Inflation has been making news for the first time in decades. In May, it reached an annualized 8.6% year over year, a 40-year high that turned some heads. Understanding what causes it may help us to understand where it might be going and how we should prepare for it.
There is good inflation and there is bad inflation. In the past two years we experienced a good bit of both.
Good inflation is when the assets that I own increase in value faster than other assets. When a portfolio goes up because asset prices rise, that is good inflation. The same goes for the increase in the value of my home, assuming I am the owner not the renter. Inflation may also increase revenue. If receipts increase relative to fixed costs such as debt service, this is a net positive.
Bad inflation, on the other hand, might be simply defined as the increase in price of the goods and services I need to purchase. Grocery bills have trended higher, dining out is getting more expensive, and even a haircut costs more. I recently set a personal record when I put $124 into the gas tank of the family Yukon. Yikes! If I am a renter, rising prices can shut me out of the housing market. And for businesses, rising input costs may crimp profits if they are not able to pass the costs through to consumers.
Economists have debated the causes of inflation since there were economists. There are academic volumes filled with treatises on the causes of inflation. In the spirit of simplification, let us offer two broad explanations.
- Monetary inflation. Milton Friedman famously stated that “Inflation is always and everywhere a monetary phenomenon.” We simply refer to this as the ‘big bucket of money theory of inflation’. Imagine a bucket with water in it. The water represents the total supply of money in circulation. Assets such as stocks, houses, and other investments are floating in the bucket. When central banks add additional money to the bucket, as they did during the Covid 19 pandemic, all the assets float higher. This doesn’t happen at the same rate. In 2020, stocks reacted, followed by housing, and then wages. Similarly, if liquidity is drained from the bucket, prices may fall.
- The balance of supply and demand. There is a constant ebb and flow between the producers of goods and the consumers of goods. Prices go up when there are more potential buyers than there are goods. Prices go down when there are more goods than potential buyers. During the pandemic, disruptions to production lead to shortages on everything from cars to appliance parts. When vaccines and an improving health landscape freed consumers to spend again, they were met with fewer choices and rising prices. Now the Ukraine crisis is causing spiking energy and food prices.
The path out of this is not clear. The Federal Reserve is attempting to cool the high rate of inflation with higher interest rates and reduced money supply without causing a recession.
Our best guess is that they will be successful in bringing down inflation. As of June 30, the market expects 10-year inflation to be 2.3% based on 10-year TIPs implied inflation.
At 2.3% inflation, $100 will buy only 80% of ‘stuff’ in 10-years time. While dollars in the bank feel ‘safe’, the saver may be locking in a slow but inevitable loss. That is the cancerous and insidious nature of inflation. Investors need to have a strategy that permits them to hold assets that can outperform inflation over the long run, even if it can be uncomfortable during inevitable periods of volatility.
- Price timing. For example, if you can wait for to buy a new auto car, you may find dealers more flexible in their pricing when supply disruptions subside.
- Consider buying out your lease. Auto leases establish the residual value of the car that you can buy it for at the end of you lease. With used car prices up, many times the residual is a significant discount from the car value. You might consider buying the car even if you immediately sell it to pocket the difference.
- Pantry loading. Don’t be afraid to buy in bulk for shelf-stable goods that you know you will eventually use.
- Perform a cash flow analysis. With prices for many goods and services higher, it’s worth being confident you’re hard-earned dollars are being spent where you want. Subscription services that accumulate on your credit card and are often unseen are prime candidates for review.