Is inflation about to take off?

Illustration: OpenClipart-Vectors. Source: Pixabay

A little historical perspective is instructive.

In April 1942, the United States Treasury Department asked the Federal Reserve to hold interest rates at a low level: 0.38% for 3-month T-bills, and 2.5% for long-term Treasury Bonds. The Fed agreed, and to maintain these rates they bought massive amounts of Treasury securities. Forget war bonds: the Fed financed World War II by monetizing the debt issued to build the ships, tanks, and ammunition used by US soldiers, sailors, and marines around the world.

When the war ended, most economists were concerned that unemployment would surge and the nation would head back into the Great Depression. About 10 million service men and women would be thrown into a labor market where wartime production and federal spending were plummeting. Government spending dropped from 42% of the economy in 1945 to 15% in 1947. At the same time, the money that consumers were forced to save during the war years came roaring back into the economy. Inflation surged from under 2% in 1945 to almost 20% in 1947.

Source: BLS, Inflation Data

During this time, long-term Treasury Bond rates were still pegged at 2.5%. Reg Q put a ceiling on bank deposit rates of 3%.

President Truman didn’t want holders of war bonds to suffer market losses as rates rose (never mind the losses in purchasing power that inflation caused). He and his administration theorized that this inflation surge would be transitory, and that the increases in consumer prices would soon settle down, as they had during the war. For a while, it looked like they were correct.

But when the Korean War broke out, prices headed back up. The Fed was faced with monetizing another wartime deficit, risking another postwar inflation surge and a significant loss in financial confidence. Truman invited the entire FOMC to the White House to discuss the situation. After the meeting, the President issued a statement stating that the Fed had pledged to support the Administration’s policy. But the Fed had made no such promise! Fed Chair Eccles released his own account of the meeting, without consulting the rest of the Fed. He also informed Treasury they would no longer support the peg. Eccles later wrote in his memoir: “The fat was in the fire”!

Despite further political wrangling, the peg ended by the end of 1951. After that, the bond market was on its own. Inflation settled below 2.5% by 1952, and wouldn’t rise faster than that for another 15 years – long enough for many market participants to completely forget about the ravages of double-digit inflation and their corrosive effects on investment, productivity, and the economy.

The point of this story isn’t to illustrate the fecklessness of politicians (it does) or even to demonstrate the importance of an independent monetary policy (also true). Rather, it shows that even transitory inflation can wreak havoc in an economy. A dollar in 1942 was worth less than 60 cents a decade later. That’s an average inflation rate of just 5.2%. Could something like this happen now? Inflation is currently running at 5.4%.

Source: Bloomberg

Investors today have a lot more tools at their disposal to protect themselves from inflation than they did in the 1940s: TIPs, commodities, swaps, and others. We should be sure to use them.