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Investigating Inflation

Patrick Chovanec, CPA

Economic Advisor


Below we summarize responses to common questions surrounding inflation.

What is worse, inflation or deflation?

Inflation is a rise in the general price level; in other words, when a unit of money buys less of anything, on average. Deflation is the opposite, when average prices fall and every unit of money buys more. Disinflation is when the rate of inflation is slowing, and could eventually, when it reaches zero, turn into deflation.

Inflation is very painful for anyone whose income—whether it’s wages, interest, or return on investment—can’t keep up with rising prices. If you own a bond paying an interest rate that’s lower than inflation, you’re getting poorer, not richer. Hyperinflation, like what happened in Germany in the 1920s, or in Venezuela today, can wipe out people’s entire savings, making the money they had in the bank virtually worthless.

Deflation may sound better—after all, your purchasing power is going up—but creates equally serious problems. People who borrowed money may find it a lot harder to pay back, with prices and incomes falling. People may also hold off spending their money, knowing its purchasing power will rise if they wait, causing the economy to sputter and slow. This is the problem Japan has been struggling with for more than two decades now.

That’s why most central banks will aim at “price stability”, neither inflation nor deflation. But they tend to err on the side of some modest inflation—the Fed’s current target is 2% per annum—because it encourages people to put their money to use, rather than hoard it, and leaves them more policy tools to influence the economy.

Hyperinflation, like what happened in Germany in the 1920s, or in Venezuela today, can wipe out people’s entire savings, making the money they had in the bank virtually worthless.

What causes inflation?

Inflation (or deflation) is ultimately about the value of money relative to the real goods and services it can buy. When the supply of money outpaces economy’s need for it, you get inflation. When the supply of money doesn’t keep up with economic growth, you get deflation.

Milton Friedman, said “inflation is always and everywhere a monetary phenomenon,” but it’s a bit trickier than that. The way money circulates can change and so can the economy’s ability to meet demand. So the government printing too much money is one way you can get inflation. But a price shock—such as a shortage in some critical input like oil—can also cause inflation by shrinking the size of the real economy compared with the amount of money in circulation.

An economy can be humming along fine when a tightening labor market puts a new limit on the pace of growth, generating inflation. So yes, inflation is a monetary phenomenon, but it’s not simply a product of loose monetary policy.

A price shock—such as a shortage in some critical input, like oil—can also cause inflation by shrinking the size of the real economy compared to the amount of money in circulation.

We’ve had very loose monetary policy lately, but no (or very low) inflation. Why?

The way money circulates can change. When there’s a financial crisis, people may want to hold onto more cash, and be more cautious about spending or lending it. That means more money is needed relative to the size of the real economy. Pumping more money into the economy doesn’t increase demand, because people just sit on it. Even when the economy starts growing again, there was probably a lot of excess capacity and idle labor that allowed it to expand without generating inflation.

Can this continue?

We’ve had eight years of recovery, and the official unemployment rate is down to 4.2%. That’s normally a point where economists start worrying that a tight labor market will limit the growth rate that’s possible without causing inflation. With the labor participation rate—especially among working age men—so low, and so many people out of work for so long, there may still be “hidden” unemployment that the official rate doesn’t count. So the economy can keep hiring, and growing apace. As for how long this might continue, we are watching to see wage pressure is picking up. So far, it’s not and we don’t expect it in the near term.

What do you say to people who argue the official inflation figures are wrong, that inflation is really higher than what the government is telling us?

Some governments—Argentina under their last president, for instance—do lie about the inflation rate. And it’s fair to question the methodology used to calculate inflation. There is no such thing as a “general price level”, only baskets of goods that attempt to reflect the average person’s spending. Even if you agree on the right basket, there are different approaches to adjusting for consumers adapting to changing prices, or changes in quality (like a faster computer, or longer-lasting chewing gum). The U.S. has both the Consumer Price Index and the Personal Consumption Expenditure Index, calculated by different agencies using somewhat different methods. There’s also the Producer Price Index, and a GDP deflator that covers all economic output. None of them are perfect, and we look at all of them.

What’s important to avoid is purely anecdotal arguments about rising prices. People tend to notice prices that rise more than prices that stay stable or decline, so their impression of inflation can be skewed. Just saying “Have you seen the price of arugula lately?” isn’t a solid argument for the inflation figures being wrong. Note: Fruits and vegetables represent approximately 1.3% of the Consumer Price Index. The index covers over 200 items organized into categories. Energy, for example, represents 7.6%, while medical care is 6.6% of the index.

Just saying “Have you seen the price of arugula lately?” isn’t a solid argument for the inflation figures being wrong.

What would happen if inflation does pick up?

If inflation picked up significantly, and the Fed wanted to rein it in, it would have to raise interest rates—in other words, ration the amount of money available in the economy. The problem—and we’ve never seen this before—is that the Fed pumped in a lot of money in response to the last crisis, in the form of Quantitative Easing (QE), and it’s still out there. Most of it didn’t circulate, but sits on banks’ balance sheets as excess reserves. Without draining all that liquidity, there’s no real constraint on bank lending and money creation. Right now, the Fed is raising rates by paying banks a higher rate of interest on their excess reserves, effectively paying them not to lend. That might work if you want to raise rates by a percentage point or so, like they’ve done so far, but paying banks 5% or 6% not to lend? It’s never been tried before, and an outbreak of inflation may be harder to control.

How does inflation affect investment strategy?

Equities depend on earnings: companies with strong pricing power in the market can keep up with rising costs, while those with weak pricing power may get squeezed. In general, though, lower inflation is positive for share prices. One reason we continue to remain comfortable with higher-than-average stock valuations is that inflation has been muted. If inflation were to emerge, valuations would become challenged and securities promising a fixed return, like bonds, can’t adjust at all unless they’re indexed to inflation. Bond interest will be worth less and purchasers will demand a price discount to compensate for that. Commodities and property, on the other hand, tend to retain their real value as prices rise. However, while we maintain a vigilant watch for inflation, a major bout does not appear imminent.

This communication contains the personal opinions, as of the date set forth herein, about the securities, investments and/or economic subjects discussed by Mr. Chovanec. No part of Mr. Chovanec’s compensation was, is or will be related to any specific views contained in these materials. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor.  All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed.

About the Author

Patrick Chovanec, CPA

Economic Advisor Contact