Runaway inflation in the 1920s in Germany led to economic collapse and opened the door for a homicidal tyrant to take control. Sky-high inflation in the U.S. in the 1970s led investors to flee the stock market for an entire decade. And much of Latin America saw rising poverty throughout the 1980s as out-of-control prices sapped consumers’ buying power.
Since then, economies around the world have enjoyed a sustained era of very low inflation, a key reason behind the tremendous rise in global stock markets that began in 1982 in the U.S. and Europe and spread to the rest of the world in the 1990s.
But with the U.S., Japan and Europe now stuck in a rut, economists are starting to talk about the beneficial effects of boosting inflation. The Federal Reserve recently announced its intention to use $600 billion in new money to buy back Treasury bonds, a strategy known as quantitative easing. The Fed hopes bond sellers will re-invest the proceeds of their bond sales in more productive areas of the economy and spark overall economic growth.
[For more information, check out our Primer on Quantitative Easing: What Is It and Will It Save the Economy?]
But inflation hawks are pretty alarmed that the Fed is printing yet more money, noting that a rapidly expanding money supply was the key cause of economic ruin in 1920's Germany, and more recently, in Zimbabwe.
The Fed’s response: if we can get the economic motor running again, we can re-absorb all that newly-issued currency before it becomes a source of inflationary pressure. The Fed is walking a fine line, to be sure, since it’s not always easy to get the inflation genie back in the bottle, but most economists applaud the Fed’s actions.
Now that the Fed has announced its plan to use quantitative easing to encourage inflation, we'll examine the good, the bad, and the worst case scenarios investors can expect from this monetary experiment.
Inflation and Interest Rates
There’s a simple reason investors fear rising inflation. It eventually manifests itself in ever-higher interest rates that can choke off economic activity. That’s what happened in the U.S. 35 years ago, when Treasury bonds sported double-digit yields and borrowers suffered through 12-14% mortgages.
At the time, most investors realized it was pretty foolish to invest in stocks in such a high-inflation environment. After all, why try to generate 10% annual returns with stocks when you can buy a government bond with a GUARANTEED 12% yield.
When President Gerald Ford took office, the campaign to “whip inflation now (WIN)” was one of his key initiatives. But it was the actions of Federal Reserve Chairman Paul Volcker during the Carter Administration who eventually took on inflation and won.
Volcker beat inflation by raising interest rates so high that the economy buckled into recession. Lower levels of economic activity removed any pricing pressures the economy was feeling. For example, the economic slowdown led to a drop in demand for oil, and gasoline prices quickly plunged.
Within a few years, inflation was steadily receding and stocks started to look increasingly attractive. The Dow Jones Industrial Average rose from 800 in the summer of 1982 to 10,000 by 1999 – an +1,100% gain in 17 years.
Deflation is the New Enemy
But now it’s possible our anti-inflation measures have been almost too good.
Stocks rallied simply because inflation -- and interest rates -- kept dropping. With bonds and fixed income investments offer lower and lower yields, investors realized that stocks offered the best chance to capture investment returns that were large enough to quickly build a portfolio. In recent years, inflation has been quite low, but that hasn't necessarily been a boon to stocks--investors fret that low rates of inflation signal too much economic weakness.
In past economic downturns, inflation dropped but never quite disappeared. In the current downturn, however, prices are not only flat, they’re dropping in some areas. And it’s a painful situation when asset prices fall but debt burdens stay the same. Just ask any homeowner that holds an “underwater” mortgage. Some inflation in home prices is something we could all rally around.
When Inflation Helps
What does inflation mean for the stock market?
Historically, the lower the inflation rate, the better it is for stocks. Stocks tend to rally when inflation -- and interest rates -- keeps dropping. With bonds and fixed income investments offering lower and lower yields, investors realize that stocks offer the best chance to capture investment returns high enough to quickly build a portfolio.
But these days, economic activity is so moribund that investors would gladly give up a little on the inflation front if it means more robust economic activity. In recent years, inflation has been quite low, but that hasn't necessarily been a boon to stocks. Instead, investors are worried that low rates of inflation are signaling too much economic weakness.
Right now, interest rates are very low – near zero for some government bonds and CDs – and the stock market would likely rally in the face of moderately higher interest rates. Stock market strategists think that inflation in the 3% range, and 30-year bonds in the 5% to 6% range would be a perfect backdrop for stocks. Investors would still seek out stocks in the belief that they can do better than 5% to 6% annually. Of course, inflation rising above that level would once again become scary for investors.
Stagflation: The Worst of All Worlds
Achieving the right level of inflation is somewhat of a goldilocks scenario.
But if we can't get inflation just right, a darker view may play out. If we keep issuing massive sums of government debt but one day can't lure buyers other than the Fed to snap up our bonds, we would be forced to offer much higher interest rates as a way to encourage investors to keep lending to us. And that could cripple our debt-laden economy via a deadly combo of higher inflation and slow economic growth, known as stagflation.
Back in the 1970’s, stagflation led economists to talk about the Misery Index, which was a combination of the unemployment rate and the inflation rate. Right now, that figure stands at less than 12 (9.6% unemployment and 1.9% inflation). The Misery Index stood at 22 back in 1980, but fell to around 7% in the 1990’s.
Fed Chairman Bernanke's goal is to bring down the unemployment rate by a greater amount than inflation rises. Few Americans would quibble with a drop to 6% unemployment and a rise to 3% inflation. But it's a delicate balancing act.
The Fed’s recent actions will take quite some time to benefit the economy, so expect some economists to call it a failure if we don’t see economic improvements in the next few months. That short amount of time isn't long enough to let the effects take hold, but in an ideal world, the economy starts to improve in 2011 while inflation stays low. That would buy time for the Fed to unwind its current economy-stimulating moves – before the inflation genie writhes out of the bottle.
P.S. As Dave mentioned, many people are skeptical about quantitative easing. If you want to hear some of their arguments, check out 9 Reasons Quantitative Easing is Bad for the U.S. Economy.
