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Portfolio > Economy & Markets > Economic Trends

Hidden Inflation

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Inflation in the United States has been remarkably low, despite a lethal combination of extremely loose monetary policy and trillion-dollar annual budget deficits, which apparently have become a new normal.

Economic theory suggests that inflation should have spiraled out of control long ago, but after four years of such policies runaway consumer price increases no longer seem to be a real threat. 

The U.S. Federal Reserve, whose two-pronged mission requires it to keep inflation in check and stimulate full employment, clearly believes that inflation will remain under control for the foreseeable future and that it needs to concentrate on resolving the problem of sluggish job creation. In early September, it announced another round of unconventional monetary policies known as Quantitative Easing 3, and vowed to keep buying mortgage-backed securities until the unemployment rate declines. 

This is an unprecedented open-ended commitment to print massive quantities of money, at a time when the economy is actually growing, albeit slowly. Since 2008, the Fed has dumped some $2 trillion worth of liquidity into the financial system, and many economists expect another $1.2 trillion infusion to result from its current operations. The Fed’s balance sheet could balloon to $4 trillion by the end of 2013.

Some economists—and Fed Chairman Ben Bernanke is among them—clearly believe that there have been structural changes in the economy that will continue to keep inflationary pressures in check.  

More Efficiency

There are many definitions of inflation, the most descriptive of which is as follows: the situation when an increasing amount of money chases after an unchanged quantity of goods and services. In other words, inflation is a measure of efficiency in the economy. If consumers have more money to spend, this could result in an inflationary spike in an inefficient economy, since producers will not be able to satisfy extra demand quickly. In an efficient economy, on the other hand, producers will promptly increase supply to meet extra demand. 

In the 1970s, the U.S. economy was inefficient and companies couldn’t respond promptly enough to changes in input prices or consumer demand. Higher prices for oil and other commodities translated into price hikes at consumer levels and demands for higher wages. Since the 1980s, however, deregulation, structural and technological changes, the spirit of entrepreneurship, improved management techniques and intensified foreign competition greatly increased economic efficiency. Companies have become more flexible; they have been able to anticipate and respond to various changes in market conditions swiftly.

Whenever there is an increase in demand, a number of producers increase production to harvest consumer dollars. This kind of heightened competition has made price hikes very difficult to implement and sustain, putting a premium on cost control. There simply is no room left for inflation in this highly efficient, saturated business environment.

As a result, official consumer price inflation has been quite low, measuring no more than 2-2.5%. Moreover, a serious debate has been raging in academia and among economic policymakers, some of whom have been encouraging the Fed and other central banks to tolerate higher levels of inflation in order to spur worldwide economic growth. The problem is that based on traditional economic assumptions, lax fiscal and monetary policy and zero percent interest rates should have long ago resulted in high inflation. Central bankers simply don’t have any other tools at their disposal to make price levels rise. 

Measurement Problem

In reality, whether we have inflation or not depends on how price increases are measured. Inflation can also be defined as a loss of value of money in terms of goods and services. 

In this regard, money has retained its value well in terms of generic goods and services, which comprise the typical basket used by the government to measure inflation. However, when measured against natural resources, for instance, the picture changes. In dollar terms, the commodities index of The Economist magazine has doubled since 2005, while the food component of the index has increased even faster, by 2.5 times. Moreover, despite a substantial global economic slowdown, the index of industrial commodities rose by 50% during the same time. 

Gold has increased some 4.5 times against the dollar since 2005. Gold prices are important, because gold is, on one hand, a benchmark for commodity prices and, on the other, a store of value and a universal currency backed by a history spanning several thousand years. Going back to 1833, gold prices in London stayed steady until the 1970s, the first significant period of the rapid destruction of the value of money. It rose during the inflationary 1970s and declined in the 1980s and 1990s, when the value of money stabilized once more. Then, it rocketed from under $300 per troy ounce in the late 1990s to around $1,750 currently. 

Another way to gauge the decline in the value of money is with silver. The silver George Washington quarter was valued under a dollar at the start of the 21st century. Today, it is worth around $6, which makes for a 24-fold jump in nominal price since 1964. 

Finally, let’s look at the price of oil. Oil came into widespread use in the late 19th century and since then it has been the most aggressively extracted and universally used industrial commodity. Unlike gold, oil is a poor store of value and means of exchange, but it can be used to provide an adequate measure of the value of money. Even though the consumption of oil rocketed in the modern era, and the past century has been marked by wars, revolutions and technological change, the price of oil has been steady in inflation-adjusted terms, fluctuating in a tight range of around $30-40 dollars per barrel in today’s money. That was approximately how much oil fetched in 2005. Since then it has increased to around $90-100 per barrel, or some 2.5 times.

When the price of a particular good or commodity goes up, it is not yet inflation, which is defined as an increase in the overall price level. Oil could have become more expensive simply because it costs more to pump it out or because the political situation in the Middle East has been volatile. But many other goods and services have actually kept pace with oil, including luxury goods, works of art and the cost of education and health care. The cost of education, for example, is up by more than 50% since the mid-2000s.

Selective Deflation

Oil and gold have become considerably more expensive not only in terms of dollars, but relative to generic consumer goods and low-skilled services. But what if such goods and services are actually experiencing price declines, which are taking place alongside a broadly based decline in the value of paper money?

Using the official consumer price index, the average consumer basket has increased in price by no more than 10-15% since 2005. But when measured in terms of oil, it is down by 35%. This makes sense, given increased efficiency of production, stringent cost control, relocation of manufacturing to China and other low-cost countries and lower demand in the U.S. and Western Europe as a result of the anemic economic recovery. Unskilled services and other nontradable goods are actually closely correlated with the price of tradable goods, as described by the Balassa-Samuelson effect. They also experienced a deflationary effect in recent years.

Hidden inflation helps explain the stock market’s performance. The Dow Jones industrial average, which was inching toward its 2007 all-time high recently, has actually been flat compared to 2000. In the inflationary late 1960s and 1970s, the Dow similarly had trouble rising. It hovered around the 1,000 barrier, experiencing several sharp corrections during that period. 

Inflation wreaks havoc with the value of money. It discourages savings and investment, and it undermines the robustness of corporate profits. The overall effect of inflation is to whittle away economic efficiency. If what we’re currently witnessing indeed constitutes hidden inflation, then an open inflationary explosion, with a sharp increase in all prices, is only a matter of time.  


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