How Inflation Became the Good Guy

Imagine this scenario: In the not-too-distant future, a man is cryogenically preserved until a cure can be found for his terminal disease. Before freezing himself, the man invests all of his money in real estate and stock market index funds. 200 years later, the defrosted man receives a pill that cures his disease. He runs immediately to a pay phone to check on his investments, and learns that his million-dollar investment has grown to 600 million dollars. Before he can enjoy a victory dance, however, the phone says, “Please insert $50 million for another three minutes.”

Inflation has been an all-purpose bogeyman since the 1970s, but a small amount of inflation comes with a healthy, growing economy. The Federal Reserve focuses on managing inflation, not preventing it. We have written often that we feel the government measures inflation incorrectly, since the Consumer Price Index undervalues food, healthcare and energy costs. As a result, excessive inflation builds for a while before the government acknowledges it, and comes as a surprise, despite our constant measurement and analysis.

But the consumer price index is only one measure of inflation. Another is the Producer Price Index (PPI), which measures inflation faced by people who buy raw materials to create other products. Watching the constant rise of producer prices over the past years, as consumer prices appeared stable, a thoughtful observer sensed that “something’s gotta give.” Add a significant credit crisis, a sudden liquidity crisis, a Fed Chairman who dreads the Great Depression’s deflation, and the table is set for significant inflation, and the possibility of hyperinflation.

The current economic crisis raises the specter of both deflation and hyperinflation for many economists and journalists, and “specter” is the operative word here. Studying deflation and hyperinflation is a little bit like studying Bigfoot and the Loch Ness monster. Deflation and hyperinflation are real, but there is as much lore as evidence in the popular press and on the Internet. In times of crisis, one struggles to separate political agendas and fear mongering from analysis.

Definitions

Deflation refers to an ongoing decrease in the price of goods and services, and the fear of deflation stems from its role in the Great Depression. Prices drop, reducing profits, leading to layoffs, reducing consumer confidence, and slowing sales, leading to further price reductions and acceleration of the cycle. In the last few months, we have seen the price of gasoline, holiday gifts, housing, copper, and lumber drop like rocks. When oil was quickly rising to $140+ per barrel, people complained, but viewed this as a sign of economic health. When oil suddenly dropped below $40 per barrel, governments and central banks recognized this as an ominous economic indicator, and began massive bailout and stimulus programs. Deflation terrifies capitalists.

Inflation is the opposite of deflation, and as we said, a small amount of inflation suggests a healthy economy. As prices and wages rise, the value of currency drops. When watching old movies or television shows, it’s amusing to see couples pay for elegant evenings out with a ten-dollar bill – including a generous tip! Business people factor inflation into their decision-making processes; one often hears the expression, “A dollar today is worth more than a dollar tomorrow. “ That’s not just bird-in-the-hand thinking – it’s economic reality, except in rare deflationary times. But Hyperinflation, as its name suggests, means that the devaluation of currency has run amok. This is why Zimbabwe recently had to issue a $2 million bill, and residents of 1920s Germany took to wallpapering their apartments with banknotes. Obviously, hyperinflation is a terrifying scenario, but also a genuine possibility. Central banks cannot simply turn inflation on and off like a light switch, and as we’ve seen so often, economic booms and busts always seem to take on lives of their own.

Fed Chairman Bernanke earned the nickname “Helicopter Ben” by suggesting he would drop hundred-dollar bills from helicopters to avert a deflationary depression. But one wonders how easily an attempt to create inflation could careen into hyperinflation. Those who struggled through the stagflation of the 1970s might note that we’ve painted our economy so far into a corner that former bogyman inflation is now the moderate, best-case scenario.

The round of deflation that began in 2007 caused great concern among economists and the Federal Reserve, but we must keep in mind that deflation and inflation can co-exist. The Fed is printing a lot of money to address the economic crisis. That action is inflationary, but if the money never gets into the hands of consumers, deflation persists and the cycle accelerates.

Without deflationary pressures, inflation typically causes prices to rise, which makes our assets worth more in nominal dollars and makes our debts easier to pay down. This is why some economists see inflation as a solution to the country’s current credit woes – imagine rebuilding housing values through inflation. Of course, the government’s borrowing costs may rise steeply once inflation accelerates.

Tax revenues drop with a slowing economy, and the country keeps borrowing money and printing new money to service its debt, in a kind of upside-down Ponzi scheme. Long-term Treasury Bonds may look good to the masses right now, but could be just another bubble built to pop when inflation inevitably spurs interest rate hikes. It’s easy to inject money into the system when it only costs a couple percent, but how long will our creditors settle for such low returns?

In the May 2004 issue of Exclusive Outlook, we wrote, “The most conservative investors should consider Treasury Inflation-Protected Securities (TIPS) (TIP). These are treasury notes guaranteed to keep up with inflation, because they actually increase the face amount of the security in proportion to the consumer price index. The problem with these securities is that the increases are taxable immediately, even though the gain does not occur until the note matures. Another problem is that the better these perform, the worse the economy is.” Recently, TIPS were available with ten-year yields of 2%, compared to 2.4% for treasury bills, but you get inflation protection with TIPS. Still, they are priced as if inflation is not expected.

