Inflation or Deflation | Michael Garber Financial Planning

Inflation and Deflation

Many financial analysts are concerned about possible coming inflation, and even hyperinflation. There may be inflation happening now, and it could increase. But there are also powerful forces operating to limit the effect of inflation. As with any prediction, it is better to take a guarded view and not assume we know what is likely to happen in the future.

What is the Definition of Inflation?

The most broadly held definition of inflation is the increase of prices for a basket of goods over time. This reflects declining purchasing power of a currency over time. The pound of hamburger that used to cost $4.00, now costs $4.10, and that represents a 2.5% rate of inflation.

The Austrian School of economics proposes a different definition. This view holds that increasing prices are not inflation in themselves, but rather a symptom of inflation, which is actually an increase in the supply of money at a more rapid rate than the production of goods.

Although the distinction matters in theory, most people think it makes no difference. If everyone’s income increased at the same percentage rate as prices, no one would feel any effect from inflation. This is not how inflation usually works in real life. The prices of some items increase more than those of others. The biggest example of this is the spectacular increase in prices of housing in Silicon Valley and the Bay Area overall. It takes a lot more income to buy a home here with each passing year, and prices have definitely increased faster than wages.

The Austrian School holds that the prices of goods through which the government injects money into the system increase first, leading to a general distortion in prices and then a misallocation of capital. We see this all the time here, as home buyers sink their life savings into their first home, in the hope that prices will keep increasing.

Clearly, the phenomenon of inflation is more complicated than just the rate of changes in prices but has something to do with a change in the allocation of goods and services in the economy. This is the underlying reason why many people fret about inflation: they expect that somehow, it will harm them, and reduce their standard of living in the future.

Current Measures of Inflation

It is said, if one needs to measure something, there should be lots of measures for it. And this is especially so with the measurement of inflation. Fundamentally, the government measures inflation as the rate of change in some price index. Inflation is just the ending value of the price index divided by the starting value. The main government agency that reports on inflation in the United States is the Bureau of Labor Statistics (BLS). BLS creates multiple indexes:

Consumer Price Index (CPI). There are several, but the main one is known as CPI-U, the CPI for Urban Consumers.
Producer Price Index (PPI).
Import and Export Prices
Employment Cost Trends
Contract Escalation

BLS has recently reported a year-over-year CPI-U rate of inflation of 5.0%. This is much higher than in recent years, when inflation has run between 1.5% and 2.5%.

Federal Reserve Data

The Federal Reserve tracks expectations of future inflation, via surveys, rates of Treasury Inflation-Protected Securities (TIPS) and other ways. In setting monetary policy, they also make use of BLS data and the views of their member banks.

Fed future inflation expectations have been running in the range of 2.5%. As noted below, this aligns with the “expert consensus” that inflation will be transitory.

Shadow Statistics Data

Over time, the government has changed the way it computes price indexes. Private organizations, such as www.shadowstats.com claim that if the government reported inflation in the same way that it used to, reported rates would be much higher than using today’s methods. The concern is that CPI no longer measures the cost of a constant standard of living, and results in the government being able to cut annual cost-of-living adjustments to Social Security and other programs. Shadows Statistics uses the assumption that a fixed standard of living implies a fixed basket of goods consumed and downplays the number of substitutions made as new goods become available at lower prices, or when the prices of existing goods make them less affordable.

Needless to say, Shadow Statistics claims inflation has been running in the 9-12% range for years. And it is fair to say that the US Government wants to do everything it can to minimize future interest payments on the national debt.

What Are “Experts” Saying About the Future?

With the recent spike in the rate of inflation, economists and bankers are talking more these days about possible future inflation. The present dominant view is that the current inflation is transitory, and will return to its historical run rate in the next year. The Federal Reserve has maintained that inflation will decline after the current opening of the economy, after more than a year of government-dictated seclusion. Others are not so sure.

One reliable predictor of future inflation is interest rates for long-term bonds. Bond interest rates remain low, and there is a 30-year trend in place. This suggests there are more factors to consider when speculating about future inflation rates. If markets expected increased future inflation, the prices of bonds would adjust, resulting in higher long-term rates of interest. This is not happening, at least not yet.

Deflationary Forces in the World Economy

Housing prices here in Silicon Valley may be spiraling out of control, but other costs are actually declining. Technological innovations from Artificial Intelligence, Big Data, Automation, Robotics, Biotechnology are both making more things possible and lowering the costs of existing processes. In parallel, forces of globalization are driving prices down – resulting in both misery and opportunity for those at the peripheries of the global economy.

Simple ultrasound machines today cost $5,000-$10,000. A company has introduced a hand-held ultrasound device that connects to an iPhone. It costs less than $2,000. This machine can perform many of the same functions as full-featured machines did a decade ago. High-end machines are becoming more capable, spawning the industry of pre-birth baby photos, and leading to ever-more-precise diagnosis of fetal medical conditions, that were formerly thought to be untreatable.

