Inflation could be lurking in the shadows

When it comes to the question of inflation —— not just random prices creeping higher, not just runaway gasoline prices, but real, hungry inflation, the kind that steals your savings and lowers your standard of living —— there is not a consistent interpretation of the signs, even among economists.

But signs there are, and some people —— among them a leading San Diego economist and an investment expert —— are interpreting them to mean the road ahead could be a bumpy one.

"The big question is this: Will there be a significant amount of inflation?" said Alan Gin, an economics professor at the University of San Diego. "I think that's why the Federal Reserve Board has been moving rates up, to choke off inflationary tendencies."

Consumers, who, unlike economists, form their opinions based on their personal real-world experiences, seem to expect inflation to burst upon the economy as a voracious predator.

As measured by the Conference Board, a New York-based nonprofit business organization that studies trends in the economy and public sentiment, consumer confidence was down in April. That's the fourth straight month consumer confidence has dipped. It's still higher than it was in November, but in November it was headed up. Today it's declining on an ever-steeper slope.

Worse news: Consumers interviewed for the survey said they thought prospects for business weren't looking very hot, either. And only one in six thought he'd be making more money within six months.

Local economy at risk

The San Diego region has been lucky in recent years, its economy surging ahead while performance in most of the land was ho-hum. As recently as March, net job creation in the area outstripped that of the state as a whole and the nation.

But runaway inflation, which some people say is possible by year's end, is something to be taken seriously here because of the peculiar characteristics of our local economy.

Per-capita personal income in the San Diego-Carlsbad-San Marcos metropolitan area, according to figures gleaned from the Bureau of Labor Statistics, is a paltry $36,000 per year. That ranks 28th in the nation, well below the metro area's ranking on the basis of population. Our earnings are below average.

But a substantial part of our economy, and one of the strongest economic growth areas in recent years, is the hospitality and tourism industry. It's an industry that pays poorly but provides lots of jobs. And it is heavily dependent upon discretionary spending by people who don't live here.

That dependence on other people's discretionary spending may be worrisome if inflation rises, because the first place those other people are likely to cut back is in their discretionary spending.

USD's Gin sees in the consumer confidence numbers cause for concern.

"A productivity downturn could lead to more inflationary pressure," he said. "It's something to keep a lookout for."

Understanding inflation

To grasp the problem, it is important to understand what inflation is. Most people see inflation and rising prices as one and the same thing, but that is an oversimplification. Medical care, for example, costs much more than it did 40 years ago. Few people would be happy to pay those prices today, however, if it meant being treated using the tools and knowledge available to doctors in the mid-1960s. Some of the medical care price increase in those four decades has been because of qualitative improvements.

Price increases are actually a symptom of inflation, not the cause. That's why economists such as Federal Reserve chief Alan Greenspan don't react strongly to wild swings in the price of energy, especially gasoline, though they do keep a wary eye on them.

Price swings such as the country has experienced at the gas pump since last year tend to be self-correcting, in Greenspan's opinion, and in any event are driven by factors not directly related to the economy.

Inflation is caused by one or both of two things that most people never see: growth of the supply of money and increases in the velocity of money. The velocity of money is the way economists refer to how quickly we spend what we earn. The faster we spend it, the more of it there appears to be, and the appearance of more dollars chasing a limited supply of goods leads to price increases.

Goods and services are in limited supply, which is why they have value. There is not enough of either to give everyone who wants them all they want. Prices regulate the distribution of available goods and services. When demand is greater than supply, buyers bid up the price until some people decide the good or service is not worth it, or some producers decide making more is justified by the price. Eventually a price is found where supply and demand are equal.

Money, just like corn or pencils, is an economic good, and just like them it is obedient to the so-called law of supply and demand. Printing too many dollars creates an oversupply, and the price of a dollar drops because it is less scarce. For people who think of the value of all goods and services in terms of dollars, it can be difficult to see the price of a dollar. But news reports of a "weak dollar" in trading with Europe are actually stories about the falling price of the dollar: fewer Euros are being offered for each dollar.

Aiding and abetting

A century ago, any increase in the money supply was an act of government.

Today, we join the government in swelling the money supply by borrowing. If you buy something with a credit card and don't pay off the balance right away, you've created money —— you've increased the money supply.

That's not necessarily a bad thing, but the unchecked expansion of the money supply eventually triggers inflation. That's why the Federal Reserve Board has been acting since last summer to increase the interest rate charged for interbank borrowing. In theory, increasing the cost of borrowed money slows the rate at which the money supply grows by discouraging people from spending money they don't have.

There is some concern that we've already slipped into an inflationary cycle, we just don't know it yet. How could that be?

"Some 60 percent of all mortgage financing is being done now with adjustable rate loans, and one-third of it is negative amortization loans," said James Puplava, president of Puplava Financial Services Inc., a San Diego investment advisory firm.

A negative amortization loan is one with monthly payments that are less than the monthly interest cost of the loan, so that the amount owed grows every month. Such a loan could be useful in a housing market characterized by rapid home price growth, because the increase in home equity would eventually pay off the increase in loan balance.

"Each month, those people are deeper in debt," Puplava said. "About 20 to 25 percent of mortgage loans now are interest-only loans, and the number of traditional, fixed-rate loans has dropped to just 15 percent. It's a sign of inflation.

"As long as you have money supply growing year over year, you have inflation," he said.

The signs are there

So, where are the price increases we usually associate with inflation?

They've been hidden by the burgeoning trade we have with the rest of the world, according to Puplava.

According to the Cato Institute, a conservative Washington think tank that focuses on the economy, "the U.S. trade deficit is the result of a net inflow of capital to the United States from the rest of the world … we remain the world's most popular destination for foreign investment."

Essentially, we're borrowing our way around inflation. The presence of all that foreign investment is made possible by the fact that Americans do not save enough to finance domestic investment, the institute concluded, making the trade deficit a "mirror reflection of the larger macroeconomic reality that investment in the United States exceeds domestic savings."

But Puplava thinks we're about to confront the consequence of that lack of domestic savings.

"Foreign-held U.S. debt is now $1.4 trillion," he said. "Part of our inflation has been camouflaged by international trade; if all you could buy was domestic goods, prices would shoot way up."

His theory is that American consumers don't want to save because there's no benefit in holding dollars when the money supply keeps expanding —— saving shrinking-value dollars isn't a good way to build wealth. Instead, they invest in assets that have been growing in value, like ever-more expensive homes, and borrow heavily to do it because if dollars keep falling in value, then the more of them you owe the better off you are. As they fall in value, the cheaper it becomes to pay off the loan.

The problem, he said, is that the rapid industrialization of China and India is creating shortages of the basic commodities on which U.S. industries rely.

That, in turn, will have an impact on both domestic prices and jobs.

"There's a good chance that, in the next 12 months, we will see those assets (the homes people have been buying) begin to lose value. The Federal Reserve won't stop raising interest rates until something breaks, and that will probably be the housing market," he said.

Hold on there, says Jack Kyser, chief economist of the Los Angeles County Economic Development Corp.

"Interest rates going up will definitely cool the housing market," Kyser said.

"But there's more to it. There's too much money sloshing around in the world economy. There are so many things going on that you cannot explain them all through normal economic theory," he said.

"It's definitely a yellow flag," he said of the signs that inflation may be building momentum. "If you're a savvy investor, you might see it as a red flag. Now really is the time to be conservative."

Although less alarmist in his view than Puplava, Kyser nevertheless agrees on one point: "We could get a much slower economy by late this year."

