‘The Times They Are a-Changin’
-Bob Dylan
Inflation has often been called a “silent thief”. It slowly steals your savings and income without you even seeing a decline on your bank statement. Inflation is like a tax you don’t see. A pickpocket that steals the value of your cash rather than the cash itself. In other words, inflation makes you poorer. It reduces your lifestyle and your financial security. It takes from your future plans and dreams.
Back to the future
During the great moderation of the past 40 years, inflation has been mostly declining or at very low levels. But the times they are a-changin. Due to a combination of increased demand from government transfer payments and pandemic supply chain disruptions, inflation began to accelerate in early 2021. For most of the last decade, inflation had been averaging a bit below 2% per year. As of the end of August, 2022 the Consumer Price Index (a common measure of inflation) had increased 8.3% year over year. Does two years of increased inflation make a trend? Perhaps. Just as we had four decades of declining inflation, it is possible we are in for an extended period of above average inflation. Perhaps not as high as 8%+, but significantly higher on average that the last decade’s 2%.
Since WWII there have been two periods of high inflation that lasted for a few years or more. The first one was right after the war as thousands of soldiers returned home from overseas. Restrictions on manufacturing were lifted, wage caps were ended, and spending on houses, cars, and consumer goods boomed. This period was relatively short lived as economic growth helped to reduce the war debt as a percent of GDP and productivity increased dramatically to lift living standards. The 1950s and most of the 1960s saw strong economic growth, relatively low inflation, and low interest rates. But by 1964, when Bob Dylan released his “The Times They Are a-Changin” album a new financial era was right around the corner. In the 1970s inflation returned with a vengeance. In many ways reminiscent to now, the Federal reserve was accommodative, government debt was high (due to the Vietnam War and increased social spending), and wages were rising. There was also an energy supply shock as the OPEC oil cartel manipulated the supply of oil. Inflation was exacerbated during this time by policy mistakes from the Federal Reserve, which kept interest rates too low for too long.
Winners and Losers
While there aren’t really many clear winners from high inflation (it is the silent thief after all) those currently working have the potential to do much better than those who are retired or living on their savings. Part of what causes and exacerbates inflation is increasing nominal wages. As prices rise, workers demand higher wages. This may cause an increase in demand for goods and services which then leads to higher prices for these limited resources. Economists call this a “wage price spiral” and it was at play especially during the inflation of the 1970s. As a wage earner, this may at least help you to keep up with the higher prices as your income rises.
Those in debt can be helped by inflation. Assuming a fixed interest rate you will be able to pay off future debts with more valuable dollars. Effectively your debt is reduced in real terms by inflation. An example would be an employee who bought a home with a fixed mortgage payment of $1,000 per month. This payment is fixed by the terms of the mortgage and will not increase along with inflation. As the employee’s nominal wages increase (due to the wage price spiral) the $1,000 monthly payment will become a smaller and smaller share of her income. This can also help governments reduce their debts in real terms as nominal tax revenue rises.
Retirees potentially find themselves in a precarious situation. Being out of the workforce they will of course not benefit from a potential wage increase, but will still face the higher prices. Furthermore, if they are living on a fixed income from bonds or a pension, the purchasing power of that income will erode with no way to increase it. They are on the opposite side of the equation as the debtor described above. One retiree income stream that does increase with inflation is social security. As of this writing the cost of living adjustment for 2023 in expected to be around 8.8%. Another factor helping retirees, at least those more well off, is that with their kids through college and their home mortgage paid off they may have more room to cut discretionary spending to weather the storm.
Unfortunately, and this is true in every economic dislocation, the hardest hit by inflation will be the poor. The unemployed (similar to the retiree situation but perhaps without the same resources), low income workers that may not have the same wage negotiating power of the more skilled workers, and those with no room to cut spending will struggle. For example, while rising gas prices are an inconvenience for everyone, it may cause someone on the margin to be unable to get to and from work and lead to a loss of that income. This is devastating for the individual obviously, but is also a negative for the overall economy as economic output is reduced (due to one less worker contributing).
What Comes Next?
One lesson that central banks took from the 1970’s and 80’s was that the way to fight inflation is to increase interest rates and slow the economy. In the early 1980’s the Federal Reserve chairman at the time, Paul Volker, raised the federal funds rate to over 20%. This ultimately worked although at the expense of a deep recession. I will discuss interest rates and their impact in more detail in a future post.
We are entering a new financial era of higher inflation, higher interest rates, and a more volatile economic cycle. Whether this will more resemble the brief post-war period when growth came quickly or the long slog of the 1970’s remains to be seen. Either way this will be an era of change, dislocation, and opportunity arising out of that dislocation. This era will require a new approach to investing, spending, career planning, and goals.
In future posts I will be delving into the inflation topic in more detail, including the potential impacts, investment strategy, and opportunities in this new inflationary era.
