A Favored View of Inflation

Al Jacobs

A most straightforward – and perhaps alarming – report on inflation just appeared in one of America’s most prominent periodicals. Its author is Wall Street Journal op-ed columnist William A. Galston, a PhD holder from Cornell University, a former professor of government and public policy at the universities of both Maryland and Texas, an author of works on partisan politics, and at one time the deputy assistant for domestic policy to President Bill Clinton.

The title of his article is “Strap Yourself In: Inflation Isn’t Going Away,” and the details he presents seem to unerringly verify the title.

Galston refers to the most recent government reports, as he describes the price increases over the past 12 months in many of the items we all regularly use: food and energy 4.6%; fuel oil 59%; gasoline 50%; home-delivered natural gas 28%; new cars and trucks 10%; used cars and trucks 26%; car and truck rentals 39%; and furniture 12%.

In all, consumer prices rose by 6.2% while wholesale prices increased a full 8.6%. It takes no imagination to realize what a continuation of this will do to those persons whose incomes cannot keep up with the escalating prices.

As for the federal government’s take on the inflationary trend, Federal Reserve Chairman Jerome Powell contended as recently as last August that the rise in inflation affected a “relatively narrow group of goods and services,” as well as insisting the current inflation spike will be “transitory.”

It’s clear his comments were designed merely to mollify the public, for he surely realizes the U.S. economy is in the process of a rapid and irreversible inflationary spiral. As Galston points out, no nation can spend money at the rate we are and avoid the price increases we are experiencing. He expands upon this by stating:

“With an aging population at home and throughout the industrialized world, slow labor-force growth will exert persistent upward pressure on wages. As the elderly spend a portion of their savings and transfer the remainder to their children and grandchildren, consumer demand will increase. Absent faster increases in productivity, more inflation than we’ve seen during the past 40 years is likely.”

I suppose I can, if I choose, continue to commiserate on the evils of inflation and the widespread harm it is reputed to cause – which is arguably valid. However, there are countless articles devoted to that topic, so you do not need another from me. I shall, instead, give you a view of inflation from a distinctly different vantage point.

What I will describe is how inflation often proves to be beneficial for certain groups of individuals who intentionally position themselves in a way to generate a profit.

Let me first acknowledge the world experienced inflationary periods where very few persons, if any, profited. One such instance occurred in Germany in 1923, where you might note the cost of mailing a letter increased from 5 marks to 10,000 marks over a 30-day period – but those types of misfortunes are remarkably unique. We will only focus on situations where the economy inflates appreciably but does not verge on collapse.

Let us now travel back to the 1970s which truly qualified as the decade of U.S. inflation. While it may be surprising to learn that for the decade as a whole the inflation rate was only 6.8%, this rate recorded as double the long-run historical average and nearly triple the rate of the two previous decades. During this 10-year period, two episodes of double-digit inflation occurred: 1974 and 1979-80.

The underlying nature of the two inflationary episodes was much the same, with food and energy increases shockingly precipitating each. In both periods, inflation was uneven; some prices increased extremely rapidly while others rose moderately. While it is now part of the conventional wisdom declaring high rates of inflation cause changes in relative prices, you should realize during the 1970s it ran mostly the other way: large unavoidable adjustments in relative prices bred inflation.

Understandably, during those inflationary years many persons found themselves hard pressed to meet their financial obligations. As a result, both bankruptcies and home foreclosures became prevalent. It is fair to say inflation does not treat many of America’s middle-class citizens kindly. However, despite the difficulties some of our friends and neighbors experienced, certain groups road the inflationary pathway remarkably well. Who might they have been? Let me tell you who.

Presume that in 1965 you purchased a 10-unit apartment building. With your purchase price of $200,000, a down payment of $50,000, a mortgage of $150,000 and rents of $150 per unit monthly, you are managing to eke out a modest return.

Now move forward to 1974. With inflationary pressures enabling you to increase your rents to $200 per unit, your cash flow increases by $6,000 annually. And with the increase in rental income, the building is now valued at $250,000. Note, however, because of the mortgage loan leverage, your initial equity of $50,000 – the amount of the down payment – increases to $100,000. Thanks to inflation, both your income and your ownership values rose appreciably. Need I say more?

We will now move on to the conclusion of the decade to see how the inflationary pressures of the 1970s became resolved. It is generally acknowledged inflation can be slowed or terminated by two actions: a cessation of government spending coupled with an increase in interest rates. By July 1979 it became apparent to President Jimmy Carter the necessity for effective action to stabilize the nation’s economy.

To provide this action, he called upon a man with an unassailable background: Paul Volker, then President of the Federal Reserve Bank of New York, with over a quarter century of intimate involvement in virtually every aspect of the national economy. Carter nominated Volker to serve as Chairman of the Board of Governors of the Federal Reserve System (Fed) on July 25, 1979. With a prompt confirmation by the U.S. Senate, he assumed the post on Aug. 6, 1979.

The monetary policies of the Fed, prompted by Volker, were widely credited with curbing the rate of inflation as well as the expectations profitability would continue. The U.S. rate peaked at 14.8% in March 1980 ad fell below 3% by 1983. To accomplish this, in 1981, the Fed, prompted by Volker, raised the federal funds rate to 20% and the prime rate to a peak of 21.5%.

Inflation quickly eased, but as anticipated, both Volker and the Fed were heartily criticized for the 1980-1982 recession as the unemployment rate rose to over 10%. Admittedly their actions led directly to the recession, but the resultant cessation of the runaway inflation proved to be far preferable to the alternative.

Now the question: Who profits from a collapse of inflation and the recession that follows? Presume you are in the mortgage loan business, loaning money at reasonable rates of return. But had you made loans in 1981 and 1982 – as did someone I knew – you could have charged 20% interest and a 15% front-end fee on a 3-year loan. This works out to an annual percentage rate of 27½%.

I recall, back then, attending a luncheon with the lender and his friend, an attorney. As we sat down at the table, the attorney made a comment I’ve never forgotten. With a smile on his face he said to his friend: “That loan you just made … you might like to know, that’s as close as you’ll probably ever get to going to prison for grand theft.” Yes, inflation and its aftermath can be quite profitable for those in a position to take advantage of the situation.

Let’s now return to rationality, and the concerns of the majority of citizens. It is true that inflation can be the cause of distress for those whose financial lives are not tuned to selective investments.  However, it is not necessarily an unrepentant evil. When the economy is not running at capacity, meaning there is unused labor resources, inflation can help increase production. More dollars translate to more spending, which equates to more demand – thereby triggering more production.

It’s significant that British economist John Maynard Keynes considered some inflation necessary to prevent what he referred to as the Paradox of Thrift. This said if consumer prices are allowed to fall consistently because the country is becoming too productive, consumers learn to hold off their purchases while waiting for a better deal. The net effect is a reduction of aggregate demand, leading to less production, layoffs and a faltering economy.

And finally, inflation makes it easier to repay loans with less valuable money. The house you purchased with a 30-year fixed rate loan becomes easier to handle as years pass and the dollar is worth less – but all the while the house becomes worth more.

A concluding admission: I confess I’m not an impartial observer in this inflation business. I’ve functioned as both a landlord and a mortgage lender most of my adult life, and it proved to be a lucrative occupation. However, had inflation not been my constant companion, I would be in far less favorable circumstances.

Al Jacobs, a professional investor for nearly a half-century, issues weekly financial articles in which he shares his financial knowledge and experience. Al may be contacted at al@abjacobs.com



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