5 Horrors of Inflation *Update*

**Scroll for Updates**

Ronald Reagan and Jack Kemp wanted to index everything, especially Treasury notes and taxes.  By "indexing," we mean tying rates (interest and tax) to the inflation rate.  Calls for indexing subsided after Reagan and Volcker did what Ford and Carter could not:  whip inflation now.

With a $2 trillion deficit this year and multi-trillion deficits projected as far as the eye can see, inflation will return to ravage the American consumer.  To make a former Economics professor happy, inflation deteriorates the purchasing power of a dollar.  (Happy, Bruce?)  But it does more than that.  Here are 5 horrors of inflation that will come to pass thanks to your U. S. Government:

Tax Bracket Creep:  When your household income exceeds $110,000 (married filing jointly) a year, you lose a lot of deductions.  For instance, the child tax credit.  As wages inflate to keep up with costs, millions of tax payers will cross this threshold and lose deductions.  In fact, it's common for a family's take home pay to fall as a result of pay increase.  You take home $60,000 a year after taxes and deductions, you get a $10,000 raise, and you're now taking home $53,000.  Fun, isn't it?

Interest Rates:  Interest rates represent the price of cash and are most sensitive to inflation.  If I lend you $1,000 for 10 years, the interest I charge must, at least, cover inflation.  If inflation is 2 percent over the period, then I would charge 2 percent interest and you would pay me $1,218.99 in year 10.  I break even.  If inflation is 18 percent (and that's not unlikely), to break even I charge 18 percent interest and in 10 years you pay me $5,233.84.  Big difference, huh? That's compounded annually.  Compounded monthly, far more common, and you have to pay me over $5,900.

Investments Lose Value:  Having seen the effect of 18 percent inflation on a $1000, 10-year loan compounded annually, you can see how careful you'll be before investing.  Would you buy a 10-year T-bill at Friday's closing rate of 3.84 percent if you knew inflation over the next 10 years would be 10 percent?  Of course you wouldn't! You'd lose money.  (To perform an easy future value calculation in Excel, type =fv([rate],[# periods],0,[present value]), for example:  =fv(.0384,10,0,1000).  A more accurate method for solving bond pricing with Excel is explained here.)

Quality Plummets:  If you were born before about 1968, you probably remember that the 1970s saw lots of really crappy, low quality junk on store shelves everywhere.  It wasn't just a change in tase, it was a response to inflation.  When prices of goods and services rise faster than consumers' incomes, manufacturers and retailers must find cheaper goods and services to fill a given need.  Jack-in-the-Box was caught mixing oatmeal in its hamburgers.  Plastic furniture replaced wood, steel, and leather.  Polyester replaced wool and cotton.  Men let their hair grow hideously long to save money at the barber.  While you can argue all you want that buying low quality costs more in the long run, if you need toilet paper today, Charmin's higher quality at $5.00 a roll does you no good if have $3.00 to spend.

Savings Dwindle:  If you know the dollar in your pocket today will be worth $0.65 tomorrow, you'll spend it today.  During periods of high inflation, the marginal propensity to consume skyrockets.  True, it skyrocketed during the relatively low inflation periods of the 1990s and 2000s, but just wait to see what happens when generations of spenders meet years of high inflation.  And every new round of fast spending drives prices higher, as more money chases after fewer, crappier goods and services.  Why not buy that $5.00 hamburger today since it will cost $5.50 tomorrow and $7.00 next week?

These are just 5 horrors of inflation.  Please use the comments section to provide your inflation horror stories.  If you have any tips to help people prepare for and deal with high inflation, please add those, too.

Why would the government touch off inflation?  Perhaps because, in the short term, inflation tends to help the poorest quintile, according to Heinz Herrmann.  While the inflation devastates the poor in the long run, a period of very high inflation over the next 2 years will allow the party in power to say, "Look, your wages have increased 10 percent since we took office."  Of course, their taxes will have gone up 12 percent, prices 15 percent, and their standard of living will have fallen.  But who wants to wallow in those sordid details?  This administration is all about hype.

MORE:  Gateway Pundit reports that Obama is killing jobs faster than any U. S. President in history.

*UPDATE*  Fed is shocked--Shocked!--that multi-trillion dollar deficits are driving up interest rates instead of stimulating home buying.  I suppose they don't teach Finance 501 in Harvard's MBA program.  With interest rates rising, home buying will slacken, economy will sink.  Hello, Jimmy Carter.  Drude reports that NYT will carry Monday morning story of tension gripping Obama's economic team.  About friggin' time.

