Rebuilding the Middle Class: Part 3: the Runaway Economy

Rebuilding the Middle Class: Part 3: the Runaway Economy

When Thomas Hoenig took over as president of the Federal Reserve Bank of Kansas City nearly two decades ago, his 85-year-old neighbour gave him a 500,000-mark German banknote to remind him of Germany's experience with runaway INFLATION following the First World War. "He told me that in 1921, the note would have bought a house," Hoenig said during a recent speech to a U.S. budget commission. "In 1923, it would not even buy a loaf of bread. That note is framed and hanging in my office."

Hoenig openly admits that invoking historical reminders of hyperinflation might seem overly alarmist in an era when inflation - a rise in the cost of living caused by heightened demand for products or the rising cost of producing them - has ceased to be a major concern for most North Americans. Central bankers have made fighting excess inflation, usually anything more than two per cent to three per cent, among their chief priorities in recent decades (some inflation is generally viewed as a good thing because it signals economic growth). But as the ECONOMY comes back to life after an extraordinary period that saw governments - particularly in the United States - resort to unprecedented fiscal and monetary measures to keep the world's economies from imploding, suddenly there's renewed concern about inflationary pressures. (Already, Canada saw a surprise jump in its inflation rate in January.) With all that extra money sloshing around in the system - inflation is sometimes thought to be caused by too many dollars chasing too few products - some are worried that the cure prescribed for the downturn could quickly become the recovery's disease.

While unwanted inflation can be reined in by hiking interest rates, central bankers seem intent on keeping interest rates low to help speed economic recovery. People like Hoenig, meanwhile, say they are worried that a massive buildup of U.S. government debt could also lead to calls for the central bank to print more money to help pay it down sooner, which could also have long-term inflationary effects.

For the average American or Canadian middle-class household grappling with an era of high UNEMPLOYMENT and stagnant wages, the prospect of rising prices over the next few years could amount to another body blow. Even a moderate rise in the rate of inflation would further squeeze workers' paycheques as prices for everything from food and clothing to gasoline and home insurance climb. And good luck trying to negotiate corresponding wage increases with employers that are still nursing badly wounded balance sheets. At the same time, a rapid rise in interest rates to thwart inflation could derail the current recovery, sending people right back to the unemployment line.

You don't need to reach as far back in history as Germany's Weimar Republic to get a sense of the havoc unchecked inflation can wreak. In fact, you really only need to go back to the early 1980s in the U.S. and Canada. Following the oil shocks of the 1970s, both countries experienced soaring inflation that ultimately led to double-digit interest rates. While lawmakers had experimented with wage and price controls, serious efforts to combat inflation initially took a back seat to economic growth and employment - goals that are once again driving today's rock-bottom interest rates.

Could it happen again? In January, Canada's consumer price index rose to 1.9 per cent from 1.3 per cent a month earlier, the largest increase in more than a year. The index measures the change in prices of goods and services bought by households, including food, shelter, transportation, energy, and clothing and footwear, over a 12-month period. While a big chunk of the increase was due to rising gasoline prices, the BANK OF CANADA's core measure of inflation, which strips out volatile items like food and energy prices, still managed to hit its official two per cent target almost a year and a half ahead of schedule. Meanwhile, wholesale prices in the U.S. were up 1.4 per cent, about double what had been forecast.

Despite the unexpected jump in core inflation, economists are nevertheless expressing confidence that pricing pressures will abate. Diana Petramala, an economist at TD Bank, wrote in a report that the increase is "rather surprising" during the early stages of an economic recovery, but noted that it's being measured against the significant price declines experienced in January of last year. She argues that core inflation will likely drop to a rate of 1.6 per cent to 1.8 per cent for the remainder of the year.

The confidence stems from the belief that there are scores of idled factories and businesses running at partial capacity that can be ramped up to meet rising demand. "At the end of the day, the prevailing forces that would keep inflation pressures at bay would be the amount of excess capacity in the economy," says Craig Wright, the chief economist at Royal Bank. "And with a high unemployment rate, you tend to see workers looking more for job security than wage gains, and that also tends to limit inflation."

