Nuts and Bolts Part 2: When inflation gets destructive

As discussed in Part 1, inflation is a natural part of all economies and a steady rate of inflation is actually a positive as it drives us to consume and invest.

However, inflation can find itself moving from being a positive influence to a negative one and can even become destructive if left unchecked. It can also become a drag if it’s not growing enough or is contracting.

Destructive inflation falls into three main types: hyperinflation, deflation and stagflation. They all describe out-of-control price movements that decimate a consumer’s purchasing power and a country’s economy.

When these scenarios take place, monetary policy, which includes things like moving official interest rates, conducting quantitative easing or tightening and adding or loosening banking regulations, is deployed by a country’s central bank in an effort to bring inflation back into a more stable and productive range.

Let’s work through these three destructive inflation events.

Hyperinflation

Hyperinflation is when a country’s domestic inflation rate rises rapidly while the value of the country’s currency plummets. The trigger to officially call inflation hyperinflation is when prices rise by at least 50% each month.

Hyperinflation is rare but there are plenty of examples throughout history of hyperinflation taking hold, mostly during civil unrest, war time or regime changes which render the respective currency worthless.

The best-known example of hyperinflation occurred in the Weimar Republic, the government of Germany from 1919 to 1933. Prices rose by tens of thousands of per cent each month, meaning a full wheelbarrow of money was needed to buy a single loaf of bread. This seized up the economy, lead to mass unemployment and eventually a regime change – Nazi Germany.

Modern examples of hyperinflation are the Venezuelan and Zimbabwean experiences where government policies directly led to hyperinflation and the local currency being effectively worthless.

In all cases central banks were forced to increase interest rates to try and slow down the ever-increasing price rises but to no avail.

Although not technically hyperinflation, one country to watch that is having issues with managing its rapidly increasing inflation because of government regime is Turkey.

Inflation in Turkey currently sits at 16.6% and has reached as high as 17.1% so far this year. The country has a massive debt problem brought about by government policy and a currency that is fast becoming worthless.

In an effort to curb the inflation crisis Turkey’s central bank has tried to increase interest rates several times since 2018, only for the President to sack the governor of the institution. He has done this three times in the past two years.

Deflation

Inflation doesn’t always go up - it can also contract. This is known as deflation. This price decline can occur across a good, a service, a whole sector or throughout the entire economy, but all are types of deflation.

Now, while, it might be enticing to think you could buy something for less tomorrow or next week, deflation can be even more dangerous than unchecked inflation.

The reason for this is that when deflation takes hold, consumers delay their purchases today for some time in the future when they know the price will be cheaper. Unchecked, deflation can diminish or seize up economic growth, which annihilates wages and fractures an economy.

Deflation is sometimes referred to as the “central banker’s nightmare”. Unlike rampant inflation where monetary policy can be used to slow it down with interest rate increases or regulatory restrictions, deflation requires a loosening of policy i.e., cutting interest rates, and undertaking programs that could stimulate spending. But what if official interest rates are already at or near zero and deflation is still taking hold, what then? How do you get the population to consume and invest?

Japan has experienced several bouts of deflation in the past three decades. But deflation really escalated after the Asian Financial Crisis of 1997. This event saw the Bank of Japan cut official interest rates to zero to help Japan recover from the fallout. But unlike what had been seen in decades gone by from this kind of action, inflation didn’t recover and neither did growth.

In fact, Japan was stuck in a deflationary spiral until late 1999 and even when inflation did start to improve it never returned to a consistent rate seen before deflation took hold. This is the nightmare of deflation and why some believe it’s worse than hyperinflation.

Stagflation

Stagflation is when inflation remains high, but a country’s economy is contracting and unemployment is rising.

Under normal circumstances, as unemployment increases, consumer demand decreases because people spend less. Lower demand means lower prices, which helps reset purchasing power. However, in stagflation this reset doesn’t take place even as consumer spending decreases, making things progressively more expensive. The best examples of stagflation have occurred in oil. Think of the 1970’s US oil crisis when the Organisation of Petroleum Exporting Countries (OPEC) put an embargo on shipments to the US driving up petrol prices even though the US was experiencing a recession which lowered GDP and drove up unemployment.

There are plenty of other inflation scenarios we could discuss like disinflation, where price rises are decreasing over time or reflation, snapping out of deflation. But these are normally short term and not as destructive as the three discussed here.

The final part of the inflation puzzle is how to beat it – investment. This is what we will discuss in the final part of this Nuts and Bolts series. Stay tuned!