A 60-basis point jump in inflation may not seem like much, just 6/10 of a percentage point, but we haven’t seen it grow this much in a month for 30 years.
There isn’t anything that matters more to the U.S. Federal Reserve than inflation rates. The Fed certainly wants to steer us away from this number going under, which is why it is important to stimulate it when it starts running too cool, but they also can’t have it running too hot either, and this is why they use monetary policy to look to achieve the right balance.
The long-term goal is 2%, and the Fed’s long-term projections have us continuing on that path again after the little hiatus that we’ve taken this year due to the self-imposed economic contraction that we have endured this year.
Smoothing the inflation curve is far from an exact science, and the Fed’s management of this key metric hasn’t been all that great historically, to put it mildly, but this can be a big challenge in more volatile economic times, and we’ve seen plenty of those over the history of the Fed.
Economic volatility is the enemy of monetary policy, forcing them to take bigger swings than they would want to, having to rein in higher levels of economic growth, which require them to hit the brakes fairly hard and often too hard. Economic policy in general is a manifestation of various levels of impatience, as these things stabilize on their own but take a lot longer to do so than we wish, and in our zeal to slow down or speed up the economy, this added sense of urgency to improve things faster than normal also causes reactions greater than ideal.
For the decade between 2010-2020, the lack of economic volatility that we have seen has made monetary policy considerably easier and much more effective than normal, where the small numbers that we have seen only require smaller adjustments and this reduces the risk of overshooting on one side or the other and has allowed the Fed to create an almost idyllic growth and inflation pattern, until now that is.
With our watching a third of our economy take a nap, and with unprecedented stimulative forces being wielded to wake it up, this is what you really call economic volatility, the sort we would not even have been able to dream up, falling that much that quickly and throwing so much at the problem.
As impressed as we have been with the Fed’s management of monetary policy over the past 10 years, when we look at their current projections, we worry that they may not be accounting for the full effects of the economic shock that this all has produced, where their turning up the heat all the way may keep us more comfortable during the ice age of this crisis, but as the temperature continues to warm, there surely has to be some overheating coming our way, which will need to be dealt with in not such a pleasant way.
It’s not that the Fed is unaware of this, and this is why they have told us that they are planning to hold the line even when inflation creeps above their goal of 2%, and there are some good reasons why that may be desirable. To get the economy running on all cylinders, we need to heat up the engine by a fair amount over where we want to be in the longer-run, as we wait for the labor market to heal more.
There can be a lag involved, and we saw a great example of this during the Great Depression, where we spent half of the 1930’s in an expansionary period of real note, seeing GDP growth even rise to double digit levels for a time, where unemployment remained extremely high. Employment grows more organically and can respond more slowly to what we could call inorganic policies, such as the stimulus strategy that we are now so engaged in. It takes time for inorganic stimulus to trickle down to the organic level.
The Great Depression was a true enigma, ultimately caused by the Fed letting the economy run far too wild, especially in their allowing so many business failures, a mistake that we have well learned from, and this is why today’s Fed is so protective against this. This is what we were on the brink of in 2008 but they ultimately came to our rescue and prevented a much more massive failure to take us back to the Great Depression days, or worse.
Monetary Policy Gets a Lot More Difficult Riding a Rollercoaster
These are definitely times which we could describe as economically volatile, and even more of a rollercoaster than we have ever seen, given the swift collapse that locking down the economy produced together with the combination of re-opening and stimulative effort much more massive than we have ever attempted, several times greater than what we did in 2008.
The reason why the economy has been so easy to manage since is that we achieved a stellar amount of stability, where the response matched the need extremely well and it took several years before the Fed even had to consider tinkering with monetary policy again.
The picture that the Fed is painting for us over the next couple of years and beyond looks strikingly similar to this, where inflation is expected to gently rise to a very desirable 1.8% and just hang there for years. While they may end up being right, all other things being equal, this time the task should not be so easy, and it’s even hard to imagine how the high speed that we have set the economy at won’t produce a fair bit of swerving instead on the straight and steady course that they have us on.
The Fed has core inflation pegged at 1% in 2020, 1.5% in 2021, and 1.7% in 2022, and then settling in to 1.8% longer term. No inflation to worry about here, although what may actually happen might be a little different.
