Today I am going to review one of the basic fundamentals in economics and finance – inflation – and why this one number is so important to you and the world economy. I’ll start of by reviewing what inflation is and then we’ll take a the late 1970s when there was exceptionally high inflation in the United States, cover the Federal Reserve’s inflation targets, and end up with what high(er) inflation might mean for the markets.
What is inflation?
Inflation is a general increase in prices and fall in the purchasing value of money.
Let’s unpack that definition and look at the consequences. Inflation is a general increase in prices. The first part is easy enough to understand. Last year a gallon of milk cost about $3.50 while this year it costs about $3.57, meaning the price has gone up by about 2%. The price of my favorite pale ale went from $5.95 to 6.15 (3.4% cost inflation). And, as my Dad loves to say, “A dollar for a candy bar? I remember when they used to be a nickel!” That steady march higher in prices is inflation. There are some areas where prices decrease through time. The 60-inch, curved screen OLED TV you bought last year? The price of that dropped by about 10%. That is deflation, which serves to counteract inflation. Of course, the price of the average TV, which is now even bigger and higher definition with more vivid colors? Well, that is an interesting case of inflation, which I’ll hit on later for fun. So, the first half of the definition is easy enough.
The second half, a fall in the purchasing value of money, is related to the first part of the definition, but has some caveats. Let’s revisit my Dad’s sweet tooth. As a kid, let’s say he put a nickel in his piggy bank. Now 65 years later he takes it out and goes to the store, only to find that he can’t buy his favorite candy bar (a Reese’s Cup), even though when as a kid he could have. That is because, through inflation, the purchasing power of his money has fallen. My Dad, as a kid, should have put that money into the bank or into the stock market where it would have received interest, meaning he would now have had enough to buy that candy bar. And this gets us to why inflation is so important to me and you:
To counteract inflation, we need to put our money into interest bearing accounts or other investments that will maintain or increase the purchasing power of our money.
For my Dad’s nickel to still be able to buy him that candy bar, which is now a dollar, he would have needed to put it in an account that was earning 4-5% interest over the intervening period. This is why you’ll hear stats like, “$100 in 1918, would be worth $1,669.13 today” (which is correct, FYI). Inflation has eroded the purchasing power of our dollar.
Interestingly enough, inflation periodically devastates a country’s currency. In Zimbabwe in the early to mid-2000’s the country experienced what is called “hyper-inflation”. For example, at the peak of their crisis inflation was 79.6 billion percent per month. Yes, you read that correct. This means that using Zimbabwean dollars you would have got a piece of bread for one Zimbabwean dollar on October 31st 2008 and by November 30th 2008 that same piece of bread would have been just under eighty billion Zimbabwean dollars. Imagine the logistical challenge this causes. This means that your currency would have been devaluing at just under 31 thousand percent per second. It means that by the time you fished the money our of the giant wheel barrow of it you would have needed, you would have needed a couple of more thousand wheel barrows of money to go along with it. In Venezuela there is an ongoing crisis with inflation hitting nearly 1.7 million percent in 2018. As a result there is a growing demand by stores to not use the Venezuelan Bolivar, but to instead pay in US dollars or other currencies. Their problem was stoked by bad government policies. Needless to say this wealth destruction means that anyone who couldn’t get their money out of the country is now essentially broke (which hits the middle class and upper middle class the hardest, as they had much to lose and very little ability to move the money into other currencies).
That is why high inflation is our enemy. It is a force that is constantly trying to destroy our wealth.
One interesting aside, that I touched on earlier has to do with inflation and technology. Let’s take computers as an example. For about as long as I can remember the laptop I want (with high-end specs, the latest processor, good battery life, and a high-res screen) is about $1200. And this is despite inflation. Hmm… what is happening here? Technology is a bit of a special case. The laptop I want now is superior in every way to the one I wanted in 1999. That laptop in 1999 had a single-core 266Mhz processor, 128MB of RAM, and a 3GB hard drive. For the same price today I get a dual quad-core 3.4Ghz processor, 16 GB of RAM, and a 1TB solid-state HD (SSDs didn’t even exist in 1999). So, I get more tan 1000x more power and speed at the SAME PRICE. This is essentially a powerful deflationary force. If you could go back in time with a modern computer, just by twenty years, every military in the world would pay you billions for the laptop you picked up at Best Buy last year.
Inflation in the 1970s
When Nixon was elected he inherited a recession from LBJ who had spent significantly on a combination of social benefits and the Vietnam War. Nixon continued with his high spending and agreed to a big increase in Social Security just before the half-way point of his first-term. To battle the recession Nixon and the Federal Reserve had a loose monetary policy – a combination of low-interest rates and high spending. This combination fueled inflation which surged from around 1% in the late 1950s to early 1960s to over 11% in 1974, prompting Nixon to add wage and price controls (what Venezuela is doing now). This led to shortages as store owners refused to sell goods at little to no profit. At the same time, workers became frustrated that they never got the raises and promotions they were promised.
Nixon eventually caved on hist terrible price/wage control policies and the market wanted to make up for lost time. Prices immediately shot up, which prompted workers to demand more money. This cycle continued in what is known as a wage-price spiral. Higher prices mean higher wages are needed and then in turn prices rise as people can buy more. This continued until when Jimmy Carter became president.
When Carter became president inflation was a major concern and Carter turned to Paul Volcker, the Fed Chairman to fix it. Volcker subsequently raised interest rates, which peaked under Ronald Reagan in 1981 at 20%. This crushed inflation and brought it back down to historical levels, but it also caused a recession and decimated some people’s finances. In the end it was the right thing to do. The winners were people who could keep their money in financial instruments that allowed them to benefit from higher than inflation interest rates – could you imagine locking in a 12 month CD at 20% these days? The downside is that meant you had home loans that were going for 10-15% or more. Compare that to today’s 3-5% rates and you can see why home-buying was nearly impossible in the early 1980s.
After this period the Federal Reserve made controlling inflation have equal, and potentially higher weight, than its mandate for full employment and economic growth.
Inflation, The Fed, and Markets
The Federal Reserve, with its mandate to maintain price stability (i.e., control inflation) varies the interest rate so that it can try and keep inflation near its 2% target. If inflation goes higher, then the Fed will raise rates, if it goes lower, they have scope to cut rates. Since the financial crisis of 2009 you might have noticed that rates were dropped to almost zero. This was in response to ultra-low inflation (and even a year of deflation, which is equally insidious, but for different reasons). This spurred investment and helped the economy to rebound. The Fed is now raising interest rates, which will help cap inflation, but will also serve as a potential drag on economic growth.
And this gets us to the effect of inflation on the market. First, it has real world consequences. It means that companies must pay you a bit more, so you can continue to buy the things you need. It means the Fed raises interest rates, which means your home, car, and other loans have higher interest rates as well. Higher inflation means higher interest rates, which means economic drag, and economic drag means a drag on stock markets, and potentially even big falls in the market if the Fed raises rates too far too fast.
There have been many books written on this, but in general, higher/increasing rates are bad for your stock market investments while lower/stable rates are good. Falling interest rates often mean we are in a recession, so there is an element of timing. That is where I’ll leave this argument for now.
Inflation is thy enemy – and we must do all we can to contain it, which is the mission of the Federal Reserve (and why it must be independent of political whimsy). We must also do our part, and our part is to not store cash in jars or under the mattress, but to put it in interest-bearing accounts and investments so that we will maintain (and maybe even increase) our buying power through time.
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