% Points of Interest

Deflated Inflation


“The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt, what is laid before him.” – Leo Tolstoy

 “Inflation is always and everywhere a monetary phenomenon.” – Milton Friedman

“The report of my death was an exaggeration.” –Mark Twain

Inflation is dead, we are told.

The leaders of the Federal Reserve, the Bank of Japan, the Bank of England, the European Central Bank: they have all checked the body and declared it a corpse. Technological improvements, globalization, and demographic factors, they tell us, have led us to a land where inflation remains permanently subdued.

Thus the logical thing is to proceed accordingly. Buy long-dated bonds, and lever up—because if there will never be any more inflation, then rates will never rise. That’s the new normal.

But can we be sure?

Inflation is a monetary phenomenon, as Milton Friedman said. The more money there is in circulation, the more it will chase goods and services. This has been proved over and over again—most famously in post-World War One Germany.

This German 100 Mark note could buy you five nights in the finest hotel in Berlin in 1913.

This German 50,000,000 Mark note wasn’t enough to buy you a beer in the hotel bar in 1923.

The Imperial German Mark was backed by gold. In 1910 there were 4 Reichsmarks to one US dollar—this at a time when the average American earned $10 a week and an annual income of $2,500 put you solidly in the top 1%. Your average man on the street in Kaiser Wilhelm’s Germany would never in a thousand years have believed that the value of his money could be destroyed.

But it was.

The Imperial Central Bank started the printing presses going to fund the First World War. In the wake of the defeat they simply accelerated. By the early 1920’s people were collecting their week’s wages in wheelbarrows and a turnip cost a million marks.

Germany is the outlier case. The shocks that led the to the hyperinflation—loss of a long, bloody war, and subsequent revolution—were extreme. Hopefully we will not see them duplicated in our lifetime.

My point though is that the inflation was not expected. No financial instrument in 1913 was pricing in the probability that the Mark would be worthless in 10 years.

History doesn’t repeat but it rhymes.

In 1965, the United States had experienced years of <2% inflation—since the second quarter of 1959 in fact. And bond investors clearly expected that to continue. The yield on the 10 year treasury was basically stuck at 4.20%. Yields were steady, even despite a slight uptick in CPI in the summer of that year.

10 Year Treasury & CPI, 1963-June 1965

(Source: Bloomberg)

They shouldn’t have been.

That uptick was the start of a broader move upward in both CPI and rates that lead to dramatic changes in the US economy. By the end of 1968—2 ½ years later—CPI inflation was running well over 4% y/y. The 10 year had reacted accordingly—up over 200 basis points.

10 Year Treasury & CPI, 1963 – January 1969

(Source: Bloomberg)

The hypothetical investor who bought a 10 year treasury in June of ’65 was down ~15% in price terms in less than three years. And this price shock hadn’t been caused by a disaster like World War One. Instead it was a series of missteps on the part of the Fed and the Administration that started the fire burning.

The economic and political worthies have told us that it’s different this time. Perhaps they are right.

But it would be wise to consider the implications of their having been too quick to pronounce the subject dead.

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