Inflation: Is it different this time?

 A year ago, 10 year treasurys yielded 1.34% p.a.  After bottoming out at 0.52% in early August, it is now back up to 1.34%.  For the past 5 years or so, treasury yields fluctuated between 2% p.a. and 3% p.a.

After plunging to 0.12% in 2015, US inflation, as measured by the consumer price index, rose to 1.26% in 2016, 2.13% in 2017, 2.44% in 2018, 1.81% in 2019.  Covid-19 knocked inflation back to 0.9% in 2020.  For January 2021, inflation (CPI not seasonally adjusted) rose 0.4% over December 2020.

 Where do we go from there?  The recent rapid rise in 10 year treasury yields suggests that investors are wary of a resurging inflation.  The Federal Reserve and the Biden Administration, on the other hand, seem more concerned with too slow a recovery from the damage caused by Covid-19. Who is right?

Milton Friedman famously said that inflation is a monetary phenomenon: too much money printed resulting in an imbalance between money and output.  Dissenters will point to Japan where the government, for years, has issued massive amounts of debt and the Bank of Japan has created massive amounts of money by buying all sorts of public and private financial instruments.

The thing is that for Friedman’s proposition to work, the money that is created has to be spent.  The vast increase in money created by the Federal Reserve after the Great Recession of 2008 found its way back home in the form of bank reserves and deposits.  Likewise, much of the 2020 financial government assistance went unspent by households, boosting saving rates at one time to over 30%.

Such inclination to save and reluctance to spent have several causes: some may be purely economic such as over indebtedness and wage stagnation, demographic with aging populations, and psychological namely fear of the future.

Japan is a good example of aging population, low economic growth causing low wage growth and, for these and cultural reasons, a proclivity to save.

The US, on the other hand, seem to occupy a very different place: the population is younger (though not overly so), economic and wage growth has been higher and consumerism rather than saving has ruled the land.

Globalization has been a big factor in putting a lid on production costs and thus prices; while it is still prevalent, the US as well as other countries have somewhat cooled down to it.

Finally, the Administration is pushing another very large relief package of up to $1.9 trillion coming on top of the $900 billion stimulus approved last December, hundreds of billions of the original $4.8 trillion which have yet to be disbursed and a yet to be announced infrastructure investing program.  When these items are measured against how much more the economy could produce, it is no wonder that economist L. Summers is concerned that inflation may accelerate and that it will then be politically difficult to throttle the stimuli back.

I for one don’t know if and when excess inflation (over 1%-2%p.a.) will arise, but the creation of money is awe-inspiring, the US are nor Japan, and assets seem very richly priced, whether one looks at stocks or real estate.  Finally, when bitcoin is being preferred over gold as a store of value in uncertain times, one can worry.

 The thing about inflation is that it starts as a monetary phenomenon and becomes a psychological condition: producers raise prices, just in case, and invest only in short-term projects; consumers buy and often finance their purchases with loans; unions and investors push for indexation of wages and fixed-income instruments respectively.  Pretty soon, indexation makes it very difficult to return to normal and years of efforts are needed to overcome past fears and mistrust.

I will finish with a graphic example of brutal inflation in Brazil during the 1970s and 1980s.  The first bill is one of 100,000 cruzeiros, by then not worth much.  In 1986, the cruzeiro was replaced by the crusado in the ratio of 1000:1.  It was in circulation until 1989 when it was replaced by the crusado novo in the ratio, you guessed it, of 1000:1.  Brazil did overcome hyperinflation, but it took many years, a lot of efforts and extracted a very high cost on the population, mostly on the poor who didn’t have savings and couldn’t protect themselves.

I am not implying that the US will fall into hyperinflation, but Brazil didn’t expect it would either. 

Were the US to have an inflation rate of 5% p.a., by no means in hyper territory, the impact on the economy and our way of life would be profound: pensioners on fixed annuities would lose 25% of their purchasing power after 4-5 years; mortgage rates would likely by in the 7% p.a. range; stocks would likely lose 40% of their value.

Better not get close to it.