Last week we looked at how inflation is measured. This week, we discuss why it is so important to remain vigilant to the threat it poses if left unchecked.
We previously defined inflation as the rate at which the general level of prices in the economy rises over time, or the rate of decline in the buying power of the dollar. Many Americans are too young to have experienced the phenomenon in earnest. It is important to keep it that way.
Our last taste of really damaging inflation in the United States occurred between 1964 and 1982. Dubbed "the Great Inflation" by economists (a clever lot when it comes to monikers), policy errors were compounded by two energy supply shocks from OPEC oil embargoes. Inflation peaked at nearly 15 percent in 1980, a pace that doubled prices of consumer goods every five years. Not the worst in our history, but painful and disruptive nonetheless.
Many countries have allowed this phenomenon to gallop out of control, leading ultimately to economic collapse. Venezuela is a real-time example today. A country rich in oil reserves, Venezuela has suffered devastating mismanagement and corruption that has destroyed the country's currency. While official figures are scarce, estimates are that prices are soaring at 4,000 percent per year. Economists call this kind of runaway scenario a "hyperinflation." Imagine prices of milk and bread doubling every two weeks and you're in the ballpark.
Perhaps the most famous example of hyperinflation is that of post-war Weimar Germany. Following the end of World War I in 1918, the country loaded up on debt and fired up the printing presses to pay for post-war reconstruction. As more and more German Marks were issued, the value of each began to dive until the currency was virtually worthless. Finally, in 1923, the Weimar government issued a one thousand billion Mark note, with a value of approximately 25 U.S. cents.
Given the imperative to corral inflation before it gets away, the U.S. took a bold and important action to stem the tide. In 1979, Paul Volcker was named chairman of the Federal Reserve Board by President Carter, and was tasked with nipping the budding menace. Volcker recognized that after nearly 15 years, inflation had become ingrained into the expectations of consumers. Commercial contracts included imbedded price escalation clauses, and collective bargaining agreements featured built-in double-digit cost-of-living adjustments. Throughout the economy, inflation was baked into the cake. Taming it meant first deracinating the expectation that it was inevitable.
The cure, at least at first, was as painful as the disease. Volcker's Fed raised interest rates and choked off the growth in the money supply. Hard. So hard that they threw the economy into the worst recession since the Great Depression (well, at that time anyway). Economic growth shifted into reverse, unemployment briefly hit 10.8 percent, but it did the trick. The drastic slackening in demand led to a mitigation in the rapid rise in prices (think fewer dollars chasing the same amount of goods). By 1982, the recovery was under way, but inflation fell to 6 percent. Over the next decade, it trended toward 3 percent, and has averaged 2 percent or less since the late 1990s.
Recently, markets have experienced an uptick in volatility related to fears of rising inflation. This apprehension is a healthy thing, for we dare not allow the beast to escape its lair again. But it is useful to reflect that the Fed performed heroically in taming inflation before, learned some valuable lessons, and stands ready to act decisively to prevent the threat from re-emerging.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager at Barnett & Co. in Chattanooga.