The IBM personal computer I bought in 1981 cost $7,000 (probably $14,000 in today’s dollars), but for $500 one can buy a computer with many thousands of times the compute power. While unimaginably more capable, instead of being built in the US, the company IBM eventually sold the business to stands accused of buying from suppliers using forced labor. Across Africa and Asia, many millions of workers are entering the labor force, and new low-cost countries are coming into the world market every year. For many of these workers, standards of living are increasing in ways they could not have foreseen just a few years ago.

It can be argued that these accelerating technological advances represent a secular shift, powerful deflationary forces that allow the unlimited printing of money, even if not all price declines are for good reasons.

We thought this same thing was happening at the turn of the century with the dot-com boom. The internet was going to improve life and create new markets. Companies would no longer have to have positive earnings, because revenues would grow faster than their fixed costs. That did not work out so well in 2001, so some caution is called for today. But deflation, as a result of technology, is more real this time around, and should not be ignored. The market no longer gives a pass to companies without earnings. This alone could explain why long-term bond yields have continued to stay low.

Who Would Be Most Harmed – and Helped – by Inflation?

The possibility of increasing inflation is still something to take seriously. Inflation is clearly taking place today for some goods, such as home prices, used cars and other items. Widespread inflation harmed many people in the 1970’s and required a double-recession (1980 and 1982) to bring it under control. Those recessions harmed more and different people.

Those just starting out in the 1970’s felt little of the harm of those inflationary years. People on fixed incomes – pensions with no, or limited, cost-of living increases, were harmed significantly. Homeowners, whose property values increased significantly, were not harmed as much as renters. Some, in fact, were helped by inflation. For others, the home price inflation of the 1970’s led to increased property taxes, forcing many to move out of homes they had paid off and hoped to live in for the rest of their lives. Property taxes increased so much that they could not afford to stay. In California, this effect led directly to the passage of Proposition 13, which limited the rate of property tax increase to 2% annually. The political class is still complaining about this 40 years later, so we know it has been effective.

Another round of inflation could harm the same groups of people. History never repeats itself in exactly the same pattern, if it repeats at all. There are new ways of looking at policy and protections (such as Proposition 13) that would probably take things in a different direction. Some experts predict significant declines in commodity prices, instead of increases as seen in the 1970’s.

Today, policymakers are proposing “Universal Basic Income” (UBI) as a way to perpetually fend off price deflation. If robots replace half of existing jobs in the next ten years, something like this may have to be implemented, regardless of the horrific social effects of having millions of people with no productive labor in their lives. However, with multiple rounds of economic stimulus payments having already been made in the last year, and active discussions about future stimulus rounds, we may be closer to UBI in reality than some would think.

Inflation and Retirement

In planning for retirement, the commonly used financial models require inputs for future inflation of the cost of living. Whatever expense rate is input, an annual inflation factor is applied. This dynamic increases the size of the investment portfolio required to live in retirement. It can result in some truly frightening calculations if common sense is not applied. And this is even before adding in the possible costs of an extended stay in a nursing home or memory care. What is wrong with all this?

The normal course of expenses in retirement does not look like this, and inflation is not uniform each year. As people age, they tend to spend less money. Following retirement, there are expenses for travel and entertainment, which often decline, as mobility decreases.

Still, fears about running out of money in retirement are well-founded. Everyone has a story of someone in their family or circle of acquaintances who had to make major changes in life when their financial situation changed. For those on the cusp of retirement, working even one or two more years can make a big difference in the outcome. Sometimes it is necessary to pro-actively plan to downsize. It is easier to make this kind of decision before it becomes an emergency.

What Can Investors Do?

As we have seen, the landscape of forecasting future inflation or deflation is extremely complex, defying reliable predictions. It is not even possible to measure even what is happening today, with everyone’s total agreement.

Individuals and firms must deal with uncertainty continually. The best approach is to this problem is to engage in hedging strategies.

A cereal company that needs to buy corn at a fixed price can buy futures contracts. Or they can enter the business of growing some corn for themselves.

The main strategies to hedge against inflation are simple:

Own and hold real estate. Real estate prices generally track inflation. Today and here in the Bay Area, they are outpacing general inflation. The best way for most people to participate in owning real estate is to own their own home, and to plan on living there for a long time. With a fixed mortgage, payments do not increase, and thanks to Proposition 13, the rate of property tax inflation is limited.
Buy inflation-protected securities. Two excellent examples are Series I US Savings Bonds and Treasury Inflation Protected Securities (TIPS).
If concerned about commodity price inflation, become something of a “” Even just buying extra amounts of items you will use around your home in the next year or two, can be a hedging strategy. Most consumer staples have a multi-year shelf life. Some religious groups have a well-developed strategy to maintain a year’s home supplies at all times. This is not practical for everyone. For those planning to move, it could result in a big job to move it all. You do not have to be stacking gold and silver coins or ammunition to implement a strategy of “buying ahead.” These assets have limited marketability in most situations.

The best hedge against deflation – assuming interest rates will decline further and that your dollars will grow in purchasing power, rather than shrink – is to buy long-term government bonds or bank CDs.

We do not know what the future holds, and the track record of “experts” is spotty at best, so we recommend hedging against both inflation and deflation.

If you are looking for a financial adviser to help you construct a family financial strategy that aligns with your personal situation and future plans – contact me, and we can start a conversation.