When inflation ran wild

Globe Investor Magazine, May 22, 2008
Photograph by CP Photo;
Graph by Douglas Coull (Source: Statistics Canada)

Inflation is running at 2.2% in Canada. At that rate, a litre of milk will cost a nickel more next year. So, what's all the fuss about? While five cents is hardly a runaway increase, inflation remains a hot topic because rising food prices threaten to make things much worse. Recently, it rose to over 4% in the U.S., and many people are worried inflation could spread like wildfire. "The U.S. is now ground zero for global inflation," says Ken Rogoff, professor of economics at Harvard. He's alluding to the fact that when the U.S. cuts interest rates, other countries are prodded into doing the same to prevent their already-high currencies from soaring further.

The worry stems from the belief that the U.S. Federal Reserve is more concerned with heading off a recession by lowering interest rates than with keeping inflation in check. The more the Fed cuts rates, the more other central banks follow suit, setting the stage for a repeat of the last time inflation went unchecked. That was back in the 1970s and early '80s, when it topped out at 12.5% in Canada.

High inflation erodes the purchasing power of money. An inflation rate of just 2% means that a dollar will lose half its value in 35 years; at 4%, a dollar will get sliced in half in 17 years; at 6%, it will take just 11 years. Meanwhile, bond investors get killed because their 5% bonds lose money when inflation is running at 6%. And one of the few good ways of beating inflation entails raising interest rates-which usually chokes economic growth.

To stamp out rising inflation, the Bank of Canada raised its key lending rate in 1981 to an astounding 21%. Economic growth withered, and in 1982 Canada experienced a severe recession that shrank its gross domestic product by 6.7% over 18 months, and sent unemployment up to 13%. The stock market was no safe haven. The benchmark stock index ended 1982 at the same level it began. After accounting for inflation, stocks actually sank over a period of 14 years.

Can inflation get as high as 12% again? That's the fear. -David Berman