06 November 2013
Inflation - What Can We Expect?
Setting the Stage?
“Investopedia defines 'Hyperinflation' as extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless. When associated with depressions, hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. Left unchecked this causes prices to increase, as the currency loses its value.”
In other words, hyperinflation occurs when there is a continuing and rapid increase in the amount of money in the economy that is not supported by a corresponding growth in the output of goods and services. This is precisely what is happening in the United States. The Federal Reserve (FED) is pumping $85 billion dollars into the economy each month. There has not been a corresponding increase in GDP. Although our political establishment likes to point out that a high rate of inflation has not happened (yet), consumers know the dollar is losing its value. (Note 1)
It would appear the Reserves of Depository Institutions are roughly 20 times larger than FED required reserves. That money could find its way into the economy. The monetary base has grown by ~ 350 percent since 2009. During this time, however, GDP has grown by only 15.6 percent. Do these factors set the stage for increased monetary inflation? Perhaps: it is hard to predict the event (or events) that would set off an inflationary spiral, but once started we can expect a vicious circle of dollar devaluation. Increased prices for consumer goods and services act to increase the velocity of money as consumers try to guess where prices are headed. The increased velocity of money, in turn, inevitably leads to ever higher prices.
In a stable economy, American consumers spend ~ 33 percent of their income on essential goods and services (including food), ~ 21 percent of their income on household goods and services, and ~ 46 percent of their income on other expenses. (BEA) Hyperinflations – or even high rates of inflation – force the consumer to allocate a greater and greater percentage of income on food, fuel and daily necessities. This, of course, decreases the money available for housing and other goods and services. For example, in the first three quarters of 1923 German hyperinflation forced consumers to spend an average of 60 percent of their income on food.
If the German experience were to be repeated, dollar denominated prices would increase all over the world during a period of high inflation. Prices relative to the value of gold would (in theory) remain stable.
The lesson? If (or perhaps when) inflation hits the United States, we can expect consumers to prioritize their spending on food, fuels, supplies, utilities, and housing – in that order. If annual inflation exceeds 10 percent (as it did in 1974 and 1979 – 1981) the net effect will be to reduce consumer spending on housing, along with non-essential goods and services.
The Federal Government is going deeper into debt, printing unbacked paper currency, and creating artificial electronic credits. Aside from a small contingent of alarmists, neither Wall Street nor the Washington political establishment has any intention of financial self-control. Expect economic and social hardship when this all unravels, followed by civil unrest.
America is not alone. Many governments are pursuing the debt and printing path to inflation. It will be interesting to see which nation is the first to experience an inflationary spiral, and how this distortion of economic activity affects other nations. If America is the first nation to capitulate to a high rate of inflation, the ripple effect will be disastrous for trade and finance in almost every nation. The dollar’s position as the world’s reserve currency would be challenged.
Do Hard Assets Protect Wealth?
It is reasonable to ask ourselves: what is the net effect of hyperinflation on the value of hard assets?
Houses: We know many investors will purchase single family homes, duplexes, quads, and so on as a hedge against inflation. Although housing is a good investment during periods of moderate inflation, it is less attractive during periods of high inflation because interest rates go up and higher interest rates decrease property values. In addition, consumers are forced to spend a greater percentage of income on essential goods and services (including food and fuels). Increased demand, particularly a sudden increase in demand, acts to create an increase in residential property valuation. However, because consumers are forced by inflation to spend a greater percentage of their income on food, fuel, supplies, and utilities, they have less money to allocate to housing. As we have seen in the collapse of the housing bubble, there is an increase in rental and mortgage payment defaults. These factors may act to decrease property values.
Residential rental units: Consumer spending priorities during a period of high inflation suggest an increase in rental defaults, and political pressure to freeze rents. Rental unit values, which are pegged to rental income, may decrease.
