How to Prepare for Coming Inflation


 

One of the most common concerns we’ve been hearing recently (and rightfully so) is the fear of impending inflation.  Government spending had already increased dramatically post financial crash in 2008, and then we saw another multi-trillion dollar stimulus package to combat the effects of COVID this past spring. The easy answer to this question would be “of course”.  How can the fed print trillions of dollars and this not dilute the value of current dollars?  Well, it’s not quite that simple.  Many people made this same argument after the quantitative easing that occurred after 2008, yet we’ve seen extremely low levels of inflation.  So what’s the difference?  Why has there been no inflation so far, and why should we expect inflation going forward?

To answer that, it’s important to realize that there is more than one way to measure money.  The amount of actual currency minted by the US Government in circulation is one measure, and is referred to as the monetary base.  However, we don’t live in a cash only society.  Most people hold their money in banks, but those banks don’t actually hold your dollars.  They hold a small fraction of those dollars, but the rest is lent out or invested.  So the dollar that you have in your savings account is the same dollar the bank may loan to your neighbor to buy his house.  The second measurement is called the M2 money supply, and this measures not only the physical currency, but all accounts that can be easily turned in to currency (checking, savings, money market etc.).  The M2 money supply is much more indicative of the actual supply of money that Americans have at their disposal to spend on goods and services, which makes it a much more reliable predictor of inflation.  The chart below shows the growth of each of these measures over the last 30 years.

What is very apparent in this chart, is that at the end of 2008, the monetary base skyrocketed, but interestingly the M2 supply didn’t follow. A primary reason for this is the banking reserve requirements increasing post-financial crisis.  I mentioned earlier that for every dollar you have in the bank, they only keep a fraction of that in reserve.  However, after many banks failed or came very close to failing in 2008/09, the requirements for bank reserves increased.  The below picture is a snapshot from the San Francisco Federal Reserve showing what happened at this time. 1

Basically what this shows is that although the Government injected a ton of money into the system post 2008, almost none of it actually flowed into the real economy.  So why is this time different?  Why should we expect inflation to follow this round of Government printing trillions of dollars?  Because this wasn’t predicated on shoring up fragile banking systems.  This was injecting massive amounts of money directly in to the US economy.  Below shows the year over year change of the M2 money supply.  That is an almost 25% increase from last year’s M2, which drastically higher than any increase we’ve seen in the last 30 years.

The last factor that impacts inflation is how much each of these dollars exchanges hands.  This is defined as the velocity of money, and a good indicator of economic growth.  In simplistic terms, if M2 money supply x velocity of money increases from one period to the next, the result is inflation.  In looking at the chart below, the decreasing velocity of money is another reason why we saw historically low inflation over the last 12 years even while the money supply increased. An overall weak economy is one (not ideal) way of avoiding inflation.  This also makes timing inflation incredibly difficult, and not something I would ever recommend trying to bet on.  But if (when) we see this velocity increase back upwards toward historical trends, it will almost definitely bring inflation along with it.

So although we don’t know when inflation is coming, it’s a good bet that it is indeed coming in the future.  So what should investors do to prepare for this impending inflation?

1.) Evaluate your exposure to the risk of inflation, which is the loss of future purchasing power.  If you have a good chunk of your net worth in a fixed income (pensions, bonds), this should be alarming.  If you have most of your net worth in assets tied to tangible things (Stocks, Real Estate, Hard Assets), this is less concerning.

2.) Diversify your risk.  If you do have a large pension, consider a greater allocation to these tangible assets with your investable assets. For investors in this situation, the principal risk of stock market exposure might be worth taking on if your purchasing power risk is very high.

3.) Avoid long-term bonds.  It is still important for most investors to have some fixed income to dampen volatility and provide liquidity.  Interest rates are historically low right now.  Generally high inflation is accompanied by higher interest rates.  If you lock into a low interest rate now and inflation hits and interest rates rise, the value of this holding can plummet.

4.) Don’t overreact.  There are always risks out there, inflation being one of them.  While it is pretty clear that we will experience some inflation in the somewhat near future, this does NOT mean that we will experience hyperinflation, that the dollar will drop to zero, or that you need to move your entire net worth to gold (that’s a conversation for a future post).  Many people in the media will try to hijack a plausible argument and push these extreme narratives to get clicks or sell product. Diversify and stay disciplined, and don’t fall victim to a solution that is worse than the problem.

1.https://www.frbsf.org/economic-research/publications/economic-letter/2012/july/monetary-policy-money-inflation/

2 Comments

  1. […] ~ 7% annualized historically to now having an expected return of closer to 5%.  Considering that inflation is probably coming, allocating half of your portfolio to bonds that are paying very little may result in difficulty […]

  2. […] Solution: Owning equities, real assets (house/land etc.), Treasury Inflations Protected Securities (TIPS).  I covered the prospect of inflation and in depth solutions here. […]

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