Talking Points

Inflation

Since his birth, Johnny had never spoken a word. At dinner one night, Johnny, now 7 years of age said, "Mom, this soup tastes terrible." His Mother said, "Oh my gosh, you spoke. After all of these years why haven't you ever said anything?" Johnny replied, "Well, up until now, everything has been Ok."

With vivid clarity I can recall a pair of pictures from my high school history book. Both were black and white photographs taken in the 1920's in a village in Germany: a demoralized man pushing a wheelbarrow full of money to purchase a loaf of bread; a child playing with bundles of Deutsch Marks because they were cheaper than blocks. Germany was experiencing a period of hyper-inflation due to the reckless abandon with which their treasury was printing money, and the Mark wasn't worth the paper on which it was printed.

Throughout the 1980s, Latin America experienced the same phenomena. The treasuries of Argentina, Brazil, Chile, and Peru printed money and their own central banks bought the newly minted currency: a different scenario with the same outcome, one that is being repeated in the United States today.

In the 1980's there was a popular joke: "When visiting Brazil, how should you get from point A to point B, by bus or by taxi?" The answer of course is, "By bus, because you pay to get on a bus but you pay to get out of a taxi and because of hyper-inflation, prices could have doubled by the time to you got to your destination." During the same period, on a daily basis, grocery stores would close at noon so they could re-price their products.

Inflation: more money chasing after the same number of goods. While post-war Germany had experienced a destruction of resources that had increased the relative money supply, the level of inflation witnessed during that time was only possible through the explosive increase in the monetary base. The relationship between inflation and the monetary base was first proposed by Milton Friedman, who famously quipped the easiest solution to counteract deflation was to "drop money out of a helicopter". He proposed a thought process that we all now take for granted: that the central bank is responsible for controlling inflation through exercising control over interest rates and the monetary base. In response to the latest financial crisis, the Federal Reserve has held a target rate between 0.00 and 0.25 percent since December 16 of last year- yet the latest CPI data shows that the year over year increase came in at -0.7%, the first instance of a twelve month decline since 1955.[1] As an increasing number of people begin to doubt the Monetarists and Milton Friedman, people might become tempted to believe that this time it might be different - that the Fed could flood the market with liquidity and historically low interest rates for nearly half a year with absolutely no consequences.

Amidst the euphoria of the recent market upturn, no one likes to consider the ramifications of what the Fed did to cause the current bull market. While the current absence of inflation is being celebrated it is often forgotten that inflation doesn't rear its ugly head until 18 to 24 months into an economic recovery. If the general consensus is that the recovery will begin in October of this year then inflation shouldn't be a concern until 2011.

As the economy stabilizes under its own power rather than through the Fed's, interest rates will begin to rise. As we begin to forget the depth of the turmoil, as the ramifications don't make themselves immediately apparent, as inflation becomes a non-issue and we forget the amount of liquidity injected into our financial system, people might, as Henry Ford once said, "extrapolate the present and not be able to see into the future". Our job as financial advisers/soothsayers is to not only see it before it becomes obvious but to also protect our client's from themselves. To keep them from making the mistakes previous generations have made.

Throughout history, we have learned that printing money or, injecting liquidity into the market, will cause inflation. The more you print, the greater the erosion of the value of that money. To put it into perspective, in 1971 President Richard Nixon took the United States off the gold standard and the U.S. currency was now backed, not by a scarce and highly valued metal, but by the full faith and credit of the U.S. Government. The erosion of the dollars purchasing power had begun in earnest. Today, that same dollar has the purchasing power of a penny.

In the near future as the market continues to improve and the recovery becomes firmly embraced, our fear should be that our clients extrapolate the present and forget how the government and the Federal Reserve had dodged a bullet. That Ben Bernankee, considered by many to be the foremost authority on the Great Depression, did what was necessary. Working in cooperation with the U.S. Treasury he flooded the banks with newly printed money. However, should we forget our lessons of past history and not prepare ourselves or our client's portfolios, we will be doomed to repeat past transgressions and once again witness the erosion of their fixed income portfolios. This time, not because of someone else's stupidity but because of ours. We will then, like Johnny, state with unremarkable disbelief, "I don't understand how this could happen, up until now (extrapolating the present) everything has been Ok."