Fed should have already started raising rates, and I hope they do so very soon to avoid these very real, negative economic consequences.

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