Inflation – Closer Than You Think: Understanding the Lag Factor

This is the second installment of our series on inflation in the economy. In the first installment, we defined inflation, examined its causes and delineated where I believe inflation may be headed (10%, based on the size of the U.S. money supply). Since that writing, the Federal Reserve has announced the purchase of another $600 billion in U.S. Treasury bonds. This should provide excellent “kindling” for the inflation bonfire that we’re expecting.

In this installment, we’re going to talk about why, despite the huge increase in the money supply, inflation has remained relatively low. The currently low rate of inflation is due to what’s know as the “lag factor.”

The sudden growth in our money supply is similar to the housing boom of 2001-2006. In the past, we have experienced periods of rapidly increasing housing prices but, we had never experienced anything like the increase in home prices that occurred between 2001 and 2006. Most people treated the unprecedented rise in housing prices like it was just another real estate boom. In hindsight, this was the most massive real estate bubble in our nation’s history, but most people didn’t view it as such at the time. The same will be true with the massive increase in the money supply and the future inflation that it will cause. Afterwards, it will be obvious that this large increase in the money supply eventually created inflation, but right now, for most people, it’s not very obvious at all.

Many people are hoping that the economy will make a tremendous recovery and the massive amounts of extra money will be absorbed into the growing economy. There are also those that believe that the Fed will be able to figure out an “exit strategy” before inflation takes hold.

Why are all these people in denial? Because, it is very uncomfortable to face the truth. Everyone wants stability. Inflation effects everyone in a negative way, including investment bankers, economists, and government officials. And that’s especially true of the very high inflation that is experienced in a bubble economy. Many incorrectly believe that if a large increase in the money supply was going to trigger inflation, it would have done so by now.

Understanding Lag Factors
Inflation doesn’t always occur immediately after an increase in the money supply, due to what economists call “lag factors.” Lag factors normally delay inflation for 18 – 24 months. In 1999, Fed Chairman Ben Bernanke wrote a paper, along with several other authors (Laubach, Mishkin, and Posen), that examined past periods of inflation and determined that a two year lag was the most common estimate they encountered in their research.

What Bernake and his co-authors discovered is that the positive impacts of increasing the money supply occur much more quickly than the negative impact of inflation. During and after World War I, Germany wanted to raise money for the war without raising taxes and then she was forced to pay about $33 billion in war reparations that she did not have. The German government decided to just print more money, rather than raise taxes and they printed lots of it!

Many people remember the German Weimar Republic for the pictures of wheel barrows of paper money that were needed to buy almost anything. What few people remember is that when Germany began to rapidly expand its money supply, it experienced very rapid economic growth and unemployment of less than 1%. But the positive impacts of printing lots of money came with a very heavy future price; the worst hyper-inflation the world had ever seen. In late 1923, it took 42 billion German marks to buy just one U.S. cent. And it took 726 billion marks to buy something that, just four years earlier, had only cost one mark.

The joys of printing money come quickly, the pain comes later. There are lots of short-term gains, followed by lots and lots of long-term pain. Inflation is very hard to control once it gets going because getting rid of inflation causes even more economic pain.

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