Inflation and Investor Sentiment

Copyright, The New York Times Company

The easy monetary policy at the end of 2008 has set up our economy for inflation, but the timing depends in part on how investors behave.

Last week I showed how the Federal Reserve dramatically expanded the monetary base (that is, the value of currency, coin and Federal Reserve deposits) at the end of 2008, and how nothing like this occurred during the onset of the Great Depression of the 1930s.

Still, even though monetary policy is so different in this recession as compared with the policies of the 1930s, inflation has not yet been very different.

During most of our lifetimes, there has been inflation: The prices of things we buy have generally increased over time. Only on rare occasions have consumer price trends suddenly changed directions.

One of those occasions was 1929.

Consumer prices were pretty constant in the 1920s. The chart below picks up the story in January 1929 with the red line. That line measures the (seasonally unadjusted) consumer price index in each month through July 1930, normalized so that October 1929 is 100 (for example, the value of 97.9 in April 1929 means that prices then were 2.1 percent lower than they would be in October).

In the fall of 1929, the inflation stopped (incidentally, the stock market crashed in late October of that year) and prices headed down, falling almost every month for almost four years.

For the first 15 months or so of this recession, consumer prices have followed a similar pattern. The blue series in the chart shows the consumer price index for 2008 and 2009. Like the 1929 series, the 2008 series is normalized so that October is 100.

The chart shows how consumer prices also rose in the spring and early summer of 2008. Inflation had stopped by the fall (there was a stock market crash in October 2008, too), and consumer prices headed down. In fact, the deflation at the end of 2008 brought prices down more than 4 percent in a couple of months, as compared with a 1 percent drop at the end of 1929.

The actions of the Federal Reserve and its chairman Ben S. Bernanke guarantee that we will not experience a four-year deflation like that of the Great Depression. But investor sentiment is an important reason why the short-run inflation patterns have been similar in 2008-’09 to what they were in 1929-’30.

During both episodes, investors had a sudden reduction in their willingness to hold private sector debt and equity and to purchase goods, and a sudden increase in their desire to hold “quality” assets like Treasury bills.

An increase in Treasury bill prices is one way markets adjust to this change in demand — and we saw this in September through December of last year — but another market adjustment is for the prices of goods, equities, and private sector debt to fall (or rise less than they would have) as investors pull their money out of these categories. Deflation is, by definition, a drop in goods prices.

Part of the next inflation may be the reverse of this process: Investors suddenly shift their demands from “quality” assets back to equities, private sector debt and goods. As some of the commenters explained last week, a sudden investor shift like this will be associated with a sharp reduction in the value of the dollar.

If I could predict exactly when investor demands will shift away from “quality” assets, both I and the readers of this blog might get as rich as the billionaire financier Warren E. Buffett. But recognizing the role of investor sentiment at least helps us appreciate why the timing of the next inflation is so uncertain.