Inflation Is Everywhere

On the other hand, it would be equally fair to say "better late than never." All the realities I've been talking about in this column for so long have finally begun to catch up with the bond market. By the way, I'm not the only one who has waited impatiently for this day of reckoning. As recently as a month ago Alan Greenspan called low bond yields a "conundrum" and an "aberration."

Why have bond yields stayed so low — and bond prices so high — for so long? And what's different all of a sudden?

I think the answer can be summed up in one word: inflation. It's not just that investors have forgotten about the ravenous beast that did so much damage to our economy and our markets in the 1970s and 1980s. More than that, it's that there are some unique things going on in the world that have convinced investors — falsely convinced, I should say — that inflation cannot possibly be a threat now. But make no mistake: It is a threat.

Investors have been making a mistake about inflation not because they're stupid. Actually, it's because they're too clever. They are sagely detecting a quantum shift in the U.S. economy toward immensely higher productivity. PCs... the Internet... just-in-time logistics... and most of all, cheap labor from China and India — it really is a new world now, in which we can produce goods and services at lower prices. How can inflation be a threat?

Simple, and here's where investors have been too clever: They've forgotten that falling prices doesn't necessarily mean there's no inflation. You can have falling prices and inflation at the same time. In fact, I'm convinced that's just what's going on.

It sounds counterintuitive, but remember one basic principle and you won't go wrong. Prices rise and fall for many reasons. But inflation is involved in those price changes only when the value of money itself changes.

Keep in mind that the price of a good is really that good's "exchange rate" for the currency in which it is priced. If apples are priced at 50 cents apiece, that means it costs one dollar to buy two apples — or, just as true, it costs one apple to buy half a dollar. That exchange rate can change for two reasons: Either something happens to apples, or something happens to the dollar. If it's the dollar that something happens to, then it's inflation.

Now here's where it gets complicated. Suppose something happens to apples and to the dollar at the same time?

Suppose we suddenly start getting all our apples from China and India, where labor is cheaper. If we knew for sure that the dollar was rock-steady, then we'd expect the price of apples to go down. Let's say labor is so cheap there that the price of apples would fall by half, to only 25 cents each.

But suppose — at the very same time — that the dollar is not rock-steady. Let's say the Federal Reserve goes on an inflationary binge and effectively prints money around the clock, doubling the amount in circulation. If it weren't for the cheap labor in China and India, 50-cent apples would inflate to $1 each. But thanks to that labor, 25-cent apples inflate to 50-cent apples.