The Inflation Has Already Begun

The Inflation Has Already Begun

May 11, 2007

Inflation is caused by a decline in currency value. When the value of a currency falls, then, over time, it tends to take more currency to buy things. This process is very obvious in the case of Mexico, for example, which went from about 3.5 pesos/dollar in 1994 to about 9.5 pesos/dollar in 1999. If a Sony Playstation cost US$200 or 200*3.5 = 700 pesos in 1994, it might have cost US$200 or 200*9.5 =1,900 pesos in 1999. Pretty simple.

The process is not so obvious when the US dollar declines in value. Due to the dollar’s importance worldwide, when the dollar declines in value, other currencies tend to decline alongside. Otherwise, they would be subject to terrible trade pressures from “beggar thy neighbor” devaluation. If the euro was trading for $1.25, and both the dollar and euro’s value fell in half, then afterwards the euro would still be trading for $1.25. However, we might expect the cost of a Sony Playstation to slowly rise to $400, as the market for Playstations gradually accommodates the fact of the decline in dollar value.

This sort of dollar decline is not obvious in the foreign exchange market, since major currencies tend to stay in line with each other. It may slowly appear in the price of Playstations, cars, crude oil, food, medical expenses or in the government’s CPI statistics, if they are being honest. In my experience, the best way of measuring this sort of decline in currency value is by looking at a different currency market. I prefer the market between dollars and gold, the world’s great monetary standard. If gold’s value remains roughly stable, then when the dollar declines in value, it will take more dollars to buy gold — just as when the Mexican peso declines in value, it takes more pesos to buy dollars. Thus, a “rising dollar price of gold” is really a decline in dollar value, with all the attendant consequences.

The last great inflationary period in US history was the 1970s. In 1970, it took only $35 to buy an ounce of gold. At that time, $2,500 (71 ounces of gold) bought a decent car, and a house might run $25,000 (710 ounces of gold). After the smoke cleared in the 1980s and 1990s, the dollar was worth about 1/350th ounce of gold, one-tenth of its 1970 value. A decent car cost about $25,000 (71 ounces of gold) and a house, before the recent mania, was about $250,000 (710 ounces of gold).

The Dow Jones Industrial Average peaked around 1,000 in 1965, or 28.6 ounces of gold. Today, the DJIA at 13,000 is worth about 19 ounces of gold.

If the dollar was worth about 1/350th of an ounce of gold in the 1980s and 1990s, and today it is worth close to 1/700th of an ounce of gold, then the dollar’s value has fallen roughly in half. This does not cause an immediate doubling in prices for everything. That process takes a long time, on the order of twenty years — or about 3.5% per year on average. However, this change in currency value distorts all manner of economic relationships. One of the first effects can be to make financial markets quite giddy. This was the case in 1972, for example. The dollar had moved from $35/ounce to around $65/ounce, kicking off the inflation of the 1970s, but for a little while the “Go Go Years” were still going full tilt. It seems to be the case today, when the dollar has moved from a long-term average around $350/ounce to around $650/ounce. As the dollar went to $100/ounce and beyond in 1973-74, the inflation really took hold and financial markets everywhere were pulverized.

The US and world economies have already received a good stiff dose of inflation. It could be remedied by appropriate action by the Fed and other central banks. In practice, this would likely mean rate hikes, although there are other, more effective methods. In 1969, to counter incipient inflation, Fed chairman William McChesney Martin took action that drove short-term rates to 10%. In 1974, Fed chairman Arthur Burns’ anti-inflation policies took rates to 13%. In 1980, Fed chairman Paul Volcker’s anti-inflation policies took rates to 14% or higher. In 1989, Fed chairman Alan Greenspan’s anti-inflation policies took rates to 9.5%. The political support for such policies today is virtually nil, especially considering the wave of adjustable-rate mortgages coming due over the next three years.

Indeed, many Fed-watchers have expected the Fed’s next move to be a reduction in policy rates. Whether this turns out to be correct or not, this expectation alone suggests that the trend toward further decline in dollar value will continue. It may not show up in the dollar/euro or dollar/yen rate — the dollar didn’t fall much against foreign currencies in the 1970s either — but it would show up in the dollar/gold rate. Following our worn but useful 1970s roadmap, a move to $1000/oz. or beyond would probably be accompanied by a blooming of full-on 1970s-style inflation. It could happen by the end of this year.

Gold never really “goes up.” It simply holds its value while the values of other things are collapsing due to inflation and currency devaluation. Many times, in the 1960s or 1990s for example, it is the most useless of assets, sitting inert and generating no income. In inflationary periods, this inertness of value is gold’s most admirable quality.

It seems these days like a lot of people can’t help blurting out the H-word — hyperinflation. I am one of them, and I notice that the normally level-headed Marc Faber has his episodes as well. We are far from such a scenario at this time, and by any reasonable standard the likelihood of such an outcome remains extremely remote. I take this premature anxiety as a sort of premonition, the way some people feel an earthquake in their knee before it happens. There is something going on that we haven’t seen before. The US dollar is apparently being rejected worldwide, partially as a result of the unpopularity of US foreign policy. How this all plays out remains to be seen, but a certain amount of preparation might be worthwhile if that tingling-knee thing turns out to be right.