There is very little (if any) concern these days regarding inflation, following years of greater worry over disinflation and even deflation. In fact, in recent years, the Federal Reserve has had difficulty (in its management of the currency and interest rates) reaching the often-stated goal of 2% annualized inflation.
What is inflation? It’s when prices for pretty much everything – food, energy, healthcare, consumer goods, real estate, transportation, commodities, etc. go higher and higher, making the necessities of life more expensive. Inflation thus means rising costs, reducing everyone’s standard of living.
Why would the Fed want any inflation? The big reason is that the government can pay off its massive debt (now over $22 trillion and growing $1 trillion per year) in depreciated dollars. But, the Fed doesn’t want too much inflation because interest rates go up and debt service payments surge, crowding out spending on other government programs and offsetting the advantage of paying back debt with cheapened dollars.
What causes inflation? Milton Friedman, noted economist said that inflation is “always and everywhere a monetary phenomenon” – too many dollars being printed (out of thin air), chasing goods and services produced by the economy – growing at a slower pace. Since the Great Recession of 2008, in an effort to revitalize the economy, the Fed turned to ‘quantitative easing’ – significantly lowering interest rates and more than quadrupling the money supply. Over the last decade, the money supply has increased from about $800 billion to $4 trillion.
Why hasn’t this massive increase in money supply caused higher inflation? There are many reasons:
- Other major countries of the world have negative interest rates, increasing demand for U.S. Treasuries that pay a positive (albeit modest) rate. This excess demand for U.S. bonds increases prices, keeping interest rates low.
- Much of the newly printed money was invested in the stock market – inflating stock values. Historically, bull markets become excessive when the P/E (price to earnings) ratio goes above 15 to 18. It reached 33 before crashing in the years 2000 to 2002. It was 25 at a recent market high in January 2018 and is currently 22 – still on the high side.
- Other major country currencies such as the Euro, Yen, Yuan and Pound have been debased even more than the dollar, which makes holding dollars seem safer.
- There is less reliance on debt financing (loan demand) normally necessary for capital intensive industries in this ‘information age’. Low bond supply coupled with rising bond demand equates to higher bond prices, translating into lower yields.
- Heightened geopolitical concerns are prompting foreign investment into the relative safety of U.S. Treasuries, keeping prices high and yields low. Also, the significant U.S. military (peace keeping) presence throughout the world enhances an image of strength and security.
- Perpetually low inflation has been psychologically imbedded into consumers’ minds by the new ‘Modern Monetary Theory (MMT)’ that government deficits and debt stimulate demand and real economic growth. In reality, MMT is a rationale for government expansion, not an enhancement of the private sector – the source of real economic growth.
- The U.S. dollar is a reserve currency – most of the world’s transactions are completed in dollars, considered the safest, most stable currency of all major sovereign nations. The U.S. is also viewed as the protector of world trade.
Why is MMT (now increasingly being accepted by many politicians) a dangerous concept? Macro economists of all stripes (especially Keynesians) have historically searched for methods to achieve non-inflationary economic growth, mostly employing monetary tools – Federal Reserve open market transactions, establishing the federal funds rate and setting bank reserve requirements. MMT introduces something new – unlimited deficit spending, literally ‘force feeding’ excessive government spending that is erroneously called ‘investment’.
But, government spending is not capital investment in plant, equipment, technologies or new creative ideas that produce services and products consumers actually need and want. Meaningful economic growth, low inflation, stable interest rates and steadily rising financial markets is economic nirvana that has never occurred before except during brief periods of time. There is no such perpetual economic motion machine. Ultimately, deficits and debt (borrowed money) lead to inflation because treasury borrowings (bonds) must be redeemed with fiat money – called ‘monetization of the debt’ – the literal creation of money out of thin air. If real goods and services don’t expand at the same pace as money growth, prices go up.
What are the factors and risks that inflation could return? The best template for answering this question is to look what happened in the 1970’s when inflation ran out of control. Even though the dollar was the reserve currency of the world, the U.S. suffered a crushing recession and a very poor world image following the Vietnam War. Contributing to the problem were government missteps – removal of the gold standard and the imposition of wage and price controls. And, of course, government spending went up as tax revenues went down during the recession, requiring more deficit spending and borrowing – this new debt – ultimately monetized, exacerbating inflation.
Is inflation beginning to return? Commodity and natural resource prices are up materially in the first half of 2019. A good way to detect the re-emergence of inflation is to watch commodity and natural resource prices. According to the Gartman Letter dated 6.17.19, the Thomson Reuters/CRB Index is up 6.9% year to date – hardly an indication of disinflation. Over the prior 10 years, natural resources have averaged about 2% annually – pretty much mirroring inflation and significantly underperforming other financial assets.
Over the years, aren’t prices for some consumer goods and services a lot higher than the published annualized rates of about 2%? Definitely. According to a ‘Seeking Alpha’ article dated 1/13/19, over the past 20 years ending in 2018, hospital services are up about 10% per year. College tuition is up an annualized 9%; hourly wages, 4% per year; housing, 3%; food and beverages, 3%. Prices for some things like cars, household furnishings and clothing have moved sideways while prices for cell phones, computers, toys and TV’s have declined, bringing down the overall average inflation rate to 2%. Advances in technology should continue to improve cost efficiencies, however, likely to be incremental compared to the huge advances over the last 20 years.
How do you protect your portfolio from inflation? The most straightforward, safe, low cost and broadly diversified way to achieve inflation protection is to include real asset funds and inflation linked fixed income funds in your portfolio asset allocation. Real assets include real estate, REIT’s, infrastructure companies, timber, energy, grains, livestock, soft commodities (like sugar, coffee, cotton), industrial metals and precious metals.