While we're at it, one of the best -- if not THE best -- article on what's wrong with the Obama economic plan is on NY Times today.  Read it.  It's very long, but you must read it.  Cohen and Lewis skewer the White House like no one I've read to date.  Intelligent, informative, penetrating, and convincing.  This is the op-ed that could topple Obama's house of cards.

Why Focus on Government Spending?

The mounting government debt--$2.98 trillion in recent bailouts and stimuli alone--is an oppressive anchor around the neck of every American.  Currently, every family of 3 is obliged to pay over $118,000 in the next 30 years.  That's a house payment with a variable-rate.  In other words, the government has done exactly what helped cause the mess for individuals by borrowing beyond its means at a teaser rate of 0.8 percent.   That Teaser Rate Will Skyrocket

In order to keep rates low, the Federal Reserve began buying up Treasuries bonds last week.  Sort of like your spouse co-signing a loan for you.  The idea was that the Fed's purchases would take some of the notes off the street, driving up the price (scarcity) which would reduce the interest rates. 

But it didn't work.  According to the Wall Street Journal on March 31:

The 30-year Treasury yield immediately moved higher Monday after the Fed bought $2.49 billion in long-dated government bonds, jumping as high as 3.656% from an overnight low 3.519%. The yield was pushed below 3.6% in the afternoon session as worries about U.S. auto makers and banks spurred a haven demand in Treasurys.

This will be an oft-repeated story until the Fed's spent its Treasuries allowance of $300 billion.  As the economy perks up (which it will for the next 2 weeks to 2 months), bond prices will fall, pushing up the yield.  Those yields will drive up the deficit and the national debt.  That's the adjustable-rate mortgage effect.  

US Debt Will Skyrocket

One reason that the deficits were so high under Carter and Reagan but low (actually some surplus) after the GOP took the House and Senate in 1995 was interest rates for government borrowing.  Even though Reagan's rates were cool compare the fever (18+) rates under Carter, they were still much higher at 8 percent under Reagan than they were in the 1990s. 

Today, rates are much, much lower than they were in 1998.  They are lower than they were late in George W. Bush's second term when, the Democrats tell us, deficit spending was "out of control."  Even with these all-time low interest rates, Barack Obama and the Democrat Congress have managed to explode the deficit and the national debt.

When rates move up, deficits and debt will move even higher.

Consumers Will Pay

In a sense, the worst thing that can happen to consumers is an economic rebound.  With trillions of dollars of cash poised to hit the streets and trillions of dollars of debt to pay, every up-tick in the economy--GDP, stocks, jobs, anything--will increase prices and rates disproportionately.  

Think of it this way (but ignore my numbers which are for demonstration only).  Suppose you own a stock whose volitility rating is 1.0.  That means if the S&P goes up 2 percent, the stock goes up 2 percent.  When the budget is close to balanced, that's how debt, rates, and prices respond to a growing economy.  If the GDP grows at the 3 percent, inflation will be around 2 percent.  

But our volitility rating is more like 1.5.  So a 2 percent increase in the broad market will yield a 3 percent increase in your stock.  In terms of inflation, a 3 percent increase in GDP will yield a 4.5 percent price increase.  (The GDP:inflation ratio might be much higher than 1.5 considering the amount of borrowing that's occured in a very short time.)  So your salary might go up 3 percent, but your cost-of-living will go up 4.5 percent, leaving you worse off than before.  

Unemployment sucks, and I want that rate to fall.  But be realistic.  Someone who lost a $60,000 job and finds a new $60,000 job will not be back where he started.  Even if he managed to survive on savings during the unemployed period, $60,000 will no longer buy what it did before.  That's the problem with inflation:  it erodes the purchasing power of the dollar.

Stop the Borrowing! Stop It Now!

The road to meaningful recovery requires the same steps as life-saving:

1.  Stop the Bleeding:  stop borrowing

2.  Start the Breathing:  cut taxes to drive investment and cash-based spending

3.  Treat for Shock:  let communities help those who need assistance until the economy lifts their boats

Currently, the administration is doing none of these.  It's force-feeding anti-coagulants which will increase the bleeding; it's raising taxes which will deprive the patient of oxygen; and it's forcing its heavy hand on those in need. Bassackwards.