Commercial real estate: Properties occupied by larger companies will be less vulnerable to rental defaults than properties which are designed to accommodate the needs of smaller businesses (such as retail, service, and light manufacturing establishments). Shopping centers and multitenant industrial buildings will be particularly vulnerable, as will the financial firms that invest in them.
Gold and silver: This is tricky. During a period of rapid inflation, gold and silver will be seen as a hedge against a decrease in the value of the dollar. Precious metals can soar in value during periods of hyperinflation. However, it should be pointed out that the valuations of gold and silver are expressed in terms of existing dollars. The FED will act to tighten the money supply by raising interest rates and increasing bank reserve requirements. The FED could also sell debt securities as a way to reduce the money supply. This may mean that during a period of rapid inflation, gold and silver will increase in value, but then decrease (or perhaps collapse) in value during the period of dollar valuation re-adjustment. As the spring 2013 action demonstrated, Gold and Silver are commodities. When investors decided possession was no longer needed as a hedge against inflation, prices declined over 30 percent.
Oil and Natural Gas: There is sufficient demand for commodities like oil and natural gas to support price increases that match, or closely follow, the rate of inflation – up to a point. It would appear that somewhere between $100 and $125 a barrel, the demand for oil will decline for the simple reason consumers cannot afford the cost of products made from oil – think gasoline, diesel, propane, kerosene, and heating oil. (Note 2)
Debt as an investment: Real estate and other forms of debt do offer a defense against hyperinflation. If you hold a fixed-rate repayment plan, you'll pay the same amount each month, whether it's the first month or the last. During a period of hyperinflation, it's conceivable that you could pay off the entire balance of your debt using suddenly available cheap dollars. Interest rates go up for all debt instruments that bear interest. For investors, however, these same high rates of inflation suggest the accumulation of debt is a good thing because - if one times the payoff correctly - expensive debt can be paid off with cheap dollars.
Our government is partially financing its debts by printing money. Government political policy favors inflation as a way to devalue government debt. Current FED policy thus favors monetary inflation to fund the Federal Government. Consumer price inflation (which is understated) is vulnerable to a change in the velocity of money. Current trends favor hard asset inflation. These are facts. But no one knows if (or when) these economic indicators will suddenly show that inflation has gotten out of control and hard asset valuations must adjust to new consumer spending patterns.
A Possible Outcome
The American banking system will attempt to buy foreign currency with deflated dollars. But this will only accelerate the decline of the dollar because foreign banks will be wary of the dollars declining value. Pessimism always feeds upon itself. The price of American goods and services will increase, and this will increase the cost of operating American government institutions – federal, state, and local. The FED will be tempted to finance rapidly increasing public sector budgets by printing even more money, which will have the effect of further accelerating the decline of the dollar’s value. High rates of inflation are a regressive tax on all consumers. Purchase prices, especially for goods purchased from a foreign nation, may increase dramatically. People will try to spend their dollars as soon as possible in order to avoid its declining value. In this situation, the Federal government will face two unacceptable alternatives: a sudden hard brake on inflation risks economic collapse – followed by civil disorder, insurrection, and revolution. If, on the other hand, the FED continues printing money, the American dollar will be worthless in foreign trade, guaranteeing even higher prices for fuels, clothing, and thousands of everyday consumer items.
Or Perhaps This Will Happen
The Obamacare fiasco will be a drag on the economy. This program has been totally mismanaged. Layoffs and reduced work schedules decrease available consumer income. In a desperate attempt to force Obamacare on the nation, Washington will spend copious amounts of money on benefit subsidies. The loss of insurance benefits, along with incredibly higher Obamacare coverage costs, is disrupting America’s fragile economic recovery. These factors will combine to increase unemployment and depress the economy. Think recession. Increased (uncontrolled) social spending is inflationary. There are calls for the FED to print even more money in order to save a flagging economy. Obama’s struggle to save Obamacare may be the event that triggers an inflationary spiral.
I still think 2014 will not be a good year. But I’m probably wrong.
Note 1: See also
Note 2: See also
Further information on this subject may be found here: