Letter to Investors: Inflation is a Monetary Phenomena
Dear Colleagues, Clients and Friends,
What a year it has been. There is a lot to talk about, consider, and take action on as the gears of the world economy and monetary policy continue to lurch forward. We are in an interesting time and the consequences of the action during this time will be felt for decades to come. Not only in the obscurity of some distant, far-off reality; rather, in the things that are critically important to our economy and our personal balance sheets.
There are quite a few things that we’d like to touch on, and they all fall around a common backdrop – monetary policy.
Often the boring conversation in the room – interest rates, money supply, debt, velocity, yadda-yadda-yadda – the inflation of the past year has shone a light on the conversations we’ve been having with our clients since the first stimulus package was initiated in 2020. Inflation is here, it isn’t transitory. The impacts of this monetary phenomena are widespread, and often loosely understood even by those who position themselves as the expert in the room. Take a look at the trends of the past 24 months and it is plain to see that the narratives assuming transitory inflation have broken down. Recognition of this will help us to understand the risks that sit on the horizon, and what we can do to actively prepare ourselves for those risks should they continue.
As the information continues to develop, these risks are reminiscent to what Americans faced in the 1970’s and 1980’s.
A Brief History
We need to get clear on one thing – what is money? It is that very concept that is at the core of what we are experiencing today and what we will experience in the near future. There are a few great books we can recommend for anyone interested – but for the sake of brevity – consider the primary characteristics you want in money. And without any knowledge in this field, there is one quality we know that is important to us – we want our money to be worth the same today, as it was yesterday, as it will be tomorrow – that’s called stability. We may not be upset if the money we have at the bank is worth more tomorrow (deflation), but we would be upset if the money was worth less than it was yesterday (inflation). This mission is so important that it was the original reason behind the creation of the federal reserve – to maximize employment and to keep prices stable.
The Federal Reserve act of 1913 created the Federal Reserve and gave them certain controls over the money supply – such as raising and lowering interest rates – to aid in their dual mandate. It is this dual mandate that sits behind many of the inflationary troubles of the 1970’s and 1980’s. When facing both rising unemployment and rising inflation (a scenario thought to be impossible by Keynesian economists and Phillips Curve enthusiasts) it seemed that the more reasonable thing to do was to encourage easy monetary policy to aid in lowering the unemployment rate. This would however prove to only encourage both the rate of inflation and unemployment. It wasn’t until inflation became so unbearable that the public sentiment turned, and the Federal Reserve changed direction under Paul Volker in 1979. They began to track and manage the growth of the money supply as well as drive prime lending rates up as high as 21%. Before Volker “various Fed chairmen made rumblings about fighting inflation, but they always backed down when the complaints about the resulting higher cost of credit grew loud” (Poole, 2005).
Before using monetary policy to reign in inflation, they tried other tactics.
“There had been a few earlier attempts to control inflation without the costly side effect of higher unemployment. The Nixon administration introduced wage and price controls over three phases between 1971 and 1974. Those controls only temporarily slowed the rise in prices while exacerbating shortages, particularly for food and energy. The Ford administration fared no better in its efforts. After declaring inflation “enemy number one,” the president in 1974 introduced the Whip Inflation Now (WIN) program, which consisted of voluntary measures to encourage more thrift. It was a failure.” (Bryan, 2013)
“[Federal Reserve Chairman Arthur] Burns believed that tightening monetary policy and the increase in unemployment that accompanied it would be ineffective against the inflation then occurring, because it stemmed from forces beyond the control of the Fed, such as labor unions, food and energy shortages, and OPEC’s control of oil prices.” (Sandra Kollen Ghizoni, 2013)
So, things will be rocky, maybe some more inflation, but we’re going to raise interest rates soon, right?
Maybe. And, we need to understand why it is more likely that we won’t raise rates. It’s highly possible that if we do raise rates it will be too little too late and yet equally disastrous for the asset bubbles easy money has propped up for over a decade. First and foremost it is a huge political liability in this divided environment. The last one holding the bag while interest rates rise will be in a heap of economic trouble – unemployment, falling stock prices, falling bond prices, etc. Beyond that, we need to understand one key thing – we have a lot more debt on our balance sheet than we did in the 1970’s.
