More inflation to come?

Reported inflation is headed higher – much higher.

The stakes have seldom been higher. With the unemployment rate still above 9%, and federal debt at record levels, this latest error by the monetary authorities is likely to be the most costly since the Great Inflation of the 1970s. Monetary instability will slow employment growth and further erode confidence in government at the same time that higher interest rates will add billions of dollars to the interest cost on the national debt. Yet, failure to act in a timely basis will lead to an even greater crisis.

When it arrives, the Federal Reserve and its defenders will call it “cost-push” inflation and blame it on economic growth, the weather, Arab sheiks, China, and perhaps greedy companies and labor unions.

The actual cause of the looming crisis is the same as the cause of the Great Inflation of the 1970’s: a too easy monetary policy that has devalued the dollar by 40% against gold during the past two years.

I choose gold as the reference point for the dollar’s value because it has the remarkable characteristic of maintaining its buying power in terms of other goods and services over long periods of time. As a consequence, the dollar price of gold is the best, though imprecise, real-time measure of the price level. Other, more traditional measures, such as the consumer price index (CPI) are merely lagging indicators of inflation or deflation that has occurred already.

I also choose gold because I remember what happened after President Richard Nixon in August 1971 severed the link between the dollar and gold. At the time, those who warned that the rising price of gold was signaling higher inflation ahead were widely dismissed as “gold bugs.” The conventional wisdom then, as now, is that economic slack would protect the U.S. economy from inflation regardless of what happened to the value of the dollar in terms of gold.

But it didn’t work out that way.

At first, the conventional wisdom seemed to hold. The rate of inflation as represented by the CPI slowed in 1972 to 3.2% from 4.3% in part because of wage and price controls, and then rose 5.6% in 1973. But, in 1974, the CPI jumped 12.2% in the face of rising unemployment. Shocked and dismayed, the purveyors of conventional wisdom made the circular argument that the unexpected rise in the overall price level was caused by the rise in commodity prices, especially the tripling of the price of oil. In other words, they blamed rising prices on … rising prices!

But, those who followed the price of gold were not shocked. For example, the sudden tripling in the price of oil between 1971 and 1974 roughly matched the tripling in the price of gold over the same time period. In other words, the rise in the price of oil was simply the mirror image of the preceding devaluation of the dollar against gold.

In the last two years, the price of gold has increased around 75% – roughly half the increase of 1972 and 1973. Last week’s inflation reports indicate that this devaluation of the dollar will hit the CPI in the year ahead just as it did in 1974.

The price of crude materials in the Producer Price Index (PPI) increased by 3.3% in January alone and now stands 21% above where it was just six months ago. Moreover, during the three months ending January, the rate of advance in the producer price indices for intermediate products, and finished goods have all accelerated into double digit annual rates of advance.

This upward adjustment of prices to the cheaper dollar is beginning to flow through to the consumer. For the past 3 months, the seasonally adjusted annualized rate of advance in the CPI is up to 3.9%, with food and energy prices – the items that have the greatest short-term impact on a family’s budget – accelerating to 3.1% and 27% over the same 3 months. Given the relative magnitudes of the dollar’s devaluation against gold, it is reasonable to expect consumer prices to be rising at a 5% plus annualized rate in the months ahead.

Fed Chairman Ben Bernanke’s assurance during last December’s interview on 60 Minutes that he was “100% certain” the Fed could control an outbreak of inflation above 2% was hubris. These data show that inflation has already broken out, and that there is little the Fed can do to stop the price indices from reflecting the dollar’s devaluation of the past two years. And, his statement last Friday in Paris at a meeting of the finance leaders of the Group of 20 that “resurgent demand in the emerging markets has contributed significantly to the sharp run-up in global commodity prices” ignores the central role of the dollar’s devaluation on rising global inflation.

Moreover, Bernanke’s promise to respond to higher inflation by raising the Fed Funds rate carries with it significant additional risks. Slowing the economy reduces the supply of goods and services relative to the supply of money, which itself can be inflationary. In addition, higher short-term interest rates increase the opportunity cost of holding currency and checking accounts, and therefore will lead to an increase in the turnover or velocity of money. That too will add upward pressure to prices.

The experience of the 1970s illustrates the danger. The Fed raised the Fed Funds rate from a low of 3.3% in February 1972 to more than 10% in July 1973. But consumer price inflation continued to accelerate for the next year.

To avoid another extended period of high inflation and interest rates, the Fed and the Obama Administration need to acknowledge that the current, paper dollar system is deeply flawed and prone to error and instability. The alternative is a rules-based system in which the Fed begins to use quantitative tightening and easing to steady the value of the dollar as represented by the price of gold. A monetary system in which the dollar is as good as gold – for all of its imperfections – would quickly deliver price stability, low and stable interest rates, and increased financial security to the American people.

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