The Impact Of Inflation On Long Term Contracts

By Ted Dieck | Employers Intelligence - Compensation - Employee Relations - Pick | Sep 14, 2012

How can prices keep rising, while the Consumer Price Index barely moves? Do low interest rates mean we have no inflation? There’s nothing here we have to worry about, right? (Right?)

I attended a meeting this week that included negotiation of a five year contract. The employee had written his own renewal agreement, extending his current employment.

Pay, bonuses, and refinements were negotiated with a committee representing the employer. The process concluded with everyone signing off on the modified document, and the meeting adjourned in good spirits.

So far, so good.

Inflation Warps Long Term Obligations

Stuck in my memory, however, is a moment when I warned the employer that raging inflation could become an issue during that five year time period.

An attorney laughed off my concerns, initially thinking I was kidding.

I’m not kidding.

I confirmed that I really do believe that inflation could cause enormous damage, and a five year pay plan with no adjustment clause is an invitation to a future renegotiation.

By the way, if you want to avoid public ridicule, you might want to avoid forecasting raging inflation, right out loud, like I did.

Earlier in the day I had also warned the employee who wrote his own contract. He, too, is unconcerned about inflation.

In fact, it’s interesting, how many people seem to think we’re in a low inflation environment right now.

Interest rates, they say, are at record lows.

And the Consumer Price Index isn’t moving much at all.

The only problem, they’ll say, is the shrinking size of products and the constantly rising prices on everything we buy.

Ummm. That’s because of inflation…

Real Life Price Tracking

Ed Butowsky is a Managing Partner of Chapwood Investments.

In his role as a financial adviser, he often finds himself explaining to clients the danger of building financial strategies against an unrealistic understanding of inflation. That can have some bad consequences.

So, to explain what’s actually happening, he created the Chapwood Index. It uses real life price tracking of products Americans buy, over time and across the country.

He offers these examples of price increases from 2008 to 2011…

Grande Starbucks Coffee +31.3%.
Basic Cable +87.5%.
Toilet Paper +33.3%.
Gallon of Milk +40.0%.
Tide Soap Powder +75.0%.

Does any of this sound familiar to you?

Now, compare these figures with the CPI reports published by the Bureau of Labor Statistics…

The word “Fantasyland” comes to mind.

Why Would Our Government Understate Inflation?

When the government fibs about inflation, it lowers its costs.

In June, Arnold Schiff explained it this way…

The current cost of money is (less than 2 percent.) And the United States borrows a blindingly large amount of money.

Currently, 6% of the federal budget goes for interest payments.

If interest rates rise to 5%, that piece of the Fed budget swells.

At a 10% interest rate, interest payments would consume 42% of the Federal budget.

That’s when very ugly things happen.

So, the government is trying to hide a massive lack of funding.

As a survivor of Jimmy Carter’s 20% inflation, I can tell you, incessant, pounding price increases can give your outlook on life a whole new perspective.

Who Pays?

Well, we do.

By introducing truckloads of fake dollars into the system, the Fed debases the dollar. It eventually trades lower and lower against other currencies.

Better enjoy your trip to Europe now, while Europeans are getting clobbered for their misdeeds.

We’ll be facing our own issues, soon enough.

For proof, you don’t have to go far to find other countries in far better circumstances. Canada, for example, didn’t engage in artificial housing markets. In addition, it doesn’t attack its own banks. U.S. citizens have lost 40% of their net worth, versus Canadians who missed out on that joy ride.

Australia is another example.

Also, anyone holding government debt gets killed by inflation.  I mean, that’s sort of the whole point.

That would make U.S. Treasury Bonds a particularly bad bet. The problem is so obvious that the largest buyer of U.S. debt is often, ummm, our own Fed.

Yep, loaning money to the good ole U. S. of A. isn’t such a good deal when you might not get your money back.

So, we print even more fake money and use it to buy even more of our debt.

No kidding.

September 13, 2012 Fed Chair Ben Bernanke announced that the Fed will buy $40 billion of U.S. debt – every month – apparently forever.

There are no limits. No dollar limits (which I suppose won’t matter, since the U.S. still has no budget.) And no time limits. Wags have already renamed QE3 with the better title, “QE-Infinity.”

One Last Caution

Rising prices do not indicate inflation.
Inflation does guarantee rising prices.

Prices can go up, simply because a product is in tight supply, or because demand has increased.

Inflation is an actual process of introducing more money into the economy.

More money, chasing the same number of goods invites buyers to bid up prices.

One Bottom Line

Actually, there are many bottom lines.

For today, I just meant to observe that today’s happy employment contract might be a problem in as little as three years.

CPI is no guide to economic reality.

And, I should add, if you’re going to invest in something, be sure it’s something tangible. Real stuff will seem to increase in value.

Good luck!