Ready for Inflation?

by Mike

I’ve covered two linchpins of personal financial planning in previous posts: knowing your net worth in “You Need Your F*@k You Money ” and the importance of understanding and controlling your spending in “Follow the Money!”  Today I’d like to turn to a macroeconomic issue that I believe we’ll all need to factor into our own personal planning soon – Inflation.

I have so far been proven wrong in my expectation of an imminent return of high inflation to the US economy.  I remain convinced, however, that inflation is destined to return to the economy relatively soon, and we all need to factor that in to our financial planning.

Let’s cover the reasons I think a return to high inflation is inevitable:

  1. War.  We refused to pay for the wars in Iraq and Afghanistan.  Instead of paying for the wars through austerity and raising taxes (as we did in World War II) we instead lowered taxes, especially on the wealthy and financed the wars through debt (as we did for the Vietnam War).  History shows that expensive wars financed by debt result in high inflation.
  2. Money.  In order to avoid a far deeper recession or even financial collapse and depression, the US Federal Reserve Bank and the US Treasury have pursued monetary policies that have expanded the monetary base and kept money free.  This has been through a combination of policies like a zero or nearly-zero federal funds rate (at which select big banks can borrow money from the government) as well as “Quantitative Easing” which basically creates new money from thin air with the US Treasuring pumping out new bonds which the Federal Reserve buys.  While these policies may have been necessary to avoid a complete collapse of the real estate market and widespread bankruptcies by financial institutions, it can’t last.  All of this money has been soaked up by financial institutions strengthening their balance sheets, and for the most part has not been put back into the economy – so monetary velocity has dropped to a crawl.  When credit starts to flow and consumers and businesses start to buy, we’ll have too much money chasing too few goods, monetary velocity will increase and inflation will set in.
  3. Deficits.  We now have structural governmental deficits that we can’t seem to fix.  Republicans have refused to raise taxes, most recently even on the wealthiest 2% of Americans, from historically low levels.  On the spending side we have entitlements (like Social Security, Medicare, Medicaid) and an enormous defense budget that would be unpopular and politically disastrous to cut.  So we are left with huge deficits at the State and Federal levels.
  4. Oil & Commodities.  Oil is the most fundamental commodity to the US and world economy.  Energy fuels the vast majority of our economic engine.  Increased demand from rapid economic growth and increased consumption in China and India plus increased instability in the Middle East will probably result in continued high prices of oil.  High oil prices will soon be reflected in upward price pressure on all manufactured goods, including food.

What are some countervailing pressures that have prevented inflation from getting into the US economy?

  1. Recession.  We have just gone through a very deep recession.  This has kept a lid on inflation – and some have even worried about deflation in this period of weak demand.  Others believe that we are headed to a “double-dip recession,” and that the GDP gains we’ve seen for the past few quarters are unsustainable since they have been driven by record government spending and deficits (TARP and stimulus) and cheap money.  If we do hit a double-dip recession this would delay a return of inflation.
  2. Unemployment. While the economy has recovered and is now delivering some growth, it has largely been a jobless recovery, with unemployment hovering around 10% nationally, over 12% in California, and at dramatically higher levels among minorities and in major cities.  This means decreased demand as people scrape to get by.  How can the economy be growing with such high unemployment?  Increased productivity.   I would argue that in this cycle we have seen a structural change – i.e. productivity levels have changed for the long term, and a broad range of middle-income jobs have disappeared forever.  Unemployment is likely to stay high for a while, leading to continued weak consumer demand.
  3. Saving.  Americans responded to the recession by reducing debt and increasing savings rate by a huge amount.  From a rate of just over 1% in 2005, the personal saving rate in the US jumped to around 6% for most of 2010.  While this is great for the individuals who are saving (we had one of the lowest saving rates in the world), it dampens consumer demand for goods and draws out the recession.  I’m betting that we will soon see some pent up demand for consumption of goods (especially durables where replacement decisions for things like cars were relatively easy to defer) will return and our saving rate overall will drop.
  4. Credit.   Directly related to the saving rate has been the restriction of consumer credit.  In response to the worsening economic situation providers of consumer credit cut back on credit.  They canceled credit cards or reduced limits.  They increased down payments required for mortgages.  All sensible things.  But it has resulted in the interesting phenomenon of free money to the big banks, but no credit for economically weak individual.  This has dampened demand for goods.  But the credit card industry has already started up its marketing engine, because to make money it has to provide credit.

So what does all this mean for you?  Most economists agree that some inflation is a good thing, as long as it is at a relatively low level and is predictable.  It allows people and businesses to make rational investment decisions and works hand-in-hand with a growing economy that is fueled by steady productivity gains.  High and unpredictable inflation, however, can destroy an economy.  The Germans, for example, lived through the hyperinflation between the World Wars and because of this history are hyper-vigilant against allowing inflation to get a foothold in their economy.  This has placed additional stress on the EU monetary union as other government’s run deficits and put inflationary pressure on the Euro.

If I am right and we see a return to high inflation in the US, you’ll need to make sure your investment plan anticipates this.  That means you should not buy an asset (like a house) using short term low interest loans that grow over time, because you could get caught having to refinance as significantly higher rates.  Instead if you plan to stay in your place for a while, you should try to lock in these low rates for as long as possible.  If you borrow a large amount of money at a fixed rate and inflation goes up, you’ll be repaying the loan with dollars after inflation.  On the investment side it means that you should not lock in low long-term return financial instruments like bonds, Treasury notes or fixed rate annuity products.

Unfortunately there aren’t a lot of asset classes that seem poised for inflation-beating returns.  Equities have already returned to high historical levels (as measured by price to earnings or PE) over the past year, commodities have already leapt up, real estate is still grinding along working through foreclosures and the building glut of the last decade.  So the only advice I have is to keep relatively more of your money in shorter-term interest bearing products, but be especially quality conscious.

As always the best solution is stay nimble and aware, but keep your long term goals in focus.  The best thing you can do to make sure you are financially secure is to know your personal financial situation, live within your means, and save as much money as you can.

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