Inflation – A Threat To Your Savings

Tthe 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 almost $37 trillion and growing over $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, extending into the Covid crisis, 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 $12 trillion to $22 trillion.

Why hasn’t this massive increase in money supply caused even higher (runaway) inflation?  There are many reasons:

• Other major countries of the world have maintained negative interest rate policies, increasing demand for U.S. Treasuries that pay a positive rate. This excess demand for U.S. bonds increases prices, keeping interest rates steady.
• 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 the market high in January 2018 and currently remains at that level (experiencing typical volatility since 2018) – 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 / digital age’.  Low bond supply coupled with rising bond demand equates to higher bond prices, stablizing yields.
• Heightened geopolitical concerns are prompting foreign investment into the relative safety of U.S. Treasuries, keeping prices high and yields lower. 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 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 – ie… inflation.

What are the factors and risks that inflation accelerates at a more dangerous pace?  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, exacerbated inflation and very high interest rates.

Is consistently rising inflation inevitable (and permanent)?  Commodity and natural resource prices (up materially since 2019) are a possible indicator of permanent inflation.  A good way to detect the re-emergence of inflation is to watch commodity and natural resource prices – all significantly higher (especially gold).  Inevitable, permanent inflation can be avoided by paying down government debt; cutting government spending and strong economic growth while maintaining money supply growth that parallels economic growth.

Over the years, aren’t prices for some consumer goods and services a lot higher than the published annualized rates?  Definitely.  Over the past 20 years, prices for hospital services; college tuition; hourly wages; housing; food and beverages are significantly higher.  Prices for some things like energy, cars, household furnishings and clothing are moderately higher while prices for technology-based products and services such as software, cell phones, computers and TV’s have declined, bringing down the overall average inflation rate.  Advances in technology such as AI should continue to improve cost efficiencies.  However, chronic inflation is likely given the constant political pressure favoring deficit spending, rising debt and money creation.  Also, an enduring 10% global tariff base (where the recent trade negotiations seem to be headed) and China (as well as other countries), avoiding trade agreements with ‘passive / aggressive’ trade policies (enacting hidden non-tariff barriers to foreign goods) over the long term is inflationary.  

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 equity ETF’s, funds and stocks of companies with pricing power, 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, water, grains, livestock, soft commodities (like foodstuffs, coffee, cotton), industrial metals and precious metals.