Thursday, March 15, 2012

How Quickly Can Price Inflation Explode to the Upside?

The answer: Very quickly.

Amity Shlaes is a senior fellow in economic history at the Council on Foreign Relations. Her writings are followed carefully by the top of the top at CFR. And to a significant degree she uses Hayekian business cycle theory in analyzing the economy. She also has the distinct honor of being hated and attacked by the Keynesian Paul Krugman.

In other words, take her very seriously.

Yesterday, I wrote on how confused Bernanke was by stating that price inflation was of little concern. Here's Shlaes putting things in historical perspective:
 A little is all right. That’s the message Federal Reserve Chairman Ben S. Bernanke has been giving out recently when asked about the evidence of inflation in the U.S. recovery.

Sometimes Bernanke doesn’t even go that far. He simply says he doesn’t see inflation. The Fed chairman recently described the prospects for price increases across the board as “subdued.”

“Sudden” is more like it. The thing about inflation is that it comes out of nowhere and hits you. Monetary policy is like sailing. You’re gliding along, passing the peninsula, and you come about. Nothing. Then the wind fills the sail so fast it knocks you into the sea. Right now, the U.S. is a sailboat that has just made open water, and has already come about. That wind is coming. The sailor just doesn’t know it.

“Sudden” has happened to us before. In World War I, an early version of what we would call the CPI-U, the consumer price index for urban areas, went from 1 percent for 1915 to 7 percent in 1916 to 17 percent in 1917. To returning vets, that felt awful sudden.

How did it happen? The Treasury spent like crazy on the war, creating money to pay for it, then pretended that its spending was offset by complex Liberty Bond sales and admonishments to citizens that they save more.

Country in Denial

In other words, the Woodrow Wilson administration was in denial, inflating in all but name. Commenting on one complex plan to make more money available, Representative L.T. McFadden, a Pennsylvania Republican, said, “I would suggest that if the administration believes that inflation of this character is necessary to finance the war the more direct way would be to issue the notes direct.”

Or, to return to sailing terms, the Treasury and Fed had tilted the U.S. monetary craft so far one way that it needed to lean back the other way before it could right. That leaning was the true tight money policy of subsequent years, including deflation of 10 percent and wrenching unemployment.

History has other examples. In 1945, all seemed well: Inflation was 2 percent, at least officially. Within two years that level hit 14 percent.

All appeared calm in 1972, too, before inflation jumped to 11 percent by 1974, and stayed high for the rest of the decade, diminishing the quality of life for whole cohorts. They paid the higher interest rates needed to reduce the inflation, and got a house with one less bedroom. Or no pool.

The thing about inflation is that it accelerates. The acceleration hit storybook levels in the most sudden case of all, that of Germany in 1922. Many financial analysts thought the Weimar authorities weren’t producing enough money.

“Tight Money in German Market: Causes of the Abnormally Rapid Currency Deflation at Year-End,” read a New York Times headline. The Germans didn’t know it, but they had already turned their money into wallpaper; the next year would see hyperinflation, when inflation races ahead at more than 50 percent a month. It moved so fast that prices changed in a single hour. Yet even as it did so, the country’s financial authorities failed to see inflation. They thought they were witnessing increased demand for money. 
The greater the denial before, the faster the inflation accelerates after. Author Daniel Yergin tells the story of a student in Freiburg who ordered a cup of coffee in a cafe; the price was 5,000 marks. Then he had another. When the bill came, it was 14,000. “If you want to save money and you want two cups of coffee, you should order them both at the same time,” he was told.

Extreme Example

Germany in the 1920s is always the extreme example. But one form of denial then warrants comparison to the U.S. today.

Bernanke talks about prices in one area - energy, for example -- as different from those in the rest of the economy. The Germans, in their denial, thought their problem was limited to exchange rates, and that their domestic economy had hope. Risibly, Chancellor Joseph Wirth tried to tie down prices by regulating foreign currency. The equivalent, and equivalently risible, move today is the Ralph Nader effort to get the administration to push down oil prices.