But some are concerned that unused capacity has been overstated. "This recession was different than others," says Yanick Desnoyers, the assistant chief economist at National Bank. "You had GM and others closing plants, less credit available in the United States, and a recession that was longer than others. All of these things suggest to us that there has been capacity destruction." If that's the case, then rising demand for goods and services could soon result in rising prices.

In Canada, for example, consumers saw a sharp rise in the price of durable goods in January that was attributed mainly to a 3.2 per cent jump in the cost of automobiles. Desnoyers argues in a report that the "unusual surge" in vehicle prices can be partly attributed to the closing of assembly plants in the U.S. auto industry. While overall auto sales remain down, the reality is that fewer cars are now being manufactured, which is causing prices to spike as consumers come back.

Desnoyers says that most economists would have expected current levels of inflation to be much less buoyant considering the events of the past two years. He sees warning signs stemming from the recent rise of prices in the service sector (including a 4.4 per cent increase for things like phone and Internet services and an 8.3 per cent rise in "other" household costs). "If 75 per cent of the economy is already in expansion and we are creating jobs, do we really need a zero per cent interest rate policy?" Desnoyers asks.

Inflation has sometimes been compared to a drug. At first, a small dose can yield a big high, but pretty soon you need more and more to achieve the same effect. Back in the 1970s, economists also believed that a little extra inflation was nothing to worry about as long as it helped spur the economy and employment in particular. The strategy worked brilliantly at first, but soon economic growth began to stagnate while inflation kept rising. Higher prices caused workers to demand higher wages and business, in turn, raised prices to pay for their rising costs. A spiral was born.

By the early 1980s, inflation hit a whopping 12 per cent in Canada, meaning a $20,000 car would cost nearly $22,500 just one year later. In its early stages, inflation puts a squeeze on households as their costs rise faster than their paycheques. But once an inflationary spiral is under way, the real danger is the level of uncertainty that creeps into the system as consumers and businesses alike try to put a price on future goods and services.

Fortunately, there's a relatively easy fix: a sudden hike in interest rates discourages borrowing and encourages saving. The bad news is that it can be a particularly bitter mouthful of medicine. In the early 1980s, central bankers in the U.S. and Canada decided to stuff the inflation genie back in the bottle and ultimately jacked rates above 20 per cent, knocking out the economy in the process. That is precisely why central bankers on both sides of the border are now reluctant to raise rates prematurely.

Case in point: the surging Canadian housing market. Spurred by low borrowing costs, average home prices rose by almost 20 per cent last year and are driving the country's economic rebound - so much so that some are warning of a bubble. "Policy-makers find themselves between the proverbial rock and a hard place," says Aron Gampel, the deputy chief economist with Scotia Bank, in a recent report. Raising interest rates would snuff out inflation related to the housing market but could send the loonie higher, hurting beleaguered exporters.

But even bigger inflationary dangers could be lurking south of the border - namely huge central bank reserves that were accumulated as part of the U.S. government's attempt to prop up the financial sector. The U.S. Federal Reserve bought more than US$1 trillion of mortgage-backed securities from commercial banks and, in exchange, increased the size of the banks' reserves, which was supposed to encourage them to lend more money. This policy, known as "quantitative easing," is the modern equivalent of simply printing more money. The fear is that an economic upturn could suddenly result in that extra money being flooded into the economy. Desnoyers, for one, says in his report that the immense reserves currently being held by the Fed represent a potential "ticking time bomb" that, "if tapped irresponsibly, have the potential to explode prices."

And there's the ballooning U.S. government debt, which some expect to reach 77 per cent of GDP by the end of the decade. Could the U.S. government, with the help of the Fed, start printing money to pay off its debt and fuel inflation? It's been done before, says Hoenig, who points to the extreme measures of the last few years and the political difficulties associated with other debt-fighting measures such as raising taxes. "I ask your indulgence in reminding all that the unthinkable becomes possible when the economy is under severe stress."

As a result, all eyes are now on the U.S. government's recession exit strategy. Under normal circumstances, the playbook would call for a gradual raising of interest rates once the employment picture stabilizes and the economy is safely back on track. But that could all get thrown out the window if inflation runs rampant. In the meantime, shell-shocked working families are forced to ponder the possibility that their bank accounts, emptied during the dark days of the recession, could now just as easily end up being ravaged by the recovery.

Maclean's March 8, 2010