“Navigating Inflation: How Central Bankers are Working to Avoid Hyperinflation”

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There is a creature, a plague, that lurks day and night. It eats everything in sight. It got fat in its excess and created quite a mess. It infects our minds with fear too terrible to endure. Desperately we ask: What’s next, what awaits us, how do we get out of this? this pandemic that affects us all?

Well I don’t really know…. Forgiveness.

So what is this about? Quite simply, prices and generally rising prices, AKA inflation. This is nothing new, it’s been around since the beginning of economic exchange to trade it for that. Still, it’s relative prices that drive the economy. That is, the price of X relative to the price of Y. This affects what people buy and don’t buy, and ultimately affects what is or is not produced, how resources are used.

High inflation really hurts, but we can easily endure low inflation like we had for many years until recently. But it became increasingly uncomfortable and is now seen as a problem.

Moderate inflation actually helps the economy and makes it easier for relative prices to adjust when demand for some products increases faster than others. Overall, central banks have set about 2 percent as the tolerable interest rate to support this. If this dampens demand somewhat, it will help keep headline inflation under control. So the market tends to keep itself under control. When this is not enough, central bankers step in. This is happening now. The Bank of Canada is making borrowing more expensive, so the cost of borrowing is getting higher. More expensive, less demand, the higher the cost, the less demand. It hurts, and of course some are critical of this approach. It hurts, but it works.

What’s in the background? What central bankers fear most is the prospect of accelerating inflation, to the point of hyperinflation. People’s expectations play an important role in this. When we anticipate inflation, we behave in an attempt to ease the pain. For example, we might buy more of some things or demand higher wages in anticipation of higher prices. Both only push up inflation, creating a positive feedback loop that causes prices to rise faster. It can happen, and two well-known examples are Germany in 1922, when inflation rose up to 29,500 percent per month, and more recently, Zaire in 1991 at 114 percent per month. In other countries it was even worse. Money becomes less and less valuable and develops into worthlessness.

I remember having a conversation with a great-uncle many years ago about the story behind an old high-denomination Deutsche Mark. It was soiled, and its story was that the value of the mark had become worth less than toilet paper – which was running out, hence the replacement. In the case of Zaire is a photo of an envelope I received in 1991 and note the number of stamps on it. It was covered front and back with stamps worth Zaire 500,000 each, for a total value of about 40 million. A zaire was used the way we use a Canadian dollar. Imagine you had to put $40 million on an envelope.

With inflation accelerating, this is the motivation for central bankers to slow down the economy by raising interest rates. Yes, it’s painful, but better than the alternative. As my father used to say, sometimes you have to be cruel to be kind. In his case he was talking about pruning in the garden.

Underneath all of this lurks what I call the Church of Presumptuous Assumption. In other words, we all believe money has value, and as long as we all believe it, money in exchange for things will continue to have value and the economy will thrive. If we all lose our faith, the whole thing can collapse.

Some are skeptical that what central bankers are doing is wrong and will hurt the economy. Some seem to think the Bank of Canada governor should be fired. Will what they do cause deflation and recession? I doubt it.

What poses a credible risk is the current pose by a group of Republicans in the US Congress threatening the US’s ability to borrow to pay off its debt. If the US defaulted, we would deal with the worst case. There would be a general loss of confidence in the US dollar. Let’s hope those who understand the system will prevail.

keep the faith and hope for the best,

John Hennig
Chute-a-Blondeau

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Source: thereview.ca