Friday, February 10, 2012

Inflation Rears Its Ugly Head

While inflation is reported as being low, prices seem to be edging up everywhere.

The other day, we stopped for lunch at our favorite pizza place, Arte Pizza.  They have a menu board, which is made up of a series of "wipe" boards, but unfortunately, someone used a regular magic marker to write up the descriptions of the entrees and their prices.

So it was quite noticeable today that they have raised their prices, as each menu item had a piece of paper taped over the price with a new number on it.

What is going on?

And in other arenas, I am seeing price increases.  The price of sheet rock has taken an number of steep increases lately, as well as other building supplies.  And trying to get that vaunted 10% discount at Lowes is getting harder and harder to do.  Even for a builder, paying retail seems to be the norm.

Gas, of course, continues to rise in price, over time, and is pretty high right now.

Rebates and discounts on cars evaporated last summer, and sales took off.   The price of used cars actually increased.  Now is not the time to buy, it seems.

Are we headed for an era of inflation?  Let's hope not!

Inflation is a bugaboo that is alien to most folks born after 1970.  Since the Reagan era, inflation has remained fairly low or at least manageable.  We've seen inflation in prices of specific commodities - houses, gold, oil, or whatever.  But this was not an across-the-board price increase on everything in daily life.  And those were not permanent price increases, either.  They were (or are) bubbles.

If you lived through the 1970's you will realize they were not the happy-go-lucky times shown on That 70's Show any more than the 1950's were Happy Days.  Rather, we had a series of gas crises, high unemployment, high inflation, high interest rates, and a declining economy.  It really sucked.  And then we had Disco.  Talk about a perfect storm of ick!

The problem with inflation is that it can wipe out savings in short order - or at least make them worth less.  If prices are going up by 5-10% a year, making 3% on bonds isn't keeping even with inflation.  Over time, your savings, in real terms, are decreasing in value.  And if you invest in riskier stocks to compensate, you risk losing it all.

At a time when baby-boomers are expected to retire on their savings, inflation could be a disaster.

In some cases - such as Wiemar Germany and Argentina in the 1980's inflation went beserk.  While economists complain that inflation is "soaring" in Argentina to nearly 10% today, in 1990, it was over 20,000%.  You read that right - twenty-two-thousand percent.

Rampant inflation of that sort wipes out an economy.  Between the time you wake up and go to bed, your money can decrease to nothing in value.   But such scenarios are rare, indeed, and only occur when the underlying economy is shot.

What causes inflation?  Economists argue about this all the time.  Printing more money is one answer.  The larger the money supply, the less money is worth.  And right now, with near-zero percent interest rates, money is easy to come by.  And while the Fed says it will continue this loose policy, like any control system, it is possible that they have over-controlled already, with the effective outcome damped by the inertia of the system.  Inflation could zoom in the coming years, because they are putting too much gasoline on the fire, now.

Higher wages and prices for commodities can fuel inflation.  In the 1970's the price of oil skyrocketed. Since nearly everything we consume has an oil component, the price of everything goes up.  Indeed, one of my professors at GMI used to tout the statistic that a glass of milk requires a half-a-glass of oil to create, package, and ship to the consumer's home.  Everything, he argued, was basically made of oil in our economy.

And as prices went up, workers demanded higher wages, and since 30% of the workforce was unionized back then, they could get higher wages and cost-of-living increases.  And that is a problem right there - some people get COLAs on their pensions and wages, while others do not.  Inflation does not affect everyone equally.

Some economists argue that inflation can be a good thing.  And indeed, in a growing economy, inflation can be a sign of progress.  Over time, in an expanding economy, prices will increase.  In a depressed economy, like the Great Depression, prices drop down to nothing - as demand drops to near-zero.  Eventually, prices drop to below cost, and companies go bust, further depressing demand.  A steady, manageable rate of inflation can be a good thing.

And some economists argue that we need inflation to spur consumption.  This is not good news for consumers, who have to pay higher prices, of course.  But economists argue that if prices go up, people will be incentivized to buy now, rather than wait.  They argue that the government should create inflation to help the economy.  And it is an argument that makes "sense" in a twisted sort of way.  But it is a dangerous argument, in some regards.

For example, it was the argument that sold homes in 2007.  "Buy now, before prices go up so high you are priced out of the market!  And we know how that worked out.

Today, people are not buying homes so much.  And why bother?  If you are looking for a home today, chances are, you can buy the same home, for about the same price, next year.  There is no "rush" to buy at this point, as the market is flat.  So sales remain flat.  If price increases were out there on the horizon, people might think "now is the time to buy!"  But instead, they say, "no hurries, no worries!"

Should we be worried about inflation?  Of course the doomsayers are saying so - there is, after all, an election around the corner.  And yes, it is possible that if we continue to borrow and print money (and keep interest rates very, very low) that prices could rise dramatically.

But there is also an alternative explanation.  Prices in the last three years have been artificially low, because demand was way down.  When people consumer less, prices drop.  So we saw gas drop in price, as people drove less.  No place to drive to, if you are out of work.  And car prices dropped as people stopped buying cars - because they were broke or just afraid to buy.   And when car sales rose this year, well, those discounts and low prices went away.

It is possible that we are seeing inflation, not as some problem, but just as part of a recovery in pricing due to an overall recovery in the economy.  As people go back to work, they spend money, which increases demand and causes prices to go up.  And we may see pent-up price demands materializing, causing a brief spike in pricing.

My friend who owns the pizza shop, for example, was scared to raise prices for the last three years, as demand was down.  If he raised prices, he feared he would lose customers.  So he was content to "hang on" and hang in there and keep prices low.  But with supply costs increasing, now he has to raise prices - and perhaps more than just to cover costs.  Now that the shop is full at lunch and dinner, he can raise prices and make more money - without worrying about losing customers.

And as people go back to work, wages will go up, and that will increase costs.  Since it is harder to hire illegal immigrants, the cost of labor for farmers and others is increasing.  Prices will go up as well, just as UAW wages increased the price of cars in the 1970's - even as the content suffered.  For those of you who favored throwing out the Mexicans, I hope you like the new $10 hamburger at McDonald's.  When the cost of food increases, everything will increase down the food chain.

But I think I will reserve alarmist judgement for the time being.  Inflation will increase - that is expected after three years of stagnant pricing and indeed, deflation in some industries.  A low level of inflation may indeed by a sign of recovery.  No need to worry, just yet.

But we can expect that inflation will increase to more "normal" levels in the coming months.  Before you invest in a 0.30% bond or CD, think about what it will be worth by the time it matures.  Long-term low-interest-rate investments might not be such a bargain right now.