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Rising Inflation is a Bigger Tax Bite than Oil

“Rising Oil prices are like a tax.” 

I’ve heard that canard repeatedly over the years. There are lots of reasons why this is not quite true – unlike a tax, lots of petrodollars leave the country, and don’t get recirculated. However, high Oil prices are a drag on very specific types of consumptive activity: driving, traveling, manufacturing, home heating are the prime endeavors that get curtailed.

Inflation is a much more pernicious a “Tax” than Oil – and on more kinds of economic activity. The ongoing reduction of the dollar’s purchasing power (a/k/a inflation) impacts much more of the economy than even energy price increases do. Consider high energy prices are merely one aspect of inflation. Everything else that rises in price – from industrial metals to insurance to housing to health care to construction materials to education to food to precious metals – impacts everything else, plus a wealth of activity that inflation acts as a tariff upon.

High inflation taxes savings, as a dollar saved becomes only a half-a-dollar earned. Indeed, why save if all you accomplish is watching your purchasing power erode? (Perhaps this is why the savings rate has plummeted). Inflation also hurts investment, as it reduces real returns, and therefore discourages parking monies for longer periods of time.

As we have heard so often from the politicos, if you want less of something, tax it more. Those who are willing to appease inflation and sacrifice long term purchasing power for a short term growth spurt do just that:  They discourage savings, retard investment, reduce consumption, dampen hiring. If you ask me, that’s a really bad tax policy.

Consider a home purchased in 1970 for $100,000; If it was sold for $400,000  $514,949 today, (according to BLS Inflation calculator) the gain would merely cover inflation. In real, after-inflation terms, your returns were zero – Nada, zip, zilch, nothing. And that is why inflation is so pernicious, and why it is incumbent upon the Fed to stay on top of it, even daresay I at the risk of slowing growth.

Ponder this: The Dow and SPX, despite reaching 5-year highs, have returned less than 5%/year over the same period. Though CPI estimates for inflation are below 5%, we know in real world terms (where we eat and use energy) these gains failed to keep up with inflation. In other words, real returns are negative versus actual – not BLS measured – inflation. Perhaps that explains why U.S. Equity markets have under-performed every other asset class and emerging market, with the lone exception being U.S. Treasuries.

Away from inflation – or perhaps because of it – we continue to watch the markets internals slowly deteriorate: The advance decline line has not confirmed recent Dow highs; the NYSE A/D line topped out in March. Meanwhile, mutual fund cash levels are down to low levels. And, we are about to enter the seasonally weakest period of the year. We have been positioned as “uncomfortably” bullish these past few months -- our view remains first half rally, second half trouble -- and we note that these elements mean risk is rising.

We strongly urge increased caution.

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Originally emailed 5/2/06 ~11am

Wednesday, May 03, 2006 | 11:30 AM | Permalink | Comments (38) | TrackBack (0)
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"Consider a home purchased in 1970 for $100,000; If it was sold for $400,000 $514,949 today, (according to BLS Inflation calculator) the gain would merely cover inflation. In real, after-inflation terms, your returns were zero – Nada, zip, zilch, nothing. "

Not exactly. You've had a place to live and the only tax deduction/shelter left, on your mortgage interest, right?

Posted by: Ned | May 3, 2006 11:46:36 AM