Last week, to almost no one’s surprise, the Labor Department announced yet another month of inflation worse than at any time since the 1980s. The March Consumer Price Index (CPI) showed inflation increasing at an annual rate of 8.5%, up from 7.9% in February.
Depending on who you talk to, inflation can be blamed on greedy corporations, greedy employees, or even consumers hoarding goods in the expectation that prices will rise even higher. Not to mention COVID-related supply chain disruptions, now exacerbated by energy and food shortages stemming from Western countries’ sanctions against Russia after it invaded Ukraine in February.
All these factors have undoubtedly worsened inflation, but in fact, neither businesses, employees, consumers, nor supply chain disruptions are the primary drivers of inflation. As we’ve pointed out before, economists define inflation as an increase in the money supply.
A working definition of the term “money supply” comes from the Mises Institute:
Cash + demand deposits with commercial banks and thrift institutions + government deposits with banks and the central bank.
Thus, when the Federal Reserve acts as it did in the early stages of the COVID pandemic to create trillions of dollars out of thin air, that action represents an increase in the money supply. And when Congress borrows trillions of dollars to send stimulus checks to all but the wealthiest Americans, as it did three times during the pandemic, that also represents an increase in the money supply.
Viewed from that perspective, inflation appears inevitable, and we’ve expressed that viewpoint unsparingly ever since the pandemic began.
But could today’s inflation actually be worse than the 1980s? We believe that it is.
If you’re old enough to remember that time, you’ll recall soaring oil prices, followed by rapidly rising prices for everything else as the impact of higher energy costs percolated through the economy.
But there are two key differences between then and now:
In the 1970s and early 1980s, the CPI measured a largely fixed basket of goods and services, leaving less room for manipulation. In 1980, for instance, inflation reached 13.5%. That number wasn’t subject to hedonic adjustments as the CPI is today. The theory behind hedonic adjustments is that as the quality of goods or services improve, their effective cost decreases, even if consumers have no opportunity to buy those goods or services at a lower price. For instance, according to the hedonically adjusted CPI, a television that cost $1,000 in 1996 should now cost $22.
Indeed, if inflation was measured the same way today as it was in 1980, the CPI would be growing at 17% annually. This chart from Shadowstats shows you the difference:
Interest rates rose in response to inflation. In the 1970s and early 1980s, the Fed raised interest rates aggressively to fight inflation, and savers were able to keep pace with it. A three-month bank CD purchased in December 1980 yielded 18.65%. Even with an average inflation rate of 13.5%, you could still considerably outpace it with a very safe investment.
Today, thanks to more than a decade of financial repression – the Fed deliberately suppressing interest rates far below the inflation rate – the best rate that can be found for a three-month CD at a US bank is around 0.35%. Using the official CPI, you’re losing more than 8% annually with your money in a bank. Measuring inflation against a fixed basket of goods and services, your “real” interest rate is a stunning -16.65%.
Indeed, in terms of real interest rates, inflation is probably the worst in US history. Other than the 1970s and early 1980s, there has been only one other period since the Constitution was ratified in 1789 that inflation was close to what we’re now experiencing.
That period was during World War I and its aftermath more than a century ago. Prices rose at an average annual rate of 18.5% from December 1916 to June 1920, as Uncle Sam borrowed heavily to pay for the war. Shortages abounded, and prices of food, clothing, and housewares more than doubled during this period.
Once again, interest rates didn’t keep pace. The average yield on 10-year Treasury bonds increased from 4.05% in 1916 to 4.97% in 1920. Yields on commercial paper were about 1% higher than Treasury yields. This implies a real interest rate of -11.5% to -12.5%.
Thus, the inflation we’re now experiencing, in terms of real interest rates, is the highest it’s ever been in American history. The question, of course, is how long will it continue and how best can we adapt to it?
In the 1980s, the Federal Reserve adapted to double-digit inflation with what can only be viewed as “shock and awe” tactics. Fed Chairman Paul Volcker presided over a Board of Governors that raised interest rates to 20% in June 1981. And while the Volcker-era policies led to short-term economic misery in the United States, they succeeded in taming inflation.
But as we pointed out last month, there’s no way that Volcker’s example could ever be repeated in today’s America, because the Fed is operating with its hands tied behind its back. The Fed can’t raise rates anywhere close to 8.5%, much less 17%.
In 1980, America’s national debt was less than $1 trillion. Raising interest rates to 20% required higher interest payments on that debt, but the amount was manageable.
Since then, America’s national debt has grown to more than $30 trillion. With an average debt maturity of just over five years, a mere 1% increase in interest rates would add nearly $60 billion to the deficit the first year it was imposed, ballooning to $300 billion annually (1% of $30 trillion) by year five. An 8% across-the-board increase would cost the Treasury an additional $480 billion per year; $2.4 trillion per year if it was sustained for five years or more. In reality, the numbers would be even higher since the national debt is increasing by trillions of dollars each year.
And that’s not the only reason why the Fed will never again raise interest rates high enough to seriously challenge inflation. Pundits call it the “Fed put.” Essentially, it’s the reality that the Fed will never allow the price of stocks to go down by more than a predetermined amount.
We’ve seen proof of the Fed put repeatedly in recent years. Every time stock prices are seriously threatened by some sort of economic calamity, the Fed steps in to save hedge funds and other well-heeled investors from a serious drawdown in the value of their stock portfolios.
As a consequence of the Fed put, the American economy has become addicted to near-zero interest rates. Both public and private debt as a percentage of GDP have climbed to record levels. Entire business models are dependent on ultra-low rates, including nearly 600 zombie corporations that remain in business only because they can borrow enormous amounts of money for next to nothing.
Thus, while the Fed has announced that it will increase short-term interest rates to around 2% by the end of the year, we’re skeptical the zombie economy our central bank has erected will be able to survive hikes on that scale. Even if it does, and inflation doesn’t get any worse, we’re still looking at real interest rates of -6% to -14%, depending on whether hedonic adjustments are applied to measure inflation.
As for what to do about inflation, the strategies we outlined last month still remain relevant; in particular, to buy productive assets that keep up with inflation. Or passive assets such as gold that are traditional inflation hedges. We also endorse the strategy of stockpiling real goods; i.e., hoarding. Stockpiling is also a powerful inflation hedge, making this strategy more relevant than ever as prices surge.
Finally, as we also pointed out last month, inflation as bad as what we’re now experiencing can literally break a civilization. As it worsens, you’ll want to look at ways of “getting out of Dodge,” if necessary. The ultimate tool for doing so is a second citizenship and passport, or at least legal residence in another country.