"Inflation - An Attack on the Prudent"

Sydney M. Williams

Thought of the Day

“Inflation – An Attack on the Prudent”

February 16, 2011

Inflation is insidious in the way it creeps silently into our pocketbooks. Worse, inflation rewards debtors and punishes creditors. And, if you haven’t noticed, we are a debtor nation, with a government that appears uneasy about addressing entitlements, the root cause of our debt. Mr. Bernanke seems willing to accept a “little” inflation, as the price of keeping deflation at bay. And, while an annual inflation rate of 2% may seem livable, the consequences of 4% are quite different. At 4%, the dollar loses half its value in 18 years and 75% of its value in a generation. By the time my grandchildren reach my age, the dollar would have lost almost 90% of its value. Inflation is a wealth destroyer.

In the early 1980s, then Fed Chairman Paul Volcker, with President Reagan’s blessing, broke the back of inflation by raising rates to what some considered usurious levels (and induced a short but sharp recession.) It worked. The 1990s were a time of modest inflation, but by the early 2000s, with the fright of a stock market collapse and the scare from the attack by Islamic Jihadists, those lessons were lost. The Fed lowered the Funds rate from 6.5% at the end of 2000 to 1% by June of 2003, when the stock market had already begun to recover. The effect was to induce asset inflation. Home prices were an immediate beneficiary, as were commodities such as gold and oil, which had lain dormant for a decade or more. Houses became much more than a roof over one’s head; they became personal ATM machines for millions of holders, seduced by the concept that valuations were a one-way street.

Just over two years ago, in December 2008, the Fed reduced the Funds rate to 25 basis points, where it remains today. At the time, credit markets were beginning to revive from what had been a near-death experience that fall, and the economy was two thirds of the way through the worst downturn since the 1930s. Despite indications that the economy has been recovering – albeit at a slower than normal pace – the Fed has chosen to keep rates at this historically low level, using a persistent 9% unemployment rate as their excuse.

To the extent their purpose was to re-liquefy the banking sector and to inflate assets, they have succeeded. A question facing investors now is have they gone too far? While the Fed looks at CPI prices ex food and energy, because of the notorious volatility in their numbers, consumers do not. In the past two years, soybean prices are up 49%, corn up 51% and gasoline up 70%. Stock prices are up almost 100%. On the other hand, the yield on the Ten-Year has risen 80 basis points, suggesting a tempering of risk and modest renewed concerns over inflation.

With almost $10 trillion dollars in Federal debt, it is in the interest of our government to keep rates low. In 2010, interest payments, at $197 billion represented 6% of the budget. With debt continuing to increase, any rise in rates will be deleterious to a budget that the President and Congress are having trouble trimming. But, it is certainly possible that increasing debt and with inflation concerns potentially pushing rates higher, interest payments will rise substantially for the fiscal year beginning in October.

Neither the Congress nor the President wants to be the bearer of bad news, thus the dance we are seeing in Washington as each waits for the other to be the first to tamper with entitlements. How much more pleasant it is to defend programs, no matter how wasteful, than to trim, whether the instrument is an axe or a scalpel.

In an economy with growth as tepid as this one, the affects of inflation will be particularly painful, especially for lower income consumers to whom food and energy represent a larger percentage of their daily budget. Savers and the elderly will be impacted, as their costs go up and income declines. Inflation is insidious; it rewards profligacy and it punishes the prudent. And sooner or later it must be addressed.