Zaks Investment Advisory Service

Effects of Inflation on the Economy (Part I)

I will begin with a brief review of the markets. Just as they have been for the past several weeks, the markets remained volatile. The S&P 500 lost 1.4 percent for the week (by the way, the S&P 500 has gained 5.2 percent for the year). Investors are eagerly awaiting the results of the September 18 Federal Reserve policy-makers meeting. Here, the Federal Reserve will decided what to do about interest rates: keep them at the same level, or lower them by either 25 or 50 points. At the moment, the markets anticipate a 50-point rates cut. What do I mean when I say “the markets anticipate?” I mean the futures and options markets, which trades Federal Funds Rate contracts. In the past, we devoted several programs to the work of the Federal Reserve, discussing how with the help of the open market transactions, the Federal Reserve supports these short-term interest rates. Well, the price levels on the Federal Funds futures and options suggest that investors believe that on September 18, the Federal Reserve will adopt a decision to lower the rate by 50 points. But clearly, if the rates are only reduced by 25 points or, worse still, left unchanged, the markets will be terribly disappointed and will probably go down. One way or another, there is not much time left until the Federal Reserve decision – just a week.

Last time, we started to discuss inflation from the perspective of investors, particularly how inflation affects various financial instruments. Why did we start talking about inflation? The ongoing financial crisis was one reason. The fact is, most analysts believe that many of the current problems will vanish or, at the very least, become less severe should the Federal Reserve cut interest rates. We will not go into whether this is the case or not (some economists believe that the effects of lower interest rates on the present situation would not be very strong). What we are interested in is the fact that the Federal Reserve is very clearly wavering, trying to avoid a forced interest rates reduction. Why? The answer is fairly evident: the Federal Reserve fears that a sharp interest rates cut would lead to higher inflation. All of the statements issued by the Federal Reserve over the past six months have mentioned inflation, and that it is – or may end up – at a level with which the Federal Reserve is not comfortable. The only time the Federal Reserve did not mention inflation was in a statement issued after it lowered the so-called discount window rates. That was on August 21.

But what is so bad about inflation, that the Federal Reserve is ready to risk the state of the US economy, or at least its housing sector, for it? We understand that hyperinflation of 100 percent, when prices double in a year, is bad. But what is so bad about inflation of, say, 10 percent? In reality, this question is not as simple as it looks.

Inflation, even at relatively low levels, “costs” real money to our economy. It is absolutely apparent that the Federal Reserve believes that the “cost” of inflation is higher than the presumed economic benefits that lower interest rates would bring to our economy. How exactly does inflation hurt the economy, and could we put a value on this negative effect? Inflation affects the economy in many ways, and some are much easier to estimate than others.

One of inflation’s main outcomes is that when it goes up, people try to get rid of money. As a result, the amount of money in the economy drops. How is this bad? We keep money in cash and in our checking accounts, even though we know that, theoretically, we could invest this money risk-free in CDs or Treasury Bills and earn a certain interest. We keep the cash because it is convenient. Our economy is based not on barter but the market: a dentist pays at the store with cash, not by filling the owner’s cavities. Cash carries a certain economic function, and, in a manner of speaking, we pay for it by turning down the interest. The economy settles at some optimal amount of money (of course, the amount of money in the economy changes constantly, but there is a certain optimal level around which that amount wavers). Suppose that at a certain point, the rate of inflation jumped. How would we react? We would eliminate a part of our cash holdings: they not only fail to earn interest, but also start to lose their purchasing power faster than before. However, society’s demand for money still remains the same. In other words, if we keep less cash, then a part of its positive economic effect disappears. Our economy would adapt to a smaller amount of money, but this would lead to a loss in productivity: a part of our productivity would be wasted on efforts to minimize the amounts of unused cash. The great economist Milton Friedman, to whom we devoted one of our programs, brought up the following example in connection with this: “A retailer can economize on his average cash balances by hiring an errand boy to go to the bank on the corner to get change for large bills tendered by customers. When it costs ten cents per dollar per year to hold an extra dollar of cash, there will be a greater incentive to hire the errand boy, that is, to substitute other productive resources for cash.” Of course, this is not the only economic example of how unproductive economic resources are used up. Different economists calculate the cost of unproductive activity in various ways. Their average figure: at 10-percent inflation, unproductive activity costs about one percent of gross domestic product. On the scale of our economy, this loss would equal about $130 billion.

We will present other examples of how even relatively low inflation affects our economy in our next program. This was Sergey Zaks. Thank you for your attention and until next time.