Inflation happens

TL;DR: Inflation is a near constant force. We’ve had it for centuries, and in the last 70 years it has become the literal policy of the Federal Reserve to maintain a ‘healthy’ level of inflation, currently targeted at 2%. Our economy is designed to work with inflation, and it breaks downs without it. Given this, we should position our investments to withstand and in some cases benefit from this inflation. Owning equity positions in hard assets of durable value is the most time tested strategy to protect yourself from this silent tax

I often talk about the risk of inflation with respect to investments. In my opinion, an investment isn’t a good one unless it is inflation protected. I say this, because inflation is a constant. It is a force that we can count on over the long run. If you hold cash, the value of that money will erode at least a little every year, and in some cases it could erode a lot! If you’re not protecting yourself from this silent tax, it will hurt you over the long run.

What and why…?

But what is inflation? Simply put, it is when the purchasing power of a US dollar (USD) goes down. Put another way, it’s when the price in USD of a good goes up. In either case, you get less ‘stuff’ for your USD today than you did yesterday.

We can tell that inflation is pretty much a constant just by looking to the past. Over the last 70 years, USD inflation has been almost universally positive, and in some cases out of control (see 1970’s):

Historical_Annual_U.S._Inflation

But if the past weren’t enough evidence, keep in mind that the Federal Reserve has an inflation target of 2%. The organization responsible for conducting US monetary policy openly states they aim for 2% inflation. They control the purse strings. If they really want to, they can just print more money. In some respects, that’s exactly what they did over the last 7 years with the various waves of ‘quantitative easing’.

You might be wondering why the Federal Reserve cares so much about inflation. Well, the short answer is that our economy breaks when we don’t get enough of it. The growth-driven, debt-driven economic model depends upon some measure of predictable price inflation to keep everything in motion. Just look at what happened during the 2008 financial crisis – inflation barely dipped below zero and we had the worst recession (depression?) since 1929.

When we experience deflation, all kinds of bad things happen:

  • Asset prices decline – due to some shock, and are expected to decline further
  • People stop spending – the prospect of USD buying more tomorrow than they do today means people will hold on to those USD as opposed to spending them, so asset prices continue to fall
  • Debt burdens grow – when asset prices shrink, the relative value of debts outstanding (in USD) goes up. This puts borrowers further and further underwater as their asset prices decline, but their debts remain the same (in USD)
  • People are forced to sell – because debt burdens increase (as per above), some people become forced sellers, and have to unload assets at fire sale prices… this further exacerbates the spiral of declining prices

There really is the potential for a deflationary spiral to spin out of control and topple this whole house of cards we call our modern economic machine. So in that context, I suppose you can understand the utter fear that politicians and policymakers have when presented with the prospect of deflation. The risks are too real and too great. Given this, the only acceptable alternative is to inflate away. Do whatever it takes to achieve or exceed that 2% inflation goal!

What can we conclude?

There are a few things we can takeaway from the above assessment:

  • Expect inflation: Given that the pain of even slight deflation is simply too much for the economy to bear, we should expect inflation. We should also expect the blunt tools they use (monetary policy => rate cuts and money printing) to overshoot every once in a while, giving us inflation much higher than 2%.
  • Debt is cheaper than you think: That 4.5% interest rate on your home mortgage is really like 2.5% (assuming a 2% inflation target holds). The true cost of borrowing is less than you think. The inflation tailwind offsets some of those borrowing costs, making the use of leverage in the right situations highly valuable
  • Holding cash or bonds is expensive: In the same way that borrowing money is cheaper, lending money becomes less attractive. If you’re getting paid back in USD that are become worth less every year, then it might not be such an attractive deal

What should we do about it?

In short, plan for inflation. Expect your USD to become worthless over time. If your USD will be losing value, then the only way to protect yourself is to purchase assets that won’t lose their value. Purchase assets that will maintain their utility over time, regardless of what the Federal Reserve does with their monetary policy:

  • Avoid bonds: The most vulnerable class of assets in this context are bonds. Owning debt denominated in USD is the same as owning USD from a purchasing power perspective. If your bond agrees to pay you back with USD 10 years in the future, and those USD can only buy you half as much ‘stuff’ in that time, then you’ve lost a lot of value. This is why I recommend staying away from bonds or any form of fixed income products
  • Own your home: Another thing I recommend doing is buying your primary home. With inflation all but guaranteed, the price of renting will go up over time. If you live in a high growth market (like San Francisco, Seattle, Denver etc.), expect housing prices to double every 10-15 years. If you’re a renter, you’ll be vulnerable to those continually rising prices (despite rent controls), but if you own, you lock in your cost of housing forever. You become neutral real estate, and protect yourself from inflation on one of the largest expenses any household faces
  • Purchase stocks: For your publicly traded investments, focus on equities. As mentioned above, there’s no point holding debt. Buy a mix of Vanguard stock ETFs and let it grow. While equities are not immune to inflation, they certainly stand up better than debt, as most companies can raise the prices of the goods they sell when inflation happens. The best companies have the pricing power to raise prices even faster than inflation – those are the companies to own!
  • Purchase real estate: As I’ve enumerated on countless occasions, real estate is an excellent inflation protected asset, because generally speaking the value of housing is durable. People need somewhere to live, and when inflation happens, it’s likely you can raise rental rates
  • Borrow money where it makes sense: As mentioned above, you don’t want to buy debt… so it stands to reason that selling debt might not be a bad idea. This is true, in the right circumstances. While I highly recommend avoiding any form of debt to buy stocks or any other form of publicly traded assets, there are situations where using a little leverage can go a long way. Specifically, when buying investment real estate, or investing in private companies. The key is to only use debt for lower risk, cash generating assets that have a healthy cushion to their cash flow built in. You want to know that even if the economy takes a nosedive, the cash coming from your assets will be enough to make the corresponding debt payments. You never want to become a forced seller!

Try one or a few of the strategies above and you’ll position yourself much better to withstand the inevitable bouts of inflation to come. While the Federal Reserve talks about maintaining ‘stable’ prices, if it’s a choice between stable prices or repairing a broken economy, they will blow up the USD overnight. As we speak, debts continue piling up in various parts of our economy, and when debts become too much of a burden, the only realistic way to deal with them is to inflate them away in one form or another. You read it here first.

Before I finish though, it’s worth throwing in a word of caution – simply because the Federal Reserve is committed to generally inflating prices, this doesn’t mean they can control short terms shocks and market corrections. The irony of the Federal Reserve’s policies is that they create a moral hazard – people expecting inflation don’t believe that a bout of deflation, or what we call a market correction, will ever happen. That belief alone creates a situation where something like that becomes much more likely. So while I recommend positioning your portfolio to withstand and even benefit from inflation, do it with caution and the realization that asset prices can and do decline over the short term. Particularly (as in early 2018) when asset prices look generally inflated, we must be cautious, use debt conservatively and position ourselves to be robust through whatever sort of market we might face. Keep that in mind, and protect your portfolio so you can live to fight another day!

Don’t be greedy!

Ramen-san

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