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Down With Inflation

Adam M. Grossman

AMONG THE FINANCIAL topics grabbing investors’ attention, inflation for many years was near the bottom of the list. In fact, between 2010 and 2019, inflation averaged just 1.8% a year, and the Federal Reserve was looking to lift that rate. Throughout 2019, the Fed lowered its benchmark interest rate multiple times, citing inflation that was running below its preferred level of 2%.

But just a few years later, in the midst of the pandemic, all that changed. In summer 2022, inflation hit a peak above 9%, prompting the Fed to reverse course, raising rates in an effort to rein in soaring prices.

Those efforts have been successful, with the most recent Consumer Price Index reading at just 3%. This episode, though, reminds us that inflation can be a serious issue—as it has been on multiple occasions throughout history.

The earliest recorded instance of inflation was during the reign of Alexander the Great. In the fourth century BC, when Alexander’s army conquered Persia, it brought back enormous amounts of gold and silver. The precise amount is difficult to determine, but one calculation estimates that it was the equivalent of trillions in today’s dollars. It was this influx that created inflation at home for Alexander, and it helps us to understand one of the three main causes of inflation.

In technical terms, the situation that plagued Alexander’s Greece is known by economists as “demand-pull inflation.” With its newfound wealth, Alexander’s government began to spend freely. Writing in The Treasures of Alexander the Great, historian Frank Holt describes how money was spent on lavish gifts, public events and construction projects.

Alexander founded 13 new cities, the cost of which Holt refers to as “incalculable.” The result was that everyday citizens had more money to spend, and that led to rising prices. As I mentioned a little while back, the Roman empire fell into the same trap. By reducing the silver content in each of its coins, the emperor was able to effectively “print money.” 

Though it was for a different reason, this wasn’t unlike the stimulus payments that the U.S. government issued in 2020 and 2021. While some of that money helped workers who’d lost their job as a result of COVID-19, this cash was distributed imperfectly. Many folks who weren’t unemployed nonetheless received windfalls, and this led to the same phenomenon—consumers feeling flush and thus able to overspend. It was for this reason that both the stock market and the housing market jumped in 2021.

But stimulus payments were just part of why inflation spiked in 2022. You may recall the near-daily headlines about “supply chain issues.” That was the second factor. Beginning in 2021, as a result of the pandemic, certain components, especially for automobiles, were in short supply. That made cars difficult to get and allowed dealers to charge list prices for the limited number of cars that were available.

Other factors, including Russia’s invasion of Ukraine and its impact on global shipping, contributed to shortages of goods. Because such shortages drive up costs across the economy, economists refer to this type of inflation as “cost push.” 

In other words, as a result of the pandemic, global economies experienced inflation due to factors on both the demand and supply sides. This created a dangerous situation because inflation was on its way to becoming what economists refer to as “built-in,” and that’s the third type of inflation.

When prices are high, workers demand higher wages to keep up with those higher prices. To pay workers more, businesses need to raise their prices, and this can lead to a cycle of wage and price increases. Once a cycle like that gets going, it’s difficult to stop. That fear, I think, explains why the Federal Reserve was so aggressive in raising interest rates and why it’s been so hesitant to lower them again.

At the same time, the Federal Reserve does want some amount of inflation. In fact, the Fed has an explicit goal of 2% inflation. Given the problems that inflation can cause—some argue that inflation brought about the fall of the Roman empire—you might wonder why the Fed would want any inflation at all. That, in fact, was the reality for centuries in Europe, where prices generally didn’t change at all from year to year. When inflation did enter the picture, very modestly, in the 1500s, it caused significant social upheaval.

So why, despite the risks, does the Fed want to see some modest inflation each year? There are a number of reasons, but economists generally focus on one: If inflation falls too close to zero, there’s a risk it could actually slip below zero and become deflation, with prices falling from one year to the next.

The reason deflation can be a problem is subtle: If consumers expect prices to be lower in the future, they might choose to delay purchases, with the hope of paying a lower price next week or next month. This causes businesses to lower prices in an effort to entice consumers, thereby compounding the problem. 

Over time, deflation can lead to economic stagnation as consumers delay purchases for as long as possible. By contrast, when prices rise modestly over time, there’s no incentive to wait, and that helps to keep the economy chugging along. This risk isn’t just theoretical. For most of the past 25 years, Japan has struggled with deflation, and this has led to what observers call Japan’s “lost decades.” Prices have only recently turned positive, but it’s been a terrible period, and this is what the Fed wants to avoid.

What lessons can we draw from all this? First, it’s a reminder that we should never be too sure about what the future holds. When the Fed was struggling with inflation that was too low in mid-2019, no one would have guessed that just three years later policymakers would be contending with the opposite problem. Since no one—not even the Fed—can see the future, the most important thing, in my view, is for investors to remain diversified.

Starting on the bond side of a portfolio, there are Treasury Inflation-Protected Securities (TIPS). These are government bonds that are guaranteed to increase in value at whatever the inflation rate is. TIPS have a close cousin known as Series I savings bonds. These function mostly the same way, but at any given time, one or the other will tend to offer investors a better yield. Today, I see TIPS as the better bet.

