The Great Inflation (Debate)

“Our purpose is to lean against the winds of deflation or inflation, whichever way they are blowing” – William McChesney Martin

“The Great Inflation”, as it became known, describes the period in the US from 1965-1982.  In 1964, inflation clocked in at 1% and then ratcheted up steadily until it peaked in 1980 at 14%.  William McChesney Martin was chair of the Federal Reserve from April 1951 to January 1970 and served under five presidents.

The significant deficit spending that the US and other countries have embarked upon in the past decade has accelerated exponentially since the outbreak of the pandemic and has brought the inflation debate back to the forefront.  And as is usually the case in the fields of economics and finance, there is little consensus on the direction and magnitude of the impact of all this spending.  Below are two brilliant minds that are on opposite sides of the inflation debate.

First, Niall Ferguson describes his thoughts about inflation. Mr. Ferguson points to the fact that inflation expectations (measured by the yield difference between the 5-year treasury securities and the 5-year Treasury inflation-indexed securities) have increased from .14% a year ago to 2.45% more recently. Hardly the 14% we saw in the 80’s, but a significant move nonetheless.  He also cites the move in the 10-year treasury rate from a low of .6% one year ago to the current rate of 1.71% as of this writing.

He points out that during the Great Inflation, the easing (lowering interest rates) by the Fed (run by Mr. McChesney at the time) was responsible for inflation getting out of control.  Mr. McChesney was interviewed sometime later in the 70’s and admitted that the Fed policy was a mistake.  He indicated that “the horse of inflation was not only out of the barn but was already down the road.”

The counter argument to inflation is summed up nicely by David Bahnsen, of the Bahnsen Group. He believes that the more reasonable case going forward is for deflation.

Mr Bahnsen points out, correctly, that the Fed does not put money directly into the financial system (yet), but does this through the banking system, and that although new dollars have been introduced into our economy, it is the velocity of money (how often the dollars are “turned over”) that influences inflation.  Banks are the primary source of money into our economic system.  They borrow money from depositors and the Fed to make loans only in response to loan demand.  If loan demand is not growing, there is little inflation pressure.  He writes that although new loans have been created at a rapid pace lately, most of this debt has been used to pay off (refinance) existing debt and no significant “new” money has entered the system.

He argues that if the Fed could create inflation, we would already have it as the Fed has set an inflation target that they haven’t been able to hit for a decade (of course, why we want inflation at all is another matter that I may tackle in a future letter).

Many in Mr. Bahnen’s camp (including the Fed) believe that inflation may spike in response to the pent-up demand created by the economic shut-downs, but that this will be fleeting.

We certainly are experiencing an uptick in inflation as indicated by the graphic below.  The Bloomberg Commodity Spot Index is much higher than it was at the bottom of the economic downturn in 2020, and more importantly, it is much higher than it was in the years leading up to the downturn.

Inflation is something that is easy to understand, but difficult to measure.   The most common measure, the Consumer Price Index (CPI), is a basket of goods and services that attempts to quantify changes in prices over time.  The problem with the index is that the basket assumes that everyone is affected by inflation in the same way.  It under-represents most people’s spending on healthcare, and does not include home prices in the calculation (it uses a rents-based formula that is currently significantly underperforming the price appreciation of single-family homes).  Not to mention that the index commonly excludes food and fuel as being too volatile (good thing nobody needs to spend money on these trifles).

People experience inflation very differently depending on their stage of life and location.  The young are sheltered generally from the high cost of medical spending, but experience it in higher education costs.  Folks in California experience much higher costs in home ownership than those in Wisconsin who may pay more for produce.

We believe that inflation is a fact of life, and you ignore it at your own peril.  We have grown increasingly concerned over the level of debt that has been created in the recent past and believe that it will have a destabilizing influence on bond markets, our economy, and the value of the dollar.

To that end we are looking at ways to lean against inflation and protect your portfolio.