What Goes Up

One of the most enduring achievements of the late Ronald Reagan "stands all but overlooked," my colleague Robert J. Samuelson wrote in The Post last week. Reagan whipped inflation.

It's easy for us to forget, but in 1979, on the eve of Reagan's election, inflation was terrifying and debilitating, with "the kind of dominance that no other issue has had since World War II," according to opinion expert Daniel Yankelovitch.

In 1976, the consumer price index, our standard measure of inflation, rose 4.9 percent; in 1979, it rose an incredible 13.3 percent, with no end in sight. As the 1980 vote approached, the public rated the problem of "holding down inflation" three times as important as "finding jobs" -- even though the unemployment rate was a hefty 7.1 percent.

It was Paul Volcker, the talented and courageous Federal Reserve chairman, who raised interest rates and brought inflation below 4 percent by 1982, triggering a recession in the process. But it was Reagan who supported and encouraged Volcker and gave him what David Stockman, then the budget director, called "the political latitude to do what had to be done."

With the exception of 1990, when it spiked to 6 percent, inflation has remained relatively tame for the past 22 years, but there are now signs that it is rising again. Over the past three months, the change in the CPI, on an annualized basis, has been 3.9 percent. While much of that increase stems from the sharp increase in the price of a single commodity, oil, it's still a troubling development.

What's wrong with inflation? It demoralizes consumers, destroys the buying power of people on fixed incomes and makes rational planning extremely difficult for businesses.

Inflation causes interest rates to rise. Say you lend someone $1,000 for 10 years (the same procedure as investing in bonds). Because of inflation, the $1,000 you get back at maturity can't purchase as much as the $1,000 you originally lent, so you demand higher rates of interest to compensate for the loss; the higher the expected inflation, the more interest you'll demand.

Also, as Volcker demonstrated, inflation inevitably leads to action by the Fed -- hikes in short-term rates to bring rising prices to heel. Nearly everyone expects the Fed to start raising rates again, either at its meeting June 29 or the one on Aug. 10.

High interest rates deter consumers from buying houses, cars and other big-ticket items because they can't handle the debt load. Higher rates also raise corporate borrowing costs and cut into profits. And, finally, higher rates make lending more attractive, enticing investors to sell stocks and switch into bonds, causing stock prices to stagnate or fall.

In the June 4 issue of his influential newsletter, Grant's Interest Rate Observer, James Grant, an expert on the history of debt, argued that we're heading into a new secular, or long-term, period of rising interest rates. The cycles are clear: Interest rates fell in the last 40 years of the 19th century, rose in the first 20 years of the 20th century, fell between 1920 and 1946, rose between 1946 and 1981, and fell between 1981 and 2003.