The Dangers of Rushing to Recovery

The Financial World According to Inya” Column by Inya Ivkovic, MA

As the global economy rushes towards recovery, another global threat lurks in the shadows — inflation. Granted, this may not be the most productive time to invoke horror stories of hyperinflations past in an era when inflation is no longer the number one concern for North Americans. After all, central bankers of the world’s developed economies have made it their top priority to combat inflation and keep it tamed somewhere between two percent and three percent. But, as the global economy recovers after extraordinary efforts by governments around the world to prevent it from imploding, suddenly, and justifiably, there are renewed concerns about heightened inflationary pressures. Some economists even fear hyperinflation, the kind that saw Germany issue a 500,000 banknote after the First World War; that is, the kind of banknote that could buy a house in 1921 and not even a loaf of bread in 1923.

Fears of inflation rearing its ugly head could be justified, simply because there is so much excess money sloshing around in the financial systems that the idea of too much money chasing after too few products is not that farfetched. Those fearing hyperinflation even believe that the cure prescribed to fix the Great Recession could quickly mutate into a debilitating disease and the recovery’s eventual undoing.

Inflation can be kept in check by hiking interest rates. However, most of the world’s central bankers are intent on keeping the interest rates at ultra-low levels, because they need them there to speed up economic recovery. Additionally, an epic build-up of the U.S. government debt could easily sidetrack the recovery with calls for printing more money to help pay it off faster, which would only advance the long-term inflationary impact.

In contrast, average American households are struggling under pressures of high unemployment and dormant wages. Even staggered and moderate increasing of interest rates could further squeeze paychecks, while prices of food, gas and home insurance are likely to continue on their strong upward path. But if interest rates are hiked too quickly, the effect could wreak devastation on ordinary citizens, sending even more of them back to the unemployment line.

Is a period of raging inflation really within the realm of possibility? In January, wholesale prices in the U.S. jumped 1.4%. Yet, many economists feel confident that inflationary pressures should subside in the near term. Although inflationary pressures in the early stages of an economic recovery are atypical, some argue that they should be viewed within the context of significant price declines experienced in January 2009. Furthermore supporting the sentiment is the fact that many factories and businesses that have been idling during the Great Recession could come back on-line and meet any future increases in demand. The only question is whether such unused capacity has been overstated, because this recession has been unlike any other and we could be talking about capacity destruction instead.

Inflation is like addiction. At first, a small dose of higher prices brings ecstasy. But soon, you need those prices to go higher and higher to achieve the same effect of the first hit. Back in the 1970s, when soaring inflation resulted in double-digit interest rates, economists did not fret about a little bit of inflation. It was nothing to worry about, because it boosted the economy and the labor market. Certainly, inflation worked wonderfully in the beginning. Very quickly, however, economic growth started languishing, while inflation continued on its upward path. In the end, it all spiraled out of control, resulting in huge interest rates that, for example, made homeownership impossible for most Americans.

This is why all wary eyes are now on the U.S. government’s recession exit strategy. If things were normal, a gradual raising of interest rates would make perfect sense, provided that the labor market could stabilize itself first. But that is easier said than done. If interest rates go up too fast, a snowball in hell has better chances than the U.S. labor market healing itself. And, without contributing workers, factories, and businesses happily plugging along, there is no way of getting the economy back on track. On the other hand, if interest rates are left at ultra-low levels for too long, inflation is likely to run rampant, resulting in people’s bank accounts having been ravaged, not only by the recession, but by the recovery as well.