We’ll leave aside the potential effects of political change which could in itself wreck this train, and the Fed doesn’t get involved in politics, although they will surely take their calculators out again if need be. The worry here is that we may end up with a situation where inflation increases and GDP decreases, which seems like a situation that is at odds, higher taxes both put inflation up and reduce GDP. The two do go together at times, something we call stagflation, and it is not pleasant.
Lowering taxes both improve production, GDP, and efficiency, meaning lower prices for the same things, and this is especially the case with lowering corporate taxes. These taxes get put directly into the price of things, lowering the cost of them when we reduce corporate taxes and increasing their cost when rates are raised.
Assuming there won’t be any change, by some miracle perhaps, although miracles sometimes happen, we will still have to deal with the thermostat turned up this high as we shut more and more windows and let less and less heat escape. The Fed forecasts GDP to go from –6.5% in 2020, to 5% in 2021, and then settling in at 3.5% in 2022, leaving is with an average gain of 0.67% over these three years, as opposed to the around 2% that was forecast before all this happened.
The biggest potential problem with this is that while GDP does have a good memory, where if we lose 6.5% this year and only make 5% back next year, we are still in the red, inflation doesn’t care about the past like this, nor has to dig itself out of a hole like GDP does.
While the Fed normally does not like GDP growth as high as 5%, it is needed on the road back to where we were, to at least get closer to the full employment we had. They need to approach inflation differently though, where they really don’t want to see this go much beyond their 2% target in any year, and their numbers sure look overly optimistic from where we currently sit.
It is true that monetary and fiscal stimulus sure don’t buy what they used to, which in one sense is a good thing as this much would put our economy in the ditch in no time. We don’t want to have to hit the brakes hard on the way back down the mountain of economic pain that we have created for ourselves. If you only have to tap them, or perhaps can coast all the way down without going too fast as the Fed is assuming, then this can all go off without a hitch, but otherwise, we have to create more unemployment essentially to slow us down if we need to, and we very well may.
The inflation numbers are in for July and the forecasters were expecting an increase of around 0.2%, but the actual number was three times higher than this, 0.6%. Annualized, this works out to 7.2%, well beyond the danger zone, and while we won’t get a number anywhere near this high on an annual basis, because we are in a point in our recovery where things are still accelerating, this does not bode well at all for our not going much above 2%.
We Need to Pay More Attention to Both Inflation and Returns
Investors don’t pay anywhere near enough attention to inflation as they should, especially in this era where inflation has been so well controlled. This wasn’t always the case, and this was actually the first time in our history that we have been anywhere near this successful in controlling it like this, tapping on the brakes from time to time instead of having to slam them on and swerve so much.
Inflation acts like a tax on our investments and savings, where if it is at 2%, that comes right off the top of your returns, where if you only earn 1%, you have actually lost 1%. The higher this goes, the higher the tax rate that we must pay to break even, and this involves a real dead weight loss, not just the one that we get when we reduce economic efficiency by raising taxes, as bad as that is.
If we have set aside a million dollars, and start our retirement and expect to live on this money, and we get an average inflation rate of 5% a year, we lose $50,000 to this form of tax every year. In 20 years, if we just let it sit, half of our money disappears into thin air.
If people thought of inflation more this way, then its detrimental effects would at least be more transparent and they would place a much higher value on our managing our economy such that we keep this tax nicely low. You can’t get rid of inflation, nor would we would ever want to, as we need a little buffer with it to provide for the growth that we crave, but just enough to see the economy grow nicely without growing too fast or too slow.
It turns out that hedging against inflation involves the same strategy as looking to grow your money in the first place, and there’s nothing really special about one approach over another apart from the net returns over inflation that they may provide. If gold is outpacing inflation more than stocks are, that’s the same thing as saying the return with gold is higher, so just pursuing return dynamically is enough to manage inflation risk as well.
The worst thing we can do here is to go with an asset over another just because it may perform better during rising inflation, although whether it does this or not in a given instance is less reliable, on top of wanting do it even before the need.
We should be looking at different types of assets at times, but only change horses when the time is right, when one of them pulls ahead and looks like they will lead for a while. If the race isn’t even going to be run for a year or two, and you have no idea how this one horse will do when we get close to it, it’s better to wait for the post parade and see how the horses look then.
We don’t want to let the Fed’s fairy tale forecast get us too comfortable and not pay enough attention, or worse, just assume that they will be wrong and put our money on that. Tomorrow does matter, but it only matters tomorrow, and we need to be clear on what day it is. Investing is at best trading on incomplete information, but less incomplete is always better.