Sailing into the Winds of Dis-inflation

(Authors note: I wrote this piece in 2016. In the article, I made a bold prediction . . that interest rates would not rise for the foreseeable future. The reason . . .dis-inflation. As the Fed has (once again) lowered rates, it is apparent that this article is still relevant and that we need another solution to economic growth.)

Several years ago, I acquired a dilapidated Marshall catboat, which seemed fitting for a middle-aged man with four children. Of all the boats in existence, the catboat may be the least nimble. Heavy and fat, they were made for fishermen who valued their stability. Since the boat has both a sail and an engine, one can venture miles from home and still plan the return trip down to the minute, confident that the boat will be moored with the final rays of sunlight. It is a simple affair: drop the sail, furl it, fire up the engine and soon enough, moor the boat to the dock. What could go wrong? As the sun was setting two years ago, I did just that. With the sail furled and the engine started, I set my course to port, but soon an uncomfortable feeling overtook me. It was taking much, much longer to get home. At first, I was oblivious as to why the trip was taking longer, but I soon realized that the engine was slowing down — eventually descending into an agonizing putter. It was only then that fear struck and my return trip turned into a two-hour ordeal. As odd as it may sound, my lesson at sea is reminiscent of the U.S. economy. Just as my engine decelerated several years ago, our economy has been slowing down, going through a period of “disinflation.”

The story of tepid economic growth with little-to-no increase in hourly earnings has been a consistent one in the United States for the past decade. Compounding the problem has been the growing disparity of wealth during the past 35 years. As average hourly wages stagnated during this period, the top 1% of all earners saw their incomes hit new highs. However, there has been one trend seldom discussed in the press. From the 1980’s to today, there has been a deceleration of the inflation rate, also known as “disinflation”.

Inflation is the rate at which prices increase over a period of time. The opposite of inflation is deflation, when prices decrease. Most people are familiar with inflation, especially during the 1970’s in the United States. While both inflation and deflation measure price changes that have already occurred, they have a significant impact on consumer’s expectations for the future. If inflation is very high, consumers will be more inclined to buy items today based on the expectation of continued rising prices. During times of deflation, consumers tend to not spend as much money as they anticipate prices to continue to fall in the future.

As the inflation rate is measured monthly, the monthly changes are used to predict which way prices will head. In the 1970’s, the U.S. experienced a period of rising inflation rates known as the “Great Inflation.” This led the Federal Reserve under Paul Volcker to begin their “attack on inflation.” The chart below illustrates the sharp rise in inflation from 1970–79, as prices (measured by the Consumer Price Index) increased 112%.

What makes the above chart interesting is that it also shows that from the early 1980’s to today, the rate of inflation has been steadily declining, creating a period of disinflation.

The slowing of the inflation rate after the “Great Inflation” is considered by many economists to be a major accomplishment of the Federal Reserve. Up until that point, economists believed that the government could only affect the economy through fiscal theory and its policies of taxing, spending, exchange rates and trade deals. However, during the 1970’s, fiscal theory was not able to curtail inflation. While doubts about fiscal theory loomed, a new economic theory called monetary economics emerged. Monetary economics states that the quantity of money in the economy affects prices and growth, not fiscal policies. While controversial at the time, the Fed implemented monetary theory by reducing the supply of money in the economy. Within two years, they were able to lower the inflation rate from 20% in 1980 to 8.5% in 1982. The Fed’s successful use of monetary theory in this capacity marked a turning point in U.S. economic history. They proved that when it came to fighting inflation, it was the quantity of money in the economy that mattered more than how the government spent it.

As the economy slowed in the 1980’s, monetary theory was periodically used to stimulate growth. Instead of the government using fiscal policies to stimulate the economy, the Federal Reserve increased the supply of money, which lowered interest rates and encouraged people to spend and to borrow. Today’s debate between liberals and conservatives on the best way to stimulate the economy can also be seen as a dispute over fiscal policy (favored by liberals) or monetary theory (favored by conservatives).

While the Fed has been effective at using monetary policies to curtail inflation, the long-term effect of this practice is questionable. The Gross Domestic Product (G.D.P.) measures the total goods and services produced in an economy, and is the primary measurement of economic growth. It is measured quarterly and much as monthly changes in the C.P.I. give insight into which way prices may be heading, long-term changes in the G.D.P. can measure the economy’s momentum. Below is a chart showing the annual percentage change in the U.S. G.D.P.

The above chart illustrates that from 1978 to today, the U.S. economy has been losing momentum. There are many factors contributing to the slowing growth of the U.S. economy. Over the next year, we will explore these in greater detail. The overarching theme is that the actions of the Federal Reserve and their use of monetary policy may have been an effective tool to curtail inflation, but used alone it lacks the ability to stimulate economic growth beyond a tepid pace. This sentiment was shared by former Fed Chairman Ben Bernanke, who wrote in The Wall Street Journal in April 2015 that “monetary policy is no panacea [for our economic troubles], and as Fed chairman I frequently said so.”

Budget deficits, lack of investment in infrastructure, underfunded pensions, the value of the dollar compared to other currencies, and tax policy are all fiscal issues that have largely been left unattended. They are so politically divisive that there has been little action taken to resolve them. For investors, the decades of disinflation have been rewarding, and it appears that it will continue for the foreseeable future. However, for the overall U.S. economy, this trend is a sign that our economy has been slowing. The economic policies of the past are no longer as effective as they were twenty years ago. If one were to have any doubt about this, all they would need to do is understand disinflation. While this may not provide the prescription to heal our economy, the diagnosis should encourage the U.S. government to realize the limits of monetary theory, and explore how sound fiscal policies can be used to get the engine of the economy back up to speed.

Craig D. Hafer is an investment professional who writes on the market, the economy and current events with a focus how these stories may impact investors.

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