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Costly Arguments

Adam M. Grossman

OPEN AN ECONOMICS textbook, and you’ll find this fundamental principle: When the money supply expands—that is, when the government prints more money—higher inflation is often the result. This topic has, for good reason, been on investors’ minds lately. Since the pandemic began, the Federal Reserve has increased the money supply by several trillion dollars.

Is higher inflation inevitable? I see five possible answers to this question:

1. Yes, of course. Between 2010 and 2020, annual inflation averaged just 1.7%. But the three most recent readings—in June, July and August—have all topped 5%. For that reason, it seems obvious that the Fed’s actions have led to a sharp uptick in inflation. It’s just as the textbooks would have predicted.

2. No, because this time is different. I’ve heard more than one concerned investor compare the Fed’s actions today to those of Weimar-era Germany. During that period, the German government printed so much new money that it resulted in hyperinflation.

How bad did it get? To cite one example, the price of bread rose from 163 marks in December 1922 to more than 200 billion marks just 11 months later. The Weimar example certainly paints a dramatic picture. But it isn’t an accurate historical analog.

Eric Hilt, an economic historian at Wellesley College, provides this explanation: “The Fed’s actions over the last 18 months have very little to do with what happened in Germany in the 1920s. The distinction is subtle but important. After World War I, Germany… printed currency (paper money) to pay the government’s bills. As the amount of paper currency in circulation expanded, the value of the currency decreased, which meant that larger amounts needed to be printed to produce the same revenue, and the situation spiraled out of control into hyperinflation.”

He continues: “None of that has happened in the U.S. The Fed has acted to backstop markets in new ways and has expanded its balance sheet, but it has done so not by increasing paper currency in circulation (printing money), but by adding to the deposit accounts of financial institutions—their reserve accounts. This is different from money in circulation because it is not going to be spent quickly.”

That last point is key: Yes, the Fed has printed an enormous amount of money, but it hasn’t all gone directly into consumers’ pockets, where it could be spent and thus contribute to driving up prices.

To be sure, some of the new money has found its way indirectly to consumers. That’s because the Fed helps to finance the U.S. government’s deficits. During the pandemic, a large part of the deficit has resulted from programs like Paycheck Protection Program loans that have bolstered consumers’ spending power. Still, Hilt makes an important distinction between the Fed’s actions today and the actions of the German government in the 1920s. Upon casual observation, they might seem similar. But they’re not the same—either in character or in magnitude.

3. No, though it’s natural to suspect fire when we see smoke. While the overall inflation rate has more than doubled in recent months, defenders of the Fed’s actions are quick to point out that there’s more than meets the eye. Foremost among these defenders: Fed Chair Jerome Powell, who has argued that the recent inflation spike will be temporary.

To support his view, Powell points to a breakdown of this year’s inflation figures, which reveals that prices have not accelerated across the board. Instead, inflation increases have been limited to specific sectors. In most cases, these are industries which have experienced COVID-related supply chain disruptions. The price of lumber, for instance, rose sharply last year, though it has moderated more recently. Car prices—particularly used car prices—have also jumped due to a global shortage of semiconductor chips. Modern cars, it turns out, require between 1,000 and 3,000 chips to manufacture.

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In other words, the Fed acknowledges that inflation has been running hotter. But Powell contends it’ll cool off once the supply chain normalizes: “As these transitory supply effects abate, inflation is expected to drop back toward our longer-run goal.”

4. No, because the world economy has changed. More or less continuously since the 2008 financial crisis, the Fed has been engaged in “quantitative easing”—a technical term for printing money. Japan has similarly been expanding its monetary base. And yet, in both countries, observers have noted that inflation has remained quite low. In fact, for several years prior to the pandemic, the U.S. enjoyed both low inflation and low unemployment. This also defied textbook economics.

For these reasons, a group of academics and politicians have been making the case that today’s economy is different and that the traditional rules no longer apply. Specifically, they believe the U.S. government can now, within reason, print as much money as it wishes and that new money can be used to finance much larger deficits than ever before. According to this line of argument, there’s no reason to fear further inflation.

