About a year ago, I was interviewing the head of a New York City-based broker-dealer for my Research column. The conversation turned to inflation — how financial planners, when they work out what kind of income their clients will need in retirement, should realize that in post-industrial society different social groups face very different rates of inflation.
Overall inflation, as measured by the consumer price index, has been low in recent years. Over the past decade, when real GDP growth averaged nearly 3 percent, consumer price inflation was tame, measuring around 2.7 percent, on average. Even when the U.S. economy accelerated in 2003-2004, inflationary pressures remained moderate, allowing the U.S. Federal Reserve to hold its interest rates close to zero and keep pumping liquidity into the financial system.
Thanks to the technological revolution, deregulation and political changes of the final two decades of the 20th century, global competition intensified and excess liquidity was put to good use. It was invested into production technologies and industrial capacity, both in developed nations and in emerging economies in Asia, Latin America and Eastern Europe. The result has been intense price competition and sustained downward pressure on the prices of generic manufactured goods and basic services. Many no-name goods are now cheaper than they were 30 years ago in nominal terms, while appliance and consumer electronics are far more sophisticated and sell for a fraction of what they used to cost only a few years ago.
Hidden InflationBut the investment boom — including purchases of residential homes, which are tallied by economists as investment — was not the only place all this liquidity has gone. Incomes at higher economic levels have been growing extremely rapidly, often reaching double-digit rates and far outstripping income growth among the poor and the middle classes. The rich, by definition, tend to want things that are not mass produced but are in some ways exclusive, such as fine art and antiques. As a result, luxury goods have been rocketing in price. While a generic shirt is now cheaper than a decade ago, it is not uncommon for a shirt with a prestigious label to triple or quadruple over the same time period.
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As liquidity continued to build up in the system, prices of everything that was in short supply — i.e., that could not be immediately mass-produced in China or outsourced to India — started to climb. Eventually, this process impacted commodities and, more recently, began to seep into food prices and overall consumer price indices. In recent months, inflation in developed and emerging economies has risen to its highest level since the 1990s.
The spike in inflation coincided with the pricking of the bubble in the U.S. housing market, which began at the highly vulnerable sector of subprime mortgages. As the crisis spread, fears of a U.S. economic downturn became serious enough for the Fed to slash its interest rates from 5.25 percent to 3.25 percent in less than six months. In January, when the Fed cut its rates by 75 basis points, it was its steepest rate cut in nearly 25 years.
Fear of StagflationAnalysts believe that the Fed, and other world central banks, will be constrained by enduring inflationary pressures and not cut their rates sufficiently to prevent a recession. In Europe, only the Bank of England has so far joined the Fed in its vigorous easing efforts. Other major central banks are still sitting on their hands or even raising their rates. As a result, markets are starting to worry about the return of stagflation — which was a period in the late 1970s when sluggish economic growth was accompanied by high inflation.
The dirty little secret, however, is that stagflation is exactly what Fed Chairman Ben Bernanke is working to bring about. Even students of beginners’ economics understand that high inflation is always accompanied by economic stagnation. Inflation destroys savings, discourages investment and spurs consumption. A large quantity of money chasing after a set quantity of goods results in reduced competition and falling quality. This is why Brazil, Mexico and Argentina could never jump-start their economies until they defeated inflation in the 1990s.
Central banks typically attack inflation by raising interest rates, which in turn curbs consumption and sends a strong economic signal to consumers that they should now save more. Savers build up funds for future investment and accumulate pent-up demand, which starts to come out in the open when inflationary pressures recede and interest rates decline.