Why Companies Should Prepare for Inflation

Why Companies Should Prepare for Inflation

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Why Companies Should Prepare for Inflation

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    "Ketchup Bottle Inflation"

    Viewed from a monetarist’s perspective, however, the current situation looks quite different; indeed, it is an absolute tinderbox for inflation. For monetarists, inflation is the product not of imbalances in supply and demand in the real economy but rather of imbalances in the overall supply of money. As Nobel economist Milton Friedman put it, “Inflation is always and everywhere a monetary phenomenon”—that is, the product of an increase in the quantity of money that is greater than the increase in the output of goods and services.

    The centerpiece of the monetarist model of inflation is the so-called quantity equation, which explains price changes by changes in output and in the quantity and velocity of money. Central banks only partially control the quantity of money by managing the monetary base. The total money supply also depends on the money multiplier, measured by the ratio of the overall supply of money (that is, including the amount of credit extended by banks) to the central bank’s money base.

    The loose monetary policy of the last two years, with its extremely low interest rates and unprecedented quantitative easing schemes, has strongly inflated the monetary base as well as the balance sheets of central banks. However, the overall supply of money circulating in the economy has not increased correspondingly because commercial banks have not passed the liquidity on to the private sector (not least because of the deleveraging of private households that has reduced the demand for credit). In fact, commercial banks have piled up $1 trillion dollars in excess reserves at the Federal Reserve, and the money multiplier has actually dropped precipitously, from between 1.5 and 2.0 to below 1.0. In other words, for every new dollar created by the Fed, there is less than one new dollar circulating in the economy as credit.

    Because the banks have held on to this money, the result has been only moderate inflationary pressure—for the moment. But if the lending behavior of commercial banks, and with it the money multiplier, were to return to historical norms, the excess reserves held at the Fed would be released unchecked into financial markets, resulting in a sudden increase in the money supply. Think of this as “ketchup bottle inflation.” Like ketchup that remains stuck in the bottle no matter how vigorously one shakes it, and then suddenly spurts out in a great splash, latent inflationary pressure may abruptly turn into uncontrolled high inflation.

    This dynamic helps explain why inflation, while not an immediate threat, represents a significant medium- to long-term risk. Of course, it is difficult to estimate precisely the probability of such a scenario. But it’s important to understand just how tempting the inflation scenario can be for both governments and businesses.

    In the current economic environment, increased rates of inflation provide a convenient means of reducing the unsustainable debt overhang by lowering the real burden of servicing debt for both households and governments. Rising inflation also works like an economic stimulus package. Because higher prices typically lead to higher wages, inflation increases disposable income and government spending, thereby fostering demand. Higher nominal wages also increase the subjective sense of wealth, and expected price increases in the future encourage people to spend their money now rather than postpone purchases.

    Initially, inflation will also have beneficial effects for business. Company revenues will increase not only in nominal terms but also in real terms. The resulting positive effect on employment and wages will further boost demand, leading to more economic growth.

    That’s why at least some observers have seen inflation as part of the likely solution to the global economic crisis. For example, the IMF’s chief economist Olivier Blanchard has called for a higher central-bank target inflation rate of 4 percent. And Société Générale’s global strategist (and noted bear) Albert Edwards has even argued that “maybe 20-percent-plus inflation will indeed prove to be the ‘best’ (or least bad) way out of this mess." The problem is that once an economy gets on the inflation treadmill, it is very difficult to get off—without doing further damage to the economy and even sparking another recession.