This is big, though overlooked, news. While Washington’s budget fracas grabbed everybody’s attention, the bond markets quietly rendered their verdict on inflation. Of the two events, the inflation verdict may be the more significant. Chronic inflation is a development only of the last half century, and especially the past 30 years. It has done enormous harm. It has worsened recessions; it has fostered, among farmers and others, massive land speculation, and it has spawned huge uncertainty. If this era is passing, there should be no mourning.
The connection between bonds and inflation is simple. No one lends money for long periods at low interest rates when rampant inflation is expected. Money’s value is destroyed. High inflation means high interest rates; investors expect to be compensated for the cheapening of their dollars. By contrast, low long-term rates imply low inflation. Now, look what’s happened to long rates. They’re 6.2 percent on a 30-year Treasury bond, down from 9 percent in September 1990. Lower rates, in turn, have pushed up the stock market, as investors switch funds into shares.
What’s going on? This may be the downside of an extended inflation cycle. Between 1960 and 1980, overambitious economic policies generated double-digit inflation. Every economic expansion raised inflation above its previous peak. Recessions dampened inflation, but the “lows” got higher. Since 1980, the pattern has reversed. When the economy expands, inflation rises–but not to previous highs. And the lows after recessions get lower.
You can see this in the table below. It gives inflation’s highs and lows by year. (Note: The inflation figures exclude volatile energy prices. The point is to show that the inflation of the 1970s didn’t stem mainly from big oil-price increases.)
Lows Highs 1.0% (1961) 6.1% (1970) 3.3% (1972) 9.8% (1974) 5.6% (1976) 11.6% (1980) 3.6% (1983) 5.2% (1990) 3.0% (now) ? (?)
If my theory is right, the next inflation high will be between 4 and 5 percent, followed by a low of less than 2 percent. After a few more business cycles, annual price increases could settle into a range between 0 and 2 percent. In practice, this would be price stability. Price increases would be so small, as Federal Reserve chairman Alan Greenspan says, that they wouldn’t influence most consumer and business decisions. In addition, it may be impossible to hit zero inflation exactly, because we don’t know where it is.
No one can measure all price changes. To produce the monthly Consumer Price Index, the Bureau of Labor Statistics sends monitors into 20,000 stores to record 80,000 prices. Even so, some economists contend that, for technical reasons, the CPI may overstate inflation by 1 percent annually. BLS officials think any error is no more than half that and probably less. But some statistical uncertainty is inevitable; a range for price changes (0 to 2 percent) accepts that.
The question is whether we reach this range by, say, the turn of the century. My theory is not a hard prediction; it’s merely a hunch about what’s happening. Only government creates inflation. If the Federal Reserve pumps out too much money and credit, prices will rise. Stable prices require the Fed to reject easy money as a way of accelerating economic growth. That policy begat double-digit inflation. Can the Fed restrain itself?
Skeptics abound. “If you polled Americans, they’d be happy with 3 to 5 percent inflation and better economic growth,” says economist Paul Isaac of Mahon Securities Corp. Isaac figures that, despite Greenspan’s anti-inflation rhetoric, the Fed will try to increase growth while staying within that inflation range. It will also fail, he thinks. Credit will remain too easy for too long, and inflation will rebound into the “high single digits.”
Jim Grant, editor of Grant’s Interest Rate Observer, considers the Disney bonds a hoot. Hey, no one may watch Mickey Mouse in 2093. “To believe that the currency will not have been debased [by inflation] again by the time Chelsea Clinton has children, let alone by the time her grandchildren have children, must be a leap of faith unmatched in the history of lending,” he writes.
If skeptics are right, then Wall Street is wrong (as it has been before). Meanwhile, though, everyone is adjusting to lower inflation and interest rates. Consumers and companies are eagerly refinancing old high-cost loans. Economist David Lereah of the Mortgage Bankers Association estimates that homeowners will refinance more than $400 billion of mortgages this year for the second consecutive year. Companies may redeem as much as $140 billion of bonds and replace them with new bonds at lower rates, says Andrew Kalotay, a consultant on corporate debt.
And the bond market is changing. Long-term lending was logical when people expected stable prices. In 1900, nearly one quarter of corporate bonds had maturities of 50 years or more, says Richard S. Wilson of Fitch Investors Service. Disruptive inflation changed all that. By 1984, new corporate bonds had an average maturity of only 10 years. Maturities are now headed up; the Disney bonds are merely an exotic example.
All this may seem removed from everyday life. It isn’t. By itself, price stability brings no virtues. But in its absence, erratic inflation shreds our economic and political fabric. It subverts confidence in the future. Bond markets are betting that we’re putting that behind us. Sounds nostalgic. It would be nice if it came true.