5. Maybe, but it depends on what Congress does next. It may be too early to tell. As recently as February, the monthly inflation reading was still below 2%. Perhaps today’s higher inflation will indeed prove to be transitory. Still, Washington is working on a new set of initiatives which will, on the one hand, impose higher taxes and, on the other, increase spending. It’s difficult to know how this will all net out.

As an individual investor, where does this leave you? As the saying goes, it’s clear as mud. But that, I think, is precisely the conclusion to draw. You might find one of the above arguments to be convincing. But ultimately, there’s no way to know where all the crosscurrents will take us.

My view: In the absence of definitive data either way, investors’ best strategy is to diversify. In the past, I’ve argued that stocks provide effective inflation protection. That’s still my view. On the bond side, I recommend an allocation to inflation-indexed bonds—either Treasury Inflation-Protected Securities or Series I savings bonds. But you want to maintain balance. Even if you have strong views on the inflation question, take a moderate approach with your portfolio, so you aren’t unduly affected no matter who turns out to be right.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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John Wood
John Wood
1 year ago

Another of your typically excellent articles, Adam.

I figure the inflation question is going to answer itself (i.e. in time, it will prove either transitory or secular).

More relevant to me, however is the Fed’s active manipulation of the bond market ($120 Bil in bond purchases per month, and the buyer of most of the new Treasury debt), such that Treasury and mortgage yields are below even the tamest inflation expectations.

I’d welcome your thoughts on this topic: Why the Fed has been so willing, for so long, to drive bond yields below the current inflation rate, providing risk-averse investors with only bad choices – voluntarily taking a loss, in real (inflation-adjusted) terms, or moving into riskier investments (e.g. junk bonds) that now yield what their safe investments used to yield?

As Peter Blanchette notes below, all of this manipulation has not been effective on their “full employment” mandate (8 million unemployed, unwilling to fill the 10 million open job opportunities), has driven serious inflation in home prices and rents (punishing low and moderate income Americans), and picked the pocket of older, more conservative savers, while the banks admit that their lending is down because businesses are flush with cash (thanks, in large part, to the ultimately unneeded PPP loans).

I’m less concerned about the self-realizing inflation question, than the Fed rigging the game for real estate and stock investors, at the expense of older savers, and those with less (and if there’s a question about this, have the Fed unexpectedly stop all bond buying next month and see what happens).

A Grossman article on the Fed’s actions would be a worthwhile read.

Mark Morris
Mark Morris
1 year ago

The Fed is NOT printing money, Mr Grossman. It is increasing bank reserves and the banks are not lending into the economy.

Peter Blanchette
Peter Blanchette
1 year ago

Unfortunately, even on networks like Bloomberg, one can rarely hear or read about the cause of inflation occurring at the present time. Commentators talk about the liquidity provided by the Fed or the stimulus provided to consumers intended solely to replace lost income. It is an inflation caused by a level of demand(not unusually high demand in most cases) that cannot be met by supply. There are all kinds of factors impacting supply. The biggest is that millions of people are not vaccinated. Millions are suffering from covid and/or from fear of getting covid. These people are not able to go to work because they are sick, the schools their children attend are not operating at full tilt because of covid concerns, Families cannot find childcare support due to a lack of childcare workers, the infrastructure of supply networks is having a difficult time being rebuilt because of the preceding factors. The Fed tapering or not tapering and/or raising or lowering interest rates is not going to have significant impact , at least in the short term, on inflation trends certainly in the near future. Somehow people have to be convinced that being vaccinated is in their best interest and therefore in the best interest of all of us. The solution to the economic problem of inflation will relate to the physical health of all of us.

Roboticus Aquarius
Roboticus Aquarius
1 year ago

This is a well-balanced article, thanks Adam! I’m mostly in Camp #3, but I try to be agnostic and prepare for all eventualities.

This relates somewhat to another somewhat narrow topic that impacts some investors with 401Ks, and that is the Stable Value Fund. I would be really interested in a solid take on when and how best to utilize them.

First considerations are of course the credit rating(s) of the insurer(s), so let’s assume those are top-notch (but everyone should check!). Then it’s a question of yield, I think.