What else might you hold to guard against inflation? In 2022, when inflation was rising, stocks dropped. That might lead us to believe that stocks do poorly when inflation is high, but that’s not entirely true. While every company is different, some have more of an ability to raise prices than others. Those that have this flexibility are able to navigate inflation quite well.

Looking back at 2022, when inflation was at its worst, companies on average were indeed able to raise prices. This could be seen in their gross margins, which measure the difference between their costs of manufacturing products and the prices at which companies are able to sell them. When I looked at the data in late-2022, gross margins had increased during that inflationary year even more than they had, on average, in the last pre-COVID 19 year. This helped to support those companies’ profits. And because profits ultimately drive share prices, this is a reason I see stocks as a reasonable hedge against inflation.

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 X @AdamMGrossman and check out his earlier articles.

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Martin McCue
6 months ago

Inflation helps the government in a number of ways – it makes it easier for the government to pay its debts over time. Each year, inflation makes the dollar cheaper (worth less in comparison to prior years), and that makes it easier for the government as a debtor, even if it is paying interest on what it borrows. Also, inflation tends to move taxpayers into higher brackets over time, and reduces the value of credits and deductions that aren’t indexed for inflation. [But even with all this inflation benefit, some in government still wants to take a bigger slice of the taxpayer’s financial pie. And that means that, unless salary increases are larger than inflation, the taxpayer has to find a way to pay for all of his or her other living costs with what is left, even though the value of what is left might also have gotten smaller.]

Cammer Michael
6 months ago

Inflation is good for borrowers because their interest rate effectively drops as money they repay with drops in value. We could argue, however, about the principal portion.

Tim Mueller
6 months ago

A very informative article by Adam.

Two percent inflation over ten years means the value of the currency drops by twenty percent. I don’t see how that’s good and what are people on fixed incomes supposed to do? Basically, the fed thinks its ok to steal two percent of our money every year. The US and most of the world were on the gold standard until 1971. The price of gold was set by the government and international agreement. One ounce before 1952 was $20.67 and after was about $35.60.That’s not because there was a lot more gold floating around but because the supply of money was limited and it had that much more value. After 1971, when Nixon took us off the gold standard, the price of gold started to rise, along along with inflation and the supply of money, until now the price of gold is $2,454 per ounce.

The argument that deflation is bad because people put off spending is kind of shallow and only goes so far. Eventually people are going to run out of things and have to buy. The government likes inflation because they can overspend and then use money that is worth less to pay off the debt which is a fixed amount. I would like to see the US Fed have the same mandate as the German Fed (Deutsche Bundesbank) which is to ensure price stability or zero inflation.

Last edited 6 months ago by Tim Mueller
Bruce Trimble
6 months ago
Reply to  Tim Mueller

The real reason deflation is bad is because people who take out loans are devastated. For instance, a farmer who has loans to pay to plant crops.

Then prices drop for their crops, and yet they still have to pay back the loan, going into debt.

Or a family who has a mortgage on a house, which has a price drop. So they are underwater.

If there is a great job that they would have to move to, they would have to pay the bank back more than they would get
by selling. Or rent wouldn’t pay for their house payments.

Deflation is what made the Great Depression the worst economic disaster in US history.

Nick Politakis
6 months ago

Excellent analysis and commentary

G W
6 months ago

Thank you, Adam, for another great article. I truly wish more people understood that the economy is not on autopilot. Good basics presented well here. Have you considered sending this to Congress?

wtfwjtd
6 months ago

Very true. I see bonds, and bond-like instruments, as potential short-term inflation hedges, and of course stocks for the long haul are great long-term inflation hedges. For bonds, TIPS or I-bonds can work fairly well with a decent above-inflation coupon (my personal cut-off is nothing less than around 2%), or even some kind of floating-rate fund based on longer rates (think something like the TSP G-fund). Social Security is also a good bond-like portfolio element since it’s indexed to inflation, and this is also a good reason to maximize it to the extent possible.

Edmund Marsh
6 months ago

Great macro lesson, Adam. It highlights to me the awesome sword that the Fed wields to deal with the Gordian knots that arise every few years. I just hope they are smart enough not to unravel things too far. It also highlights the need to cover all bases with a personal money plan that’s broad and simple and doesn’t make a big bet in any one direction.

eludom
6 months ago

While Rome did debase the coinage at times (more in the later Imperial period), the actual parallel to the income Alexander brought/sent home came as the late republic expanded (Punic wars, conquering Greece, etc) … the wealth of the provinces flowed to Rome. The result was a huge inequality in wealth, sumptuary laws (largely unsuccessful), and conflict between the Romans self image of being sturdy, frugal, “Spartan” people and outrageous opulence. One irony is that one round of such inflation was driven wealth from silver mines in Spain, which ~1800 years later drove a similar round inflation as they plundered wealth from the new world. What goes around…

A bit off topic, but if anyone wants Roman history in interesting bite-size chunks, check out the “History of Rome” podcast: https://thehistoryofrome.typepad.com/revolutions_podcast/the-history-of-rome.html

SPQR

Winston Smith
6 months ago
Reply to  eludom

eludom,

Your podcast suggestion is excellent! It is one of the ones I try to listen to.

Highly recommended!!

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