The word “inflation” has gotten a lot of buzz lately — and for good reason. Inflation impacts just about everyone’s financials in one way or another, but it can be difficult to understand exactly how and why that happens.

The purpose of this blog post is to describe how the Federal Reserve’s actions can stimulate the economy, then cause inflation and slow the economy before starting the cycle all over again. But don’t fret — we are not going to bog you down with economic jargon.

Instead, we will tell a story about a little faraway island economy. This excerpt comes directly from Mark Boucher’s book, The Hedge Fund Edge.

“A Three Hour Tour”

Suppose you were taking a tour aboard a boat that sank and left you stranded on a deserted island with nine of your fellow survivors and a few items you were able to bring aboard your life raft. When you inventoried your goods, you found that your combined cash equaled exactly $1,000 (or $100 for each person). As you and your companions attempted to deal with your plight, you started to develop a small economy: some of you tried fishing, one person built huts, some picked coconuts, and others purified water—and you each used your $100 to trade among the 10 survivors. At times, coconuts were in shortage, and their price would rise—but that only meant that the price of fish or water had to fall commensurately, because there was only the same $1,000 total in circulation; and that was as much as the sum of the price of absolutely everything could be worth. There was no “real inflation” because the sum price of absolutely everything in the economy remained the same.

Treasure Discovery

But then one member of the group happened to find some debris from the ship that included $500 in cash. He decided not to tell the other islanders about it, and slowly but steadily he began to spend an extra dollar here and there until he had spent over $120 of the new loot. Because more dollars were competing for goods and services, prices of most goods began to rise until the other islanders noticed the increases and realized that someone must have extra undisclosed money. The inflation rate had risen 12% because the sum of the price of absolutely everything had gone up 120/1000 or 12%.

Coconut Price Index

After a long meeting in which the islanders all tried to get the guilty party to come clean to no avail, they decided to appoint one of the group to be an economic analyst. The analyst reasoned that it was too difficult to monitor the price of everything in the growing island economy, but that coconuts were an absolute staple being a source of liquid, a fruit, a plate for fish, a critical component of clothing, and an ingredient in virtually every meal. Monitoring inflation with a Coconut Price Index (CPI for short) seemed to be a sensible way of gauging when any islander spent money beyond the initial pool of cash that had been agreed on and declared.

Introducing the Central Bank (Federal Reserve)

About this time, the cash finder decided he had better cut back on spending any new money for a while. However, he also decided to scan the island for any further debris. Low and behold, he discovered a box with over $100,000 in cash. The person who found this extra cash had an odd name — Central Bank — CB for short. CB was a smart fellow, and began to realize that he could spend money pretty much however he saw fit, at least until the Coconut Price Index began to head higher. Although he was now wealthy, CB never spent his new money directly on coconuts. First he spent money to get a bigger hut. The hut-builder was willing to work harder and put in longer hours because CB could pay the going hut-rate for the extra time. After a couple weeks of this, the hut-builder got hungrier and began buying more coconuts with some of the “new money” he earned from CB. The CPI would rise a little bit, triggering suspicion and outcry from the island economist. The hut-builder, however, also put money into buying more fish, savings, and other goods, so that only a fraction of his new spending ever hit the coconut market.

Monsoon Season

Now imagine what happens if CB is using lots of new money at the time of a monsoon. Since demand for huts is paramount, almost all the new money ends up in this hot area. Naturally, CB is spending new money on improving his hut roof, but in addition nearly every dollar he spends elsewhere is taken by other islanders and put immediately into demand for hut-building services. With CB’s new money, prices of hut production don’t just skyrocket, they literally explode to much higher levels because more money is chasing the same good (service). This high price translates into an acute signal to the other islanders — several decide to drop their tasks and move toward hut production even though this is essentially a false signal. It is not that islanders want huts so much compared with other goods, but merely that new money is being funneled into a hot area masking as real demand. CB, the richest man on the island, is approached by several islanders who ask for a loan to help build up hut-production tools and facilities. It is obvious that demand is acute, and that the fisherman, coconut picker, clothier, and other islanders cannot drop their absolutely necessary daily chores to build roofs, so CB makes the loan.

Sowing the Seeds of Financial Ruin

In this situation, the new entrants spend most of their time gearing up new hut-production facilities instead of helping the existing hut-builder. After they have created new tools and roof-factories, they compete to solve the excess demand problem. But, a new problem begins to develop as the roof problem is cured and the monsoon season begins to dry up. Prices for hut-building with the new money drop severely because there is now more competition for providing hut-building services. Since the original hutmaker has tools without any debt attached, he can lower prices below that required by the other builders, who try to stick out the price war as long as their savings allow. The fisherman, clothier, and coconut producers don’t want their fellow islanders to starve or freeze, so they extend them credit, but eventually their debts become too large to facilitate. Now what will they do? Perhaps the island will have to develop some bankruptcy infrastructure.

Economic Fallout

In any case, the false signal of artificial demand has led to a misallocation of resources in favor of a hot area — and the fallout from this misallocation has serious repercussions. It requires significantly more loss of total island production in terms of time and utilization of the new hut-producers for as long as they remain in the wrong business; in terms of the loss of investment in the new factors of production that will not be utilized; and in terms of the lost credit extended by everyone to the entrepreneurs. The overall production or gross domestic product (GDP) of the island falls from the misallocation below what it would be if the farmer/gatherer simply went back to his old vocation in the proper allocation of resources. In addition, the adjustment from the misallocation takes longer, and is much more painful and widely felt by everyone on the island, than it was without the new money.

Start the Cycle Again

Now that the island economy is really struggling, CB feels bad and tries to help by spending some of this money to get the economy going again. The whole cycle starts again.

The Lesson

You can see from this example how the Federal Reserve can stimulate the economy, which is helpful at first. Over time, too much stimulus can create inflation and misallocations of resources in the economy. When the stimulus is removed, the economic pain is larger and felt more broadly than it would have been had the stimulus never been there.

Understanding this concept will help explain why stock market investors are nervous about the Federal Reserve raising interest rates and halting their bond purchases. The fear is the Monsoon Season is about to dry up.

If you have any questions about the information above, please contact your Impact Capital advisor.