$300,000,000,000 to $29,000,000,000,000
That’s how much the US government’s balance sheet increased since 1963. The total 1963 debt is now a +/- 1% rounding error for the current debt. And it is debt we can’t pay. You may have heard some conversation last year about our “debt ceiling” and the government potentially shutting down or defaulting on its obligations. A slew of politicians came to the stage to announce that “America always pays it’s debt”. Remarkably, they don’t seem to realize that we satisfy our credit cards by increasing the limit on our credit cards. That is the simple understanding of what it means to “raise the debt ceiling”. There’s nothing heroic about it. There are current discussions where political heavyweights such as Janet Yellen have called publicly for the Federal Reserve to fund without question the spending packages passed by congress. The question is if we cannot pay our debt at low interest, how on earth would we pay our debt with higher interest without printing even more money?
When the government spends money it does not have, it must sell treasuries notes (promises to pay dollars in the future). The primary buyer for our treasury notes is our own Federal Reserve. This is a function known as debt monetization and is the primary funding mechanism for our government – spending trillions of dollars more than it receives in taxes. Unfortunately, it is this debt monetization feature that has politicized our money supply in a way that was never intended. It should be clear now that how much debt we generate is a direct result of the policies passed by our lawmakers.
In 2017, I attended a conference in which Federal Reserve Chair Janet Yellen was the last speaker, engaging in a fireside chat with the CEO of a large bank. If you’ll recall, 2017 was a remarkably docile year for markets, with the S&P 500 returning around 20% with fewer than 10 movements of 1% or more throughout the year. And, since the year had been so calm, naturally, the question arose, “So, what keeps Janet Yellen up at night – when you look out into the future, what are you concerned with?” Her response, which I promptly wrote into my notes was that, “In the next 10 years, the interest on our debt will be larger than our GDP, and that’s something we’ll have to contend with.” This was before the trillions of dollars in stimulus and COVID relief spending, infrastructure bills, etc.
We will face a rock and a hard place with interest rates, a weak economy, and inflation. If the economy were strong, unemployment low and inflation high – then all traditional signs would point to raising interest rates. If we consider that the biggest benefactor of low interest rates is government spending, and that there are no signs to slow down, then we can start to understand why we may see signs of interest rate hikes with little to no action. It begins to make more sense why the Federal Reserve stuck to its position of transitory inflation without so much as a fight.
Dangers and Opportunities - Here are the things that we want our clients to be aware of:
Inflation is a monetary phenomenon – while it may show up as shortages or price hikes, those are the impacts of inflation. A builder stocking and storing supply for fear of shortages when he needs the supply to do business is not inflation – that is the impact of inflation.
Cost of money / interest rates may be moving too slow. As we’ve already started to see, in anticipation of interest rates moving up, mortgage rates have begun to increase. Normally, this would slow home buying and potentially reduce market prices. That has not been the case so far in 2022. This would be an indication that rates are not moving fast enough to have a considerable effect on inflation.
Variable rates may spike. Fix as many costs as you can. A fixed rate mortgage is preferable to a variable rate mortgage, especially if you are nearing the end of the adjustable-rate term.
Higher taxes. One of the theory’s surrounding currency reserve status is the taxing authority of the nation. As Janet Yellen calls for broader taxes abroad, consider that this is to set the stage for higher taxes at home. We anticipate tax rates will increase and believe tax planning should be an active consideration.
Real asset classes. Business, real estate, commodities, and precious metals are a few physical assets that you can own. Some of these can be picked up in your investment portfolios, and some may make more sense to own directly such as real estate. We maintain that including assets that broadly benefit from inflation are worth owning at this time, even if only to hedge the potential inflation risks. Consider allocations to Large Cap US and Foreign Value stocks, reducing growth positions, and ensuring you have enough short-term cash to provide liquidity during volatile markets.
Bonds could fall in price. If concerns with the dollar persist or become more apparent, then bond markets will likely suffer a rapid decline in prices. If my dollar is decreasing in value today, then why would I want that same dollar 30 years from today? Consider allocating to non-correlated asset classes such as cash value life insurance as a substitute for traditionally safe asset classes such as bonds.
Bill Combs and The Olivia Team
Resources for you:
Nixon Ends Convertibility of U.S. Dollars to Gold and Announces Wage/Price Controls
President's Message: Volcker's Handling of the Great Inflation Taught Us Much
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William Combs is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly owned subsidiary of Guardian. WestPac Wealth Partners LLC is not an affiliate or subsidiary of PAS or Guardian. Insurance products offered through WestPac Wealth Partners and Insurance Services, LLC, a DBA of WestPac Wealth Partners, LLC. CA Insurance License Number - 0I49903| 2022-133554 Exp. 02-24