From the October 2009 issue of Research Magazine • Subscribe!

October 1, 2009

Prepare for Inflation

It may not be imminent, but a price spiral is coming.

Debt can be a tricky thing.

As everyone who ever held a margin account knows, when prices of shares in your portfolio go up, the ability to buy stocks on margin is a very good thing. It becomes leverage -- a lever that helps you to lift your portfolio. But when the market turns against you, leverage is an albatross around your neck. It's easy to lose your capital and end up owing interest on money you borrowed.

The same principle applies to the macro economy. When the economy is expanding, being able to borrow is a blessing. You can take advantage of a wider range of opportunities, offering in return not a share of your profits, as you would to an equity partner, but a set percentage. But when the economy stagnates or shrinks, debt becomes a killer -- as the roughly one third of U.S. households owing more on their homes than they are worth can attest.

Incidentally, the fact that economies in Europe were stagnant throughout the Middle Ages may explain the prohibition on money lending by the Catholic Church.

Dangerous Deflation

The invention of money, and especially paper currency not backed by gold or other assets, added an "accelerator" to the Jekyll/Hyde dichotomy of debt. Paper money goes hand in hand with inflation, which reduces the value of funds in which borrowers repay their debts. Inflation occurs in periods of rapid economic growth, so that being leveraged becomes even more advantageous.

Not so when prices are falling -- and money is appreciating. Deflation happens when growth stagnates or goes in reverse, adding an extra burden on debtors. Suddenly, it becomes a vicious cycle. Debtors want to pay down debt, because they see its real value going up. Moreover, what during an upturn looked like a bargain borrowing rate of, say, 6 percent, suddenly becomes 11 percent if deflation is running at a 5 percent annual clip. But paying down debt may be difficult if you lose your job or if your assets lose value.

A deflationary environment becomes a no-win situation for debtors, who may end up in bankruptcy. But deflation is horrible for creditors, too, because not only their default rates rise, but the value of the collateral they seize falls -- as banks running today's foreclosure sales have discovered.

In the United States, where private consumption accounts for 70 percent of GDP, deflation also delays economic recovery. That's because when prices are falling, consumers start postponing their buying decisions on hopes that prices will decline further. This makes further price cuts a self-fulfilling prophesy.

There has been considerable optimism a year after the Lehman collapse. The IMF announced that the global recession ended in the second quarter, and the Federal Reserve, having patted itself on the back for saving the world by infusing trillions into the banking system, predicted that the U.S. economy is about to return to growth.

However, the economic environment continues to point to a deflation, as both producer and consumer prices fell over the past year. Job losses have been swift and severe, with around 7 million positions lost in a year and a half. Consumer credit outstanding declined in nine of the past 12 months. Savings rates rose after falling to zero late in the expansion, and consumer spending sagged, suggesting that households are indeed trying to pay down their debts.

Central bankers fear deflation even more than they fear inflation. When inflationary pressures accelerated in 2006-07, the Fed took its sweet time raising interest rates and certainly didn't starve the economy of credit in order to stem price increases. But when a deflationary specter began to emerge in late 2008, rates were slashed to zero and the printing press was turned on full-speed.

The authorities have reason to worry. After more than a decade of going into debt, both the consumer and the federal government have maxed out on their proverbial credit cards. Now, as consumers save more, Washington steps into the breach. The fiscal year ending Sept. 30 saw government debt rise by around 15 percent, toward $12 trillion. With so much debt around, deflation could become a death spiral for the economy.

What the Fed and the U.S. government are trying to do now is turn a deflationary trend -- i.e., the appreciation of money -- into an inflationary one. They are trying to create enough money and spread enough of it around to make it cheaper.

Some signs of success are evident. Oil prices reached $75 per barrel in August, their highest level of the year. Oil's price rose even while demand for it was weak -- a clear sign of cheaper money. "Cash for clunkers" burned through $3 billion in just a few weeks, creating a buying frenzy and shortages of some models that could lead to auto price increases. Home sales too have risen, spurred by tax incentives for first-time buyers.

Inflationary Specter

The debate among economists has already shifted to the need to unwind the fiscal and monetary stimulus. Such luminaries as Warren Buffett and Alan Greenspan warn about nascent inflationary pressures. This may be premature, with the recovery promising to be jobless and therefore consumption-less. The Fed will continue to pump money into the banking system and the government will spend all or most of its $800 billion fiscal stimulus package, of which only about $130 billion has been spent so far. Even after the package runs out, Washington will go on spending. Forecasts now envision federal deficits adding up to $9 trillion over the next decade, nearly doubling the current government debt burden.

The Fed is convinced that, having defeated inflation in the 1980s, it knows how to do it. Indeed, inflation can be reduced by extremely tight monetary policy and draconian interest rates. In 1981, the Fed jacked up its rates all the way to 20 percent, and yields on long government bonds rose to around 15 percent. But back then, neither the government nor the consumer was so heavily in debt. Imagine what happens if interest payments by the U.S. government double or triple from last year's record of $253 billion, or if consumers face 35 percent interest rates on their credit card balances. Consumer credit doubled over the past decade and increased 3.5 times in the past 20 years.

In fact, inflation may reach high levels and continue long enough to allow the U.S. government and consumers to reduce their debt burdens at the expense of their creditors. Even if this scenario is not a foregone conclusion, the risk to investors is very high, and they and their advisors should have a plan for this eventuality. John Maynard Keynes once wrote: "By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some."

Inflation favors the debtor and punishes the creditor. Those who take long-term, fixed-rate loans at today's advantageous nominal rates are likely to benefit, while creditors and bondholders are likely to take a bath. Creditors to the U.S. government are particularly at risk.

Keynes also observed that inflation undermines normal capitalist relations and creates a volatile, highly unpredictable environment. It debases the currency, which means that dollar-denominated assets will lose their value relative to other currencies. Keeping funds in low-inflation currencies -- such as the Japanese yen, for example -- will be desirable to safeguard the value of financial assets.

While inflation is bad for stocks in general, some industries will do better than others. Long-term investment suffers in inflationary periods, and companies with fixed costs and large R&D outlays should be shunned. But industries with low fixed costs and the ability to raise prices quickly, such as basic consumer goods, will do relatively well, as demand will be stoked by depreciating money. New brands will find it hard to get established -- in fact, there were hardly any new brands that appeared in the inflationary 1970s -- but established brands with a loyal following generally can do well.

In general, there are two underlying principles in investing in times of inflation: short rather than long and short-term rather than long-term.

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