Inflation, like gravity, is a silent force, unseen but felt in some of the most high-impact areas of our lives. How much we pay for goods and services, how much we are paid, how we invest and what our investments are worth are all highly influenced by inflation. While inflation sometimes has negative connotations, a primary goal of central banks’ policies involves controlling, and sometimes even encouraging inflation. So, as investors, it is important to understand this significant influence on our economy and how it impacts our financial lives. In this commentary, we will discuss what drives inflation as well as the monetary levers and pullies used by central banks to reach the desired levels of inflation. We’ll also discuss some of the consequences – intended and unintended – of our current low interest rate environment and what we expect to see in the future.
To understand how inflation affects you as an investor, it is important to first understand what inflation is and how it is calculated. Inflation is the rise in price of a basket of commonly used goods and services. Conversely, deflation is the opposite of inflation when the cost of goods and services declines. The most common inflation measurement is the Consumer Price Index (CPI), which is calculated by the US Bureau of Labor and Statistics (BLS) and measures the average change over time in the prices paid for a market basket of consumer goods and services. Those goods and services include:
CPI Categories & Weighting1
- Housing: 42%
- Transportation: 17%
- Food and beverage: 15%
- Medical Care: 7%
- Recreation: 6%
- Education and communication: 6%
- Apparel: 4%
- Other Goods and Services: 3%
According to the BLS, the CPI is often used to escalate or adjust payments for rents, wages, alimony, child support and other obligations that may be affected by changes in the cost of living.
Over time, there have been three significant changes to the CPI calculation. The first was in 1983 when housing prices were removed and replaced with the owner’s equivalent rent, which over time, proved to be volatile. The second significant change came in 1998 when Hedonics was introduced. Hedonics is the adjustment for the quality improvement of a good. A simple example could be if an air conditioner’s cost rose by 10%, but improvement produced a 10% increase in cool air at the same cost, then there would be no increase in inflation even though the air conditioner’s cost went up. The third significant change was in 1999 when substitution was added. This happens when the cost of a product or service increases, but a substitute at a lower cost is found. Buying a hamburger instead of steak is an example. These changes have fueled a debate about whether the cost of living is as low as the Bureau of Labor Statistics calculates.
Silent Source of Inflation: Taxes
An additional source of inflation that is never discussed because of the variations by regions and municipalities are taxes. Whether we want to admit it or not, taxes affect the cost of living and include national income taxes, state and provincial taxes, property taxes, state and provincial sales taxes, fees, service charges, etc. Admittedly, these are generally stable; however, we are entering a period when we can expect additional taxes and service fees to cover the recent pandemic cost. For example, New Jersey recently increased the state gas tax by nearly 10 cents per gallon. While that is regional, the cost of living in New Jersey just increased for residents who need a car or truck for daily commuting. Additional taxes will take money out of the economy, reducing the velocity of money necessary for growth and a stable economy.
Fiscal and Monetary Policies
Next, we look at the Central Bank Policy. The current Central Bank policy follows what is called Keynesian economics. The central theme of Keynesian economics, developed in the 1930s after the Great Depression, is the “theory of total spending in the economy and its effects on output and inflation.”3 Economic demand can be influenced through government policies of activist stabilization and economic intervention. Activist fiscal and monetary policies are the government’s basic tools to reduce the impact of recessions and slow overheating economic growth. In periods of recession, lower interest rates, lower taxes, and more social program spending is intended to increase demand. In periods of strong growth, the Central Bank raises interest rates, recommends fiscal measures of higher taxes and lower support of social programs to cool demand.
A Change in Approach
The US Federal Reserve recently completed an academic review of monetary policy strategy, tools and communication processes. The review was a re-assessment of inflation targeting, a policy shift in 2012 under Ben Bernanke, the then Chairman of the US Federal Reserve. To promote a dual mandate of low unemployment and stable prices, the inflation target was set at 2%, bringing the US Fed in line with other Central Banks. Central Banks control inflation through monetary policy. Under the Keynesian theory, as mentioned above, higher interest rates stall economic growth, and lower rates stimulate economic growth, or so they thought. As a result of the recent US Fed review, Chairman Powell announced a change from inflation targeting to inflation averaging and signaled it would make job growth pre-eminent. Further, Chairman Powell added the importance of a strong labor market. With unemployment rates at 10% and a slower economic recovery than expected, the change in policy is interpreted to mean interest rates will be kept lower longer than under the previous targeting approach.
There are several unintended consequences of historic low-interest policies. First, low interest rates have forced investors into other asset classes, creating bubbles. One of the most famous is the housing crisis of 2007 and 2008. Low interest rate environments can also force investors to take on more risk, both in equities and high-yield debt, to replace the income from low-yielding bond portfolios. Still, another unintended consequence that does not receive much attention is taking place today with savers. In theory, low interest rates are supposed to force consumers to spend rather than save. However, there is a breakpoint where the opposite happens. The chart below, produced by the Bank of America Research Investment Committee, shows that once yields fall below 4%, spending as a percentage of disposable income decreases and saving for retirement and future expenditures increases.
Lastly, the most serious unintended consequences of low interest rates are felt by government employees, teachers, police, firefighters, and trade unions with defined pension plans. This type of pension promises a defined benefit at retirement based on an actuarial calculation that considers the contributions by both employee and employer, the contributor’s life expectancy, and the expected rate of return on the accumulating assets. The actual pension is based on the last 3 to 5 years of an employee’s annual earnings before retirement. Most defined benefit plans are underfunded, and estimates of unfunded government liabilities in the US range as high as $4 trillion. The lower the interest rates, the more money it takes to fund these government pensions and all defined benefits plans. Most Statements of Investment Policy require upwards of 50% of assets to be invested in bonds, which at current historic low yields, puts more stress on equity investments of the asset pools. Most plans use a discount rate or require a return rate on assets between 6% to as high as 8% in the current environment. The higher number requires less funding and the lower number requires the opposite. Pension administrators and actuaries can adjust the discount, making the funding appear better than it might be. Making matters worse, these benefits to government workers are guaranteed and many state supreme courts have ruled benefits cannot be reduced. There is no way out of this deficit hole other than raising taxes to cover the deficits. Contrast this to the average Joe who is required to save for their retirement. Lower interest rates force savings and higher taxes, taking money out of the economy, thus reducing economic activity and economic growth.
Japan introduced zero interest rates in 1999 based on the Keynesian model that indicates zero interest rates force spending; only it did not happen. In Europe, they went even farther and took rates into negative territory. Again, it did not stimulate economic activity. In North America, it is debated whether the Fed will drive rates into negative territory. With all this evidence, it seems clear that low rates alone will not stimulate economic activity to the level initially thought. It is simply not enough. Fiscal measures must be implemented in combination. What is required has not happened. It could be argued that low rates helped, and in certain situations, that would be true. However, low rates for an extended period as we are currently experiencing do not work and arguably put the whole financial system at risk.
Nature has a way of correcting extremes. Global Central Banks have taken rates to extremes creating unintended consequences which, over time, will correct. Unfortunately, the correction will not be pleasant for the financial system and will likely cause a great deal of suffering.
Warren Gerow is an independent investment wealth consultant to Sightline Wealth Management.
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