I Love football. High school. College. NFL. All of them. Now, admittedly, there are brief moments where that love gets tested these days, whether that’s a hardnosed kid getting kicked out of a college game for targeting or one of those silly taunting penalties that we’ve all come to hate in the NFL. College has the better product now (especially since the employees of the multi-billion-dollar enterprise are no longer simply paid in education) and no team will match the love I have for my Indiana Hoosiers. But the 2000s were such fun for we Colts fans; watching them go on to become the winningest of any team in a decade – topping the 1980 49ers. Yes, we wish they had done more than 1-1 in super bowls – but it was a fun ride.
They had another chance at a good run in the following decade with Andrew Luck, especially the year that was stopped short by the Deflategate game. I bring that up not to dig it back up or to blame it for us stopping short of the Super Bowl. I watched that game with my own eyes…a few ounces of air in a few footballs did not decide that game. Furthermore, the discussion should have ended the next year when colts had a chance to beat the pats on the field. They didn’t. I bring it up because it became tiresome to talk about it, much like its opposite problem in economics today: Inflation. Inflation has dominated discussion for most of the year. To complement a talk I am giving this fall; I’ll summarize here the collective of these discussions I’ve been having this year.
Inflation Impacts: Investment portfolio vs. Financial Planning
When investors bring up inflation, we separate the issue between two aspects: Financial planning and investment. For investing, the job is to be repositioning amidst a changing landscape of winners and losers depending on whether we are under an inflationary or deflationary environment. Under inflationary circumstances, banks, materials and energy stocks and TIPS bonds will normally find themselves amongst the winners. Under deflationary circumstances bonds and safer noncyclical stocks are among the first to be turned to. Like every other thing with investing – this isn’t something that will be gotten right all the time. But it is continually part of the allocation dynamics, even in years where inflation isn’t such a hot and pressing topic.
For financial planning purposes, the inflationary impact is about the interaction between our savings, our future spending and what role changing price levels will play in that relationship. And these changing price levels affect us all differently depending on what our consumption basket looks like. The more it looks like the national average, the more it will resemble CPI and other well-known broad representations for inflation. The less it resembles it…the more it will be…well, different. For the financial planning implications, it’s always a good idea to test financial plans against various inflation scenarios and see what changes, if any, might need to be made. This process can help take an intangible fear and replace those fears with clarity and confidence – even if that means some changes might need to be made if the harsher scenarios do indeed play out.
Sure, as advisors it would be nice to provide a solid forecast for which direction inflation will take. But those forecasts have severe limits, and you should take them all with a grain of salt from whomever is providing them (especially the media)!
Better Luck Flipping A Coin?
In an industry that is ripe with poor forecasting, inflation predictions come in right there at the bottom. As simple as inflation is as a concept, we are far from a unified theory of understanding the forces behind it. Disagreement in the field of economics is wide on the topic and the only consistency is missed forecasts. Granted that’s a broad brush with which to paint everyone…but it is my experience from both the classroom as a student and as a CFA by profession. I just think it’s important to have this humbling reality at top of mind when providing guides to the future on the topic. With that gigantic disclosure…
Here is my read on where we are
Fears for a return to a 70s style inflation are overblown. I thoroughly respect that, at best, we can only estimate probabilities and it is certainly possible for very high levels of inflation to kick in. I just don’t see it as probable. The last several inflation readings have been in the 5% neighborhood – something we haven’t seen for some time. Its also likely overstated for the time being.
One reason for the readings this high is simply the comparisons to the relatively lower prices a year ago in the heat of the pandemic. A better way to look at it is 2-year inflation rates (chart below) to take out some of the noise of year over year comparisons. We can see that the 5% readings overstate the current rate just a bit .
However, that we are still in the upper part of the inflation range we have seen the past couple of decades.