The reason a little inflation is not all right, and the reason inflation comes suddenly, is expectations. 
The phrase “perception is reality” is overused generally. But perception can be reality in monetary policy. The bond market doesn’t act merely on what it sees. It acts on what it expects of the Fed or the government. And our own Fed has let us know it’s capable of just about everything, which includes inflationary monetary policy. Disillusionment can come as fast as a gust, but building faith that the government won’t inflate again is like building a new sailboat, a project of years.... 
The reason that markets haven’t jumped yet is that the last great inflation and correction happened in the late 1970s and early 1980s, just long enough ago that most adults in the financial markets don’t remember it.

I consider this column by Shlaes the most important column written to date about the developing price inflation. It for the first time paints the picture of how fast the price inflation can develop. When she writes "perception is reality", she is really discussing the change in the desire to hold cash balances. The desire to hold cash balances was very high during the financial crisis. That is now changing. As the price inflation picks up, the desire to hold cash balances will collapse causing prices to climb very fast.

Read this post day after day. It will prepare your mind for what is coming and cause you to start preparing for what is sure to be very serious price inflation, most likely double digit inflation.


  1. Thanks Robert! Ha, I just read Ms. Shales Bloomberg piece on Inflation and immediately came here to check if you had read it. Of course you have and responded so succinctly, wonder how the Krugmaniacs will respond?

  2. "The reason a little inflation is not all right, and the reason inflation comes suddenly, is expectations. "

    It's a good thing the Fed is now able to roughly monitor inflation expectations via tips spread in real time now. No reason why expectations will suddenly sneak up on them. All the Bernank has to do is utter a few words about raising interest rates or IOR and the market will respond immediately with lower inflation expectations. This alone will lower commodity prices immediately and prevent drastic price increases. One of the main tools of modern central banking is shaping inflation expectations. It's even more important than the money supply, at least in the short term.

    The only way high inflation will happen is if Bernanke wants it to happen and allows it to happen. And seeing how headline CPI has only increased a whopping 7% in 4 years in a time where he has had the perfect excuse to inflate like crazy, I see no evidence of Bernanke being a glutton for inflation. Just the opposite. He probably even engineered the 2008 crash because he was so afraid of the commodity price boogie man.

  3. The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent. This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation. There are still people in the country who have not yet become aware of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services.

    These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy. But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against “real” goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap pater. Nobody wants to give away anything against them.
    Human Action pgs 427-428

    --- I find it funny that so many people talk about a coming deflation. The feds would never allow deflation. It's not coming. Once people realize that - BOOM - $1.5 trillion in high powered money or approximately $13 trillion in M2 hits the streets, doubling money stock. OUCH!

  4. You can keep inflation low by keeping unemployment high. The velocity of money will slow to a trickle meanwhile you inflate the money supply for the 1% to 'create jobs' that never get created.

  5. Shales said "The reason that markets haven’t jumped yet is that the last great inflation and correction happened in the late 1970s and early 1980s, just long enough ago that most adults in the financial markets don’t remember it."

    This statement kinda tells me that Shales is really no genius when it comes to what inflation really is. If she thinks we haven't seen great episodes of inflation/boom/bust since the 70's and 80's, it tells me she's 2nd tier clown when it comes to economics. Right?

    That said, I understand Shales is an important person - for whatever reasons - to a lot of people, and so this recent piece is significant.

    1. Your comment tells me that you didn't live through the inflation of the late-1970s/early-1980s. If you think anything since has come close, you have no idea what the70s/80s were about and no idea as to what is about to hit.

      Further, it is not how important Shlaes is but the fact that she is among the first to discuss how fast price inflation can accelerate.