What’s an Entrepreneurial Investor to Do?

Some would argue that in a truly hyperinflationary environment, money would be the least of our problems. As former Treasury Secretary William Simon testified to Congress,

“We all know that neither man nor business nor government can spend more than is taken in for very long. If it continues, the result must be bankruptcy. In the case of the federal government, we can print money to pay for our folly for a time. But we will just continue to debase our currency, and then we’ll have financial collapse.”

Simon went on to link this collapse with the loss of liberty. This was not a reference to Benjamin Franklin’s observation that when you incur debt you give another power over you. Rather, Simon rightly acknowledged that hyperinflation destroys nations. Hungary, Germany and Zimbabwe leap to mind.

America’s Great Depression was a deflationary depression, and some would say that the difference between a deflationary depression and an inflationary depression is that you can work your way out of a deflationary depression. At the time, America was still flush with natural resources, cheap labor, and manufacturing capacity. So, if inflation and default are the only options in dealing with America’s debt, the government and the Fed must walk the fine line between inflation and hyperinflation. No one knows how slippery that slope is, since we no longer have a gold standard bringing some discipline to the process.

With our currency likely to be dropping in value and our interest rates likely to be moving up (they certainly cannot go down much farther), what should one own?

Real assets and companies that can withstand and benefit from inflation over the long-term are good options. Examples include companies with popular, everyday products, like Johnson & Johnson (NYSE: JNJ), Cadbury (NYSE: CBY), Clorox (NYSE: CLX), Kimberly Clark (NYSE: KMB), and Molson Coors (NYSE: TAP).

Another opportunity might lie with companies like Automatic Data Processing (Nasdaq: ADP), which processes payrolls and earns float on the overnight deposits. As interest rates rise, so will ADP’s profits. Payroll processors might experience a dip in volume as layoffs and bankruptcies spread, so investors must consider that risk. Other ports in an inflationary storm usually include real assets like oil, coal, steel, lumber, copper, and gold. If we were the U.S. Government, we would borrow as much money as possible at current low rates. Carefully managed inflation could actually solve many of the U.S.’s financial problems, but not without consequences. For one thing, baby boomers about to retire will suffer significantly reduced purchasing power when inflation kicks into gear.

The simplest, healthiest scenario might be a 5-10 year “regression to the mean,” as we rebuild the nation’s wealth through innovation and entrepreneurialism. But the people’s impatience for an instant return to the good times may spur central banks and governments to take bold - and shortsighted - action. Many articles reassure people that rampant deflation and hyperinflation are unlikely scenarios. Fair enough, but a key lesson of our current financial crisis is that all signs of rain fail in dry weather, and a wise investor does not ignore a rare possibility simply because it is rare.

Comments

[surferonice:]

Deflation is a great thing for savers that have jobs. Deflation happens when you produce enough of something to make it economical to lower the price so that you can sell more of the something.
Deflation does not happen to products or services that are short in supply or are faceing an extinction of product or service due to unmanageable depletion of product or need for service.
Only government authoraties can cover up reality through mass media exposure.Or manipulate otherwise intelligent individuals with bribes of optimistic babble.
Deflations are caused by caution of the masses. A paranoid outlook of life in general brought on by circumstances not under any particular goup or persons in authorative control. Just happenstance if you will.AS far as the physical world is concerned, deflationary depressions cannot happen unless they are engineered and controled by authoratarian regiems with a quest for power weather it be rightous indignation or not. In fact Inflations cannot occurr either for the same reasons. However the ups and downs in prices are rather normal reality in a free market economy. Shortages and oversupply happens naturally.And without any help at all will disappear unless a power structure interferes with human activity to the degree that those humans are coherced into accepting someone elses rightous forsight into the future they would like to enjoy rather than recognize real change as frightening as it might be.
Therefore any group,club,political concern not in the business to produce services or products should stay the hell out of the markets and do their job defending those that do produce.These people in a real economy would be protectors
Looking out in the future you can see the Globalist point of view.One government, one currancy, and one protection team.Also you can see the problems. No one wants a big brother at least not one sticking his nose in your soup bowl. Therefore we have borders. They start with your own personal body and work up to large populations of the same culture in one area.
Course anyone who studies animals knows that.

Jan 28 01:43 AM

[donzelion:]

"Deflation terrifies capitalists." Indeed, it's a troubling concern for everyone, but the magnitude of the threat posed varies depending upon the quantum of management stupidity.

Deflation rewards savers and penalizes debtors; in practice, deflation should drive down producer prices (for raw materials and labor), so that declining revenues are offset by declining costs.

However, long-term fixed costs and sunk costs (aka long term debt and operational costs) will remain - so managers who overpaid on these fixed items will kill their companies.

Hence: "growth companies" (which earned their money by merging/acquiring others, possibly overpaying), debt-riddled companies, and banks (which earn their money promoting debt financing) will all suffer severely.

But that doesn't mean the economy will enter catastrophe, any more than inflation means everyone suffers equally.

Jan 30 02:08 AM