Supply Chain & Shipping
Let’s start with the supply chain problems that are clearly part of underpinning some of these higher readings. Supply chain problems are stemming from capacity constraints (from both labor shortage & physical capital) as well as international logistical challenges. These challenges are hitting corporate America more than the retail evidenced by the extremely elevated producer price index relative to consumer price index.
This means price increases (largely due to supply constraints) are hitting manufacturers faster than they can pass them along to consumers. But even though it’s not being passed through in 1 to 1 fashion, they are contributing to higher end user prices. Perhaps this can be seen nowhere as clearly as in shipping backlogs. There just seems to be no end in sight to the challenges with getting stuff shipped to where they need to be and there are no quick fixes. Hopefully the recently announced plans to operate both LA & Long Beach 24/7 will work to improve the bottlenecks.
I am not a practicing economist in the academic or professional forecasting sense of the word so I don’t have any clue or insight as to specific contributions these logistical challenges are to future CPI readings (whether its .2% or 2% and over what time frame). But I do think it’s important in building out this framework to acknowledge, in my opinion, that a part of these supply issues will be permanent. That is because of choices made by companies to adjust their sourcing policies. More importantly, we were already undergoing a de-globalization trend and this likely accelerated a piece of it. This, at a minimum, is a counterwind to what was a long-term disinflationary trend. Again, to what degree I don’t know. But it is a factor. We can also agree there is also an element that is indeed temporary. The pandemic appears that it will continue to have its ebbs and flows, but as global vaccination rates continue to tick up and along with natural immunities, COVID’s impact will diminish over time in its disruptions on prices.
Commodities
Another probability working against the prospects of 1970s style inflation is the rarity of commodity super cycles. The chart below from Cuddington et al. shows the past century whereby we often have a commodity or two in a bull cycle but it’s rare for a simultaneous boom in the majority of them.
Commodities traders have an adage that “high prices cure high prices”. This means that higher prices curb demand and invite more supply. We’ve seen that with Lumber and Iron ore. I can personally speak to the lumber – which was all the rage this spring. I was fortunate enough to begin a home improvement project last fall. Based on conversations with my contractor, had I begun in the spring, the rising lumber prices would have exceeded my budget and we wouldn’t have pursued building. Some who weren’t as fortunate with their timing had to pump the brakes on projects which curbed demand. The sustained rally in lumber prices also prompted lumber mills to pump up production. This doesn’t happen overnight, but eventually the incentive is there to ramp up production.
I believe this core microeconomic principle is why it’s rare to have a bulk of commodities booming simultaneously for a sustained period. At any point in time, some commodity or another will be in a bull market, but as the chart shows above recent history only has 3 examples of such “super cycles”.
Monetary Policy and Money Supply
Also, for the 1970s it’s important to note that we had just pulled the plug on the gold standard which set off a chain of events that helped fueled inflation for the decade. Pulling that plug allowed for easy monetary policy to continue far too long and dovetail a commodity super cycle. In the end, the Volcker led Fed of the early 1980s created the playbook for successfully stamping out inflation. The present-day Fed certainly will not want to dust this playbook off, but they will if the hand is forced. You see some tealeaves of that here in the September Fed meeting.
No conversation about inflation is complete without a thorough discussion of money supply. Milton Friedman would otherwise be spinning in his grave. Our most treasured definition of inflation, after all, is too much money chasing too few goods. The challenge, and it’s a big one, is in that definition of “too much money”. If an economy is 10 people on an island with only a few seashells as currency, then money is easy to define, measure, and observe. If you go from 10 shells in currency circulation to 50, but fish and coconut production is still 10 each per day, the price in terms of number of shells for each is likely to skyrocket.
The real world and modern-day economy are more complicated than that and the definition of money is ever changing. I feel I could go down a rabbit hole of Fed papers on the topic and not come out any better than I was when I started. For instance, go back and revisit the Great Financial Crisis and the steps that were taken to help put out the economic fires in 2008 and 2009. These steps were brand new to many of us as we observed the “money printing” by the Fed truly causing our most basic measure of money (called M0 or base money) to skyrocket. Base money is the hard currency in circulation as well as reserves that banks keep on deposit at the federal reserve. I can still remember a clip of Glen Beck being circulated where he was climbing stairs to illustrate the heightened level of money on a chart.