    2. It seems to me, Robert, if you look at current CPI as measured in 1980, we're pretty much there right now.

      I'm not the original poster, but I was a teen in college during the late '70s. The only difference now seems to be that the government has rigged the stats, and now people see the rise in oil and food prices as totally superfluous.

  6. But what to do? My only savings is $35K in a 401K rollover account. I either get whipsawed by the coming inflation or if I put it in equity funds, get that 60% correction hit I avoided in 08-09. Where to go?

  7. I like to compare inflation to bacteria.

    ''A scientist is experimenting with bacteria that are one micron in diameter and that reproduce by dividing every minute into two bacteria. At 12:00 PM, she puts a single organism in a container. At precisely 1:00 PM, the container is full.

    Q: At what time was the container half full?
    A: 12:59PM.

    Q: When could have one noticed that the container was getting full?
    A: Well, the container was only 1/4 filled at 12:58PM. It was 1/8 filled at 12:57; 1/16 at 12:56, and 1/32 at 12:55. So the glass was only 3% filled 5 minutes prior to 1PM.''

    1. Didn't think I would like this analogy, and I didn't...

      I LOVED it!

      Great job BBH!

    2. Not that this analogy isn't great and hugely accurate, I'd like to point out it is similar to Nassim Taleb's stadium filling with water example from The Black Swan. Instead of having a lot of bacteria, you drown instead.

      The suddenness of the "event's" occurence is what's important. Everything seems fine, until it's not.

  8. People keep talking about another round of QE. But does the FED really need it? After all, the funds rate at <0.25% for the past three years and for the foreseeable future is highly inflationary, and accomodative to the banking sector, in and of itself. Remember the housing bubble. It was able to reach the magnitude that it did with the funds rate at 1.0% for just a year. What kind of devastation will come from the popping of a treasury bond bubble which grew on the back of a <0.25% rate for four years or more? Look out! This is likely the bubble that brings the entire house down.

  9. I remember '80, '81.

    12 - 14% on a 'factory financed' new car loan was a GREAT deal.

    Mortgage rates over 20%. People walking away from their homes when their mortgages came up for renewal & there was absolutely no way they could make the payments. Many didn't have enough equity to qualify to re-fi at the suddenly MUCH higher rates.

    We've based a whole (haha!) "recovery" on artificial stimulus and ridiculously, artificially low interest rates.

    It doesn't take a genius to foresee what will happen when the current monumentally high levels of personal debt meet interest rates that are whole number multiples higher than they're paying now.

    The higher the pressure builds before something lets go, the more violently uncontrolled the release will be.

    How much pressure has the Fed "pumped" the economy with?

    How fast will things change when they lose control?

    I think Schlaes is quite correct. It will seem relatively sudden.

    And as for anyone who believes that cheaper iPads and flatscreens somehow offset rising energy & food costs, they won't even clue in until it's all over.

  10. Considering most WW2 price controls were lifted in the fall of 1946 it isn't hard to believe there was a quick spike up in the following years. Also one may remember Nixon imposed controls in the early 70s which I suspect may distort CPI numbers then. In "honor" of Cato institute :)

  11. So under the above inflationary scenario will gold and silver be a good hedge or will they just go up with everything else? No more, no less. If we have inflation then there will be know more QE, so precious metals may lose their edge.

    1. Gold and silver will do much better because they are going to be the new preferred currency. Much of the money currently in the treasury and fiat currency markets will be forced into precious metals. Average people will eventually be scrambling to get their hands on gold and silver. When you see the masses literally lining up outside of local coin shops to buy, it may be time to think about selling.

  12. This article writes: "the consumer price index for urban areas, went from 1 percent for 1915 to 7 percent in 1916 to 17 percent in 1917. To returning vets, that felt awful sudden." Yes, in fact it felt like a time warp, since the US didn't *enter* WWI until 1917 and the veterans were returning from the future.

    You gold nuts wonder why you're not part of the mainstream, but your articles are full of mistakes like this.