At one point I was considering a Fixed Investment Allocation split one third each to Tips, Intermediate Treasuries (total bond works too but I follow Swensen on this), and SVF. I figured this balanced risks of inflation, deflation & rate changes.

However, my SVF fund has for years had a higher yield than Tips or IT’s (about 2.7% this year, well above the alternatives), so my FI has been 100% SVF. Now, the SEC yield is basically the expected return for the current mix of bonds over the next year ignoring possible rate changes, I believe – and it bothers me that I’m using a short-term metric for a long-term decision. It also bothers me that I’m giving up standard bonds as a counterbalance to stocks, though I think that their main value lies in lack of fluctuation rather than the less-than-consistent negative correlation to stocks that bonds sometimes display. SVF funds seemed to ride out the 2008 crash relatively well, so using one as Markowitz’s ‘riskless asset’ doesn’t seem entirely unreasonable. I would be very interested to read your thoughts on the matter.

Last edited 1 year ago by Roboticus Aquarius
Rick Connor
Rick Connor
1 year ago

Adam, another terrific article.
Thanks for addressing an important, complex, and controversial topic. As someone with no formal training in economics or government finance. I’ve tried to learn as much as I can, from multiple sources. My brother has degrees in economics, chemical engineering, and executive MBA, and a CFA. We trade books, articles, and podcasts – often over expensive coffee at Starbucks (see Dick Quinn’s latest blog post). He turned me on to MMT, and it has intrigued me.

I’ve read Dr. Kelton’s book, and I really learned a lot from the discussion of how money is actually created by our sovereign government. I keep reading the same criticism of MMT – that proponents believe that we don’t have to worry about inflation. But my understanding is that inflation is the main thing they worry about. What they don’t worry about is debt, just because it’s debt. Debt is an issue if it causes inflation, but not until then. That is a different approach than I had previously held – debt was in and of itself dangerous and to be avoided. But in my 46 years of adult life we’ve only had one balanced budget, and yet we’ve prospered.

The concept that I got from The Deficit Myth was to tie fears of inflation to the unused capacity in our economy. As long as the government uses the additional spending to effectively activate the unused capacity for useful work, inflation is unlikely.

I’ve been noodling on a thought experiment. I spent my entire career working for major aerospace and defense contractors..I’m guessing 95% of the projects I worked on were financed by government spending. In most of those years we ran a budget deficit. Many of the projects were important to a small percentage of the population. It often produced end products that were rarely used (arcane science data) or hardware that was stored and (we hope) never used. The funding for these projects was “printed” not provided by taxpayers out of widespread demand. The jobs created, the technology developed, and the industries supported or started, clearly adds to our GDP, and employs lots of Americans.

My concern with MMT isn’t theoretical. It seems to require a well functioning government to monitor inflation, understand it, perhaps predict it, and make rational and effective actions. These, I think, would be fiscal actions. That’s a big job – I’m not sure Congress is up to that.

Philip Stein
Philip Stein
1 year ago
Reply to  Rick Connor

Good response. Consider two additional points.

Some may believe that debt is nothing to worry about, but it still has to be repaid. At the levels of government debt we are seeing today, my generation will not come close to paying this down. The burden of repayment will fall mainly on future generations. I doubt this is a legacy that most people would want to pass on to their children and grandchildren.

If I’m not mistaken, proponents of MMT claim that if the inflation rate does rise, government can counter it by raising taxes. Do we really want to see Congress raise our taxes to fight an inflation they caused?

And if Congress does raise our taxes to fight inflation, are we confident that they will lower our taxes once the inflation rate declines?

Last edited 1 year ago by Philip Stein
IAD
IAD
1 year ago
Reply to  Rick Connor

I’ll readily admit I know little to nothing about MMT, but on the surface it seems so illogical. How can debt not matter? Even with very low inflation, as debt rises so does debt payments. Maybe I’m being too simplistic, but large debt burdens and a reliance on Government doing the right things are two guarantees that things will not go well.

Mr Moderate
Mr Moderate
1 year ago

Totally agree. I refer to The Richest Man in Babylon 1926 book by George S. Clason. Having 6 different buckets of investments helps protect your income stream than just 1 bucket.

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