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.

2009 Economic Prediction *Bumped and Updated*

*Originally posted February 15, 2009* I know this is a little late, but I was waiting for Congress to spend another trillion dollars or so before committing my prediction to the public.  Here goes:

GDP and unemployment will  flatten and even improve a bit in first half of 2009 for a couple of reasons:

First, people will begin to look for excuses to spend money.  This includes businesses.

Second, the hideous transfer of power from individuals to government that passed Congress on Friday will have a psychological effect on people making some believe that things will get better soon. 

Together, let's call this mass hypnosis.

That hypnosis, though, will wear off when we begin dissecting first quarter 2009 numbers in April.  The reality will then hit home:  downward economic trends slowed or reversed because things couldn't get much worse.  (Again, this is the psychological feeling, not economic reality.)  In other words, people will stop thinking "It's getting better," and start thinking, "We're stuck on bottom."  It'll be like old WWII submarine movies where the disabled sub settles on the ocean floor.  The crew's not out of the woods--oxygen will run out eventually--but they've stopped descending toward collapse depth. 

Then, of course, some idiot seaman rolls a bowling ball toward the bow, a rock they're sitting on gives, and the sub starts sliding into 38,000 foot trench. 

The other economic bowling ball that will hit the pins in early summer is Treasuries.  With the uptick in private sector activity and the flood of Treasuries hitting the streets, investors--especially China--will shift their purchases away from government debt.  This will drive up yields quickly until equilibrium re-establishes.  I don't know what the level will be, but it will be high.  

Having obligated over $65 trillion (with a "t") in promisory notes since September, the US government must issue massive amounts of bonds.  If you're a bond salesman with crateful of US Treasuries, a weak economy is a wonderful thing--there's nothing else for investors to buy.  But a growing economy makes Treasuries, which are now riskier than ever before, a less attractive alternative.  Stocks and corporate bonds offer the possiblity of recovering some of the losses of the 50 percent stock market dive.  Treasuries do not.  Not until their yields hit the 12 percent range.

High interest rates will cause already skiddish companies to pull back even more, touching off a new round of layoffs and another dive in both stocks and GDP.  

Of course, I'm just a computer guy; I could be wrong.