Inflation

Inflation seems to be heating up, although not in any large way at this time. Food and energy are leading the way. The BLS gave its report for April:

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.4 percent in April on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 3.2 percent before seasonal adjustment.. ... The 12-month increases of major indexes continue to climb. The all items index rose 3.2 percent for the 12 months ending April 2011, the highest figure since October 2008. The energy index has now risen 19.0 percent over the last 12 months, with the gasoline index up 33.1 percent. The food index has risen 3.2 percent while the index for all items less food and energy has increased 1.3 percent; both figures represent increases over recent months.

(Thanks to Karl Denninger for the link) 

My guess is that inflation will be tamer in the next few months as oil prices are dropping and the dollar increasing. This is in spite of the traditional increase in gas for the summer driving season. Continued low interest rates will also tend to keep inflation lower. I do expect higher inflation, but not the catastrophe that some, like Peter Schiff, are predicting.  

I see a repetition of the 70’s, a decade of stagflation. Historically Nixon imposed wage/price controls on August 15, 1971 when the inflation rate was the “intolerable” rate of 4%--about what we have now. Like the proverbial frogs in water that are gradually brought to a boil who do not realize they are boiling to death, we do not perceive that 4% is very bad. It will get worse, but not until after Obama is reelected. What was horrible in 1971 is the “new normal.” If we are lucky, that is all the inflation we will get.

Here are three case studies to show the negative effects of inflation: A small business, a retired person, and a real estate investment. I am going to assume that inflation is 5%, and the tax rate is 50% (state and federal), with 20% rate for capital gains (state and federal).

Small Business

Let’s say we have a small business with $1 million in inventory. It pays its owner a market salary for the work he does. The business is making $50,000 a year. It has made more in the past but times are tough. At the end of this business year its inventory is now $1,050,000. As a result of the increase of inventory, because of the way inventory accounting works, the business will show an additional income of $50,000. For tax purposes the business income is $100,000. The tax bill (assuming that the business income is applied to the highest marginal rate) is $50,000. The bill paid to suppliers for the additional inventory is $50,000. So while the business seems to be making money, in fact it has a negative cash flow of $50,000 a year. Do you wonder why small business is not hiring?

Retired

The hypothetical retired person I am imagining here is not your typical baby boomer. This person actually saved money! Let’s assume that the interest rate they are receiving is 8% with that 5% inflation we are assuming. This is a very generous assumption as the current rate is not even 2% unless you take the risk of lending money out at a longer term, a very bad idea in this environment. This hypothetical person pays taxes of 4% on the 8% they receive. So their net after taxes is 4%. Since inflation is 5% they are losing money every year. 1% in fact. It is far worse for the retired person today who actually gets less for their money than the inflation rate, yet must still pay taxes on that money. In other words they are paying “income” taxes when they have no income after inflation is factored in.

Real Estate 

Our real estate investor invests in a parcel of land for $1 million. He keeps it ten years. He sells it for $1.5 million. He pays his tax of $100,000 and thinks he did well. But in fact with inflation at 5% for those ten years, he has $1.6 million in the property in terms of purchasing power. In order to break even after taxes the investor needs $1.75 million in the sales price after closing costs.

Mad as Hell?

Of course each of these people in these case studies are wealthy individuals deserving of a tax increase come 2013. (Sarcasm alert.) The super wealthy, of course, will not be affected as much, as they understand this and hedge their investments. It is the moderately wealthy, the suckers, who pay and pay. There are not enough of these people to generate real money, so the middle class is going to suffer as well. This is especially true if the entrepreneurial class stops investing and hiring the middle class to work for them.

But the real unforeseen effect of inflation is the false signals that are given to each of our people in these case studies. They think they are doing well, but in fact they are losing money. These false signals are distorting the economy and are the major source of our boom/bust history. Yes they will survive, but if they realize they are being had and that the system is stacked against them, then watch out as investment and savings plummet. If they realize that the system, Babylon the Great, has stacked the deck against them, the only rational thing to do is not play the game.