“Why is inflation so destabilizing?
“Prices are the market’s air supply; they signal surpluses and shortages and tell businesses and consumers when to produce more or consume less. Inflation contaminates this air supply.” -Greg Ip
“Fire and Ice.” That’s how Greg Ip titled chapter five of his book, "The Little Book of Economics: How the Economy Works in the Real World." He was referring to the phenomena of inflation and deflation, the two forces that can drive economies—and stocks—off the rails.
Many examples of inflation come to mind: The North American price inflation that occurred between 1966 and 1980, when inflation rose from 3% to 14%. Looking back from there, inflation in Germany after World War I turned into hyperinflation and helped fuel World War II. Looking forward from 1980, there is the ongoing hyperinflation in Venezuela, which in a relatively few years helped destroy what was once South America’s strongest economy.
Deflation is less of an issue since it is less common, but it remains an important force in economic developments nevertheless.
The economic effects of both inflation and deflation can have dramatic effects on stocks, not to mention on politics. It can, as the quote above highlighted, have serious destabilizing effects.
Broadly speaking, inflation affects two classes of people, and affects them quite differently. It “arbitrarily” punishes savers and rewards borrowers. Ip used the example of retirees who buy a 4% bond, only to see inflation increase to 5% and their purchasing power be eroded. On the other hand, it will be beneficial for speculators who lock in a 5% mortgage and then see inflation push up the price of their property by 50%.
Ip also argued inflation is a hidden tax. Employees naturally negotiate for higher wages as inflation increases; however, they then pay more in dollars despite taxation rates remaining fixed, allowing governments to collect a windfall.
Investors can profit during inflationary times, assuming the right level of inflation. Ip cited the Goldman Sachs’ finding that investors do well with low inflation. When inflation is high, stocks do make gains, but “not by much.” When hyperinflation strikes, though, everyone loses, including investors.
To keep all of this in perspective, Ip reminded readers that steady inflation below 5% does little economic damage, and that is what Americans have seen since the early 1980s. Above 5%, the consequences are less predictable, particularly since high inflation can feed upon itself and quickly explode out of control.
Why does inflation exist? Ip reported there are two competing schools of thought:
- Money supply: This school of thought is associated with Nobel economist Milton Friedman, who said, “Inflation is always and everywhere a monetary phenomenon.” The “Monetarist” side blames inflation on too much money chasing too few goods. It focuses on the supply of money, specifically the government printing money or issuing bonds to the central bank. Look to Venezuela, where the government wildly prints money but gains nothing.
- Excess spending and inflationary psychology. This school is associated with what’s called the New Keynesian economic perspective. When demand for a product or service increases more quickly than the product or service can be produced, then buyers will bid up prices, potentially increasing inflation. On the inflationary psychology front, Ip noted that inflation depends on what people “think” it will be. For example, if all employees and all companies think inflation will be 2% in the coming year, then they will agree that will be the amount of pay raises. Something of a self-fulfilling prophecy sets itself up.
Deflation, wrote Ip, also comes in two types. Good deflation occurs when companies and their workers learn how to be more productive, and thus make—and sell—products at a lower cost. Ip noted that Intel (INTC, Financial) kept cutting the cost of computer chips but was still able to increase its profits and its employees’ wages.
Bad deflation, on the other hand, is “rarer and, potentially, nastier.” It occurs when spending collapses and companies reduce prices. When they do so, consumers may defer their purchases, expecting even lower prices in the future. This leads to employee wage reductions and, eventually, layoffs. Prices and wages “follow each other down” in a downward spiral. Two examples of this phenomena occurred during the Great Depression between 1929 and 1933, and to a lesser extent in Japan since the late 1990s.
Interestingly, voters seem to have the last word about inflation and deflation in many cases. Since 2008, wrote Ip, “People continued to expect inflation of around 2 to 3 percent, which has made it hard for either inflation or deflation to get a toehold.”
He also wrote, “in the long run, politics dominate: Voters and governments choose the inflation they want through the goals and leaders they give to their central banks.”
Inflation and deflation from a new investor’s perspective
As noted above, stocks do best in a low-inflation environment and less well in all others. When inflation remains below 5%, we can expect companies to pass on cost increases to customers, thus protecting their margins and other fundamentals. Of course, if the fundamentals swell, we can expect the same of stock prices, at least eventually.
Beyond the low-inflation environment, we get into the world of “hedging,” which refers to the use of alternative assets.
In the case of inflation and hyperinflation, the most common hedge is gold; it increases in value as the dollar wanes (because of nationwide inflation). Companies also may create their own hedges. For example, airlines can hedge their fuel costs with contracts that allow them to buy specific amounts of fuel at a specific price at a specific time in the future.
When hedging against deflation, investors may turn to high-quality bonds, which will continue to deliver a specified yield. They might also sell their holdings in companies with high fixed costs because corporate costs will remain the same while their output sells for lower prices. The same holds for companies that are highly leveraged—their repayments will remain level while their output will sell at lower prices.
Summing up, in chapter five of "The Little Book of Economics: How the Economy Works in the Real World," author Ip provided a guided tour of inflation and deflation, explaining the causes and effects of each. I added a postscript that briefly outlined how stock investors might hedge against severe inflation and deflation.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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