Thursday, May 05, 2011

Thinking Out Loud About Inflation

With the Fed having just printed over $2T of unbacked greenbacks in the past two years and commodity prices having shot up, I don't think it's unreasonable to expect to see a high rate of inflation pretty soon. How high? Well, here's a chart of inflation, unemployment and the Fed's interest rates during the last bout of high inflation about 40 years ago. It peaked at about 20% way back when. There's something else that sticks out on that chart, too.

1979 != 2011

Unemployment was low during the time of high inflation. It wasn't until the Fed stepped in to crush inflation that the job situation got bad. For this reason, I think it's a bad idea to draw conclusions from the 1970s about what's going to happen this time. Here are some random, untested thoughts to mull over:
  • Housing wouldn't seem to be a hedge against inflation at all. Prices are set by supply and demand. There's still a ton of foreclosed houses out there which haven't been released onto the market and with unemployment as high as it is, there is a smaller than usual pool of potential buyers.

  • Any firm that sells things that aren't necessary is going to suffer. After paying more for food, gas, clothing and housing, there's going to be a lot less left over. Atlantic City and Las Vegas, Macys and Nordstroms, high-priced restaurants are all going to take it on the chin.

  • Government bonds are going to be dumped and that's a fact. Only an idiot would hold on to bonds that are paying 3% when inflation is at 8% or higher. How this doesn't end up in QE III is beyond me. The government has been borrowing with mostly short-term bonds, so they're going to be revolving a HUGE amount of debt every year. Trillions of dollars worth of bonds are going to come due and we'll have to refinance at the higher rates or simply print more money and have the Fed buy them resulting in ... yet more inflation.

  • Stocks would seem to be a bad place to be as well because I can't figure out how anyone is going to make any money in this environment other than the discount retailers and the folks what make necessary consumables like oil and food.

  • I have no idea what to do with gold. That's such a charged topic and I know so little about it that it seems pointless to touch it.

  • Companies with a lot of debt are going to suffer. Interest rates are going to rise and with it, interest on corporate debt.
That's about the limit of my thinking right now. I guess it says that if I had $$ to invest, I'd pick companies that make things people have to buy in order to live and who have low levels of debt.

Update: Would it make sense to use your disposable cash to retire all the debt you could? I think that some mortgages (all?) can be called due at any time. If you had no debt, you'd have no exposure to panicky debtors whose own bills are eating them alive.


Jeff Burton said...

If you have a fixed rate mortgage at a reasonable rate and you have cash flow that rises with inflation, it's better keep the mortgage.

Anonymous said...

Generally it is stupid to repay your mortgage in an inflationary period, particularly if you have a low fixed rate mortgage. This is because the dollars that you pay back are worth progressively less than the ones you borrowed. There are some nifty tax incentives too. In general your rules are backwards, in an inflationary environment you don't want to hold less cash as it is constantly going down in value. That's why you see hoarding in hyper-inflationary economies, you really don't want to hold any cash.

Note that this holds true for government debt too. You focus in on higher cost of carrying debt as interest rates go up, but those dollars the government pays back are not worth as much as the ones they borrowed. I'm not saying that debt isn't becoming a problem, but just that there are some counter-cyclical things that happen to make it less grievous than you might think.

I never quite get the 'unbacked dollars' phrase either. Are there some dollars you think are backed by something? We haven't backed dollars since Nixon took the US off the gold standard, money is very much a Peter Pan flying experience, it has value because people think it does.

But the other thing about QE is that it isn't a one way street. Right now the Fed has all these bonds it holds as assets, if it thinks it needs to contract the money supply it can just sell those and sop up cash.

You are correct about 1979, inflation then was the result of an oil supply shock, not an over-heating economy, nor a money supply that grew too quickly.

K T Cat said...

Anon, I don't have time for a long reply, so I'll just leave it at unbacked dollars. How you don't see this is a mystery to me. Printing money to cover a government's bills with no corresponding growth in the economy is just that - unbacked currency. That is, if you have an economy with 100 bricks and $100 and next year you have 120 bricks, you need to print another $20 to keep the relationship stable. If the number of bricks doesn't changes and you print another $1500, you've devalued the currency, which is another way of saying "inflation".

The problem is that a thing's value changes according to the demand for it. The demand for luxury goods or property is higher in times of full employment than it is in times of high unemployment, regardless of inflation.

There, that's enough for now. More later.

K T Cat said...

Jeff, I'm coming to the conclusion that if you're paying Alternative Minimum Tax, then the calculation is simple. If you can find a fixed interest rate investment with a higher rate than your mortgage, you store your money there. Otherwise, you pay off your mortgage. The safest place to be is without debt.

K T Cat said...

The Fed is going to sell those bonds to ... who?

Anonymous said...

Err, to whom. At some discount some whom will find them attractive, they don't really have to worry about making a profit or breaking even because they can print their own money.

Anyway, what you are talking about is just a fixed ratio of money supply, it still isn't backed by anything, the very definition of fiat money is that it isn't backed by anything, so I understand you now. I guess I'd just note that to believe that to be an ideal model would require constant demand, which doesn't necessarily happen. For instance it looks like we have a nice 1$/brick ratio, but what if instead of buying those bricks, people paid down their debt, and if instead of loaning that money out again, the bank just sat on it and improved their equity position; something a lot of folks believe is happening now and why market inflation expectations aren't really that high despite QE1 & QE2. Now the velocity of money is decreasing and you have deflation.

K T Cat said...

Anon, printing money to cover your debt is a marker of the terminal stage of a nation or at least a governing philosophy. It's possible that this time it's different and that shoving $2T of newly minted bills into the hands of the Federal government isn't going to lead to inflation, but it seems pretty unlikely.