False Alarm
Upon closer inspection, all that base money was being created it to facilitate asset swaps with the banks. Banks simply traded in one government obligation they owned (US Treasury Bonds) for another (Federal Reserve Deposits). Because the banks never really underwent any massive loan growth, we witnessed no explosive inflation in that decade (more on that later).
Today, the most alarming measure to monetarists (those that follow Milton’s monetary theories) is a rapid increase in our broader measure of money M2. M2 takes base money and adds checking, savings and other highly liquid accounts that can easily be converted to cash (Personally I follow a private market measure called m4 which has shown similar trends).
The relief efforts from the Pandemic were strong contributors to the M2 money supply shooting up. We found all sorts of ways to helicopter money into economy. Heck, we even figured out how to get the banks to facilitate loan through the PPP program…by simply having the federal government guarantee the loan to the issuing banks. It remains completely possible that this increase in M2 represents a bona fide increase in money circulating in the economy and will translate into higher prices. Its also completely possible that this threat is overstated.
False Alarm Part Deux?
For one, M2 as a percentage of GDP has been rising for a couple of decades now but we have observed nothing but disinflationary trends. We can thank many factors for these, including technological innovation, globalization, and more. But in the end, a lot more M2 has not been enough to overwhelm these factors and create inflation. Also keep in mind a that M2 includes time deposits like savings accounts and money markets. How likely is it that this money gets spent and circulating? Time will tell.
For me, it all comes back to our fractional reserve economy. One person deposits $100. The bank keeps $10 in reserves but lends out $90 to a borrower. Voila …..$100 in money supply turned into $190. Oh, and guess what, when that $90 that was lent out gets deposited at their bank, that bank keeps $9 on reserve but lends out $81 to another borrower. On the other hand, when a lot of money gets used to pay down debts etc., we might just wind up with reverse money creation. For me, both inputs (up and down) to inflation from M2 are completely possible. But, it’s unlikely to really crank unless bank loan growth takes off. In a fractional reserve economy, banks create money…or in a deleveraging environment -shrink it. Right now, we are just seeing modest loan growth at best.
Shelter Costs – Clearly More Floor Than Roof
Shelter costs are the 800lb gorilla in today’s inflation discussion. Prices for homes have skyrocketed, but it will take time for rising housing costs to filter through the ways we measure inflation. No doubt about it, current inflation readings are light on housing calculations and this component is headed higher in the months ahead.
Pump The Brakes on What We Think We Know
Once again, I come back to the reminder that we still don’t know that much about inflation – at least relative to how simple as it is conceptually. Consider this quote from former Fed governor Tarullo:
“The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policymaking”
That’s why I start with what the market is pricing in for inflation. It’s the sum of all fixed income investors expectations and today sits roughly at 2.5%. Again – forecasts are dismal and I find it important to keep myself humbled before trying to think mine will fare much better. But I look at these factors above and have a hard time choosing sides at this point. That’s not always the case, most of the past year it was clear to me the market was way offsides on inflation pricing (see here for why in post from 2020)
Invest Agnosticly
Regardless of what our forecasts call for, it’s imperative that on the investment side we stay nimble. In our system at FEG, we are free to change uniforms from team inflation to team deflation at any time. I don’t care if I think 5% inflation is coming…..if the trends and data suggest that I am wrong, at least for now, we’ll be buying up the things that perform well when inflation comes in light (staples, bonds, etc). When trends change, we’ll swap uniforms and sign up with team inflation. We have worn both uniforms on the investment side over the past year. Right now – consider me a free agent.
Taken collectively, I do not believe that the current levels of 4,5 or 6% (though possible) is sustainable and that we’ll moderate back into something normal like 2-3%. Nothing magical here, after all its just what the market says.
