Inflation 101: Understanding the ‘why’ behind today’s inflation

The Bureau of Labor Statistics just reported a whopping 9.1% year-over-year increase in the inflation rate – This is the highest in forty years and many economists suggest that inflation will get worse before it starts to get better. To put a 9.1% inflation rate in perspective, one million dollars today has only $909,000 worth of purchasing power compared to just one year ago.

Americans are facing higher prices for food, fuel, and housing and are grasping for answers about what is causing inflation, how long it will last, and what they should personally be doing to combat its effects.

There are no easy answers or painless solutions when it comes to the inflation problem. Before we jump into how long it will last and what can be done to resolve it, we need to define what is causing inflation in the first place.

What is Inflation?

Stated in its simplest terms, “inflation happens when too many dollars are chasing after too few goods and services”. So, inflation is really a supply and demand problem. When there is an equilibrium between the supply of goods and services and demand (money available to spend), inflation is in check. When the demand outpaces the supply of goods and services, inflation accelerates. Once this concept is understood, we can dissect what is limiting the supply of goods and services and what is driving demand.

The Supply Issues Impacting Inflation

A couple of events have contributed to the limited supply of goods and services:

First: The COVID pandemic in early 2020 led to lockdowns and numerous restrictive measures by governments around the globe to stop the spread of the virus. These government-imposed lockdowns disrupted the global supply chain as factories were shut down and maritime ports were closed. Currently, COVID continues to affect worldwide supplies as China, the world’s largest manufacturer, is still troubled by shutdowns as they try to get on top of the COVID pandemic still plaguing their nation.

Second, The United States went from being energy independent just a couple of years ago to once again being forced to purchase oil in the world markets. U.S. production has decreased while our consumption has increased. The inevitable result of this supply/demand imbalance is inflated oil prices. Higher oil prices serve as a catalyst to higher prices in all other parts of the economy as higher energy prices increase the cost to produce and ship goods.

The Demand Issues Impacting Inflation

Consumers are spending big. When the pandemic started, the personal saving rate in the United States was sitting at an all-time high. With large amounts of savings on hand, the federal government sending out relief checks to individuals and businesses, and employees sitting at home with shopping at their fingertips, the U.S. consumer spent a lot of money. And the spending spree isn’t over, with unemployment numbers sitting at all-time lows, employees are either finding better paying jobs or are requiring higher wages from existing employers. These higher wages continue to encourage high demand for the limited goods and services available.

Additionally, with the pandemic mostly behind us, there is a pent-up demand from people looking to travel and vacation once again. If you have traveled recently, you would have noticed the inflated prices of airline tickets, rental cars, hotel rooms, restaurants, and more.

So, how long will high inflation rates be with us?

There are thousands of economists attempting to answer this question, all with different opinions. So, how long this recent inflation acceleration might last is anybody’s guess. However, there is a consensus on how the inflation supply/demand equilibrium will be brought into balance. The inflation rate will decrease as consumer spending slows down, or in other words, when the demand for goods and services is reduced. Two of the main ways demand is reduced is either by raising interest rates, by the economy suffering a recession, or both.

Raising Interest Rates

The Federal Reserve has the responsibility to monitor the economy and implement policy to maintain the equilibrium between supply and demand, in other words, keep inflation in check. The Federal Reserve is raising interest rates to slow consumer demand and subsequent price growth. This policy response means that the economy will surely head for a slowdown. We have already seen how higher interest rates and higher borrowing costs have begun to cool off the housing market. The question — and big uncertainty — is just how much federal action will be needed to bring inflation under control.

Having A Recession

A recession is when the economy shrinks. This is a more painful and less desirable way to slow consumer demand, but it can work towards taming inflation. During a recession, the overall economy struggles, corporations make fewer sales and become less profitable. Workers are laid off and unemployment surges.

The hope is that the Federal Reserve can raise interest rates just enough to slow consumer demand without throwing the country into a recession. This optimistic scenario, often called a soft landing, is difficult to orchestrate and despite the best efforts by the Federal Reserve board, can still end up throwing the economy into a recession.

In our current environment, the so-called soft landing is especially challenging. As the Federal Reserve tries to reign in demand with higher interest rates, they have zero control on the supply side of the equilibrium. If supply chain shortages persist, the Federal Reserve will be required to raise interest rates more drastically to slow the demand enough to bring higher prices under control. It’s an economic tightrope, we will see if the Federal Reserve can walk it.

What will not help inflation?

Currently, there is talk on Capitol Hill of sending out additional stimulus checks to help the U.S. consumers pay for high gas prices and other goods. This is indeed a noble thought, but terribly misguided. The demand side of the equilibrium is already out of balance. In other words, there is already too much money chasing too few goods and services. Going into more debt, to throw more money at a problem caused by too much money pursuing too few goods and services is not the answer. We cannot spend our way out of inflation and any attempt to do so, will only result in higher inflation.

Conclusion

We have addressed the causes of inflation and talked about how the rate of inflation will be reduced. In our next blog we want to get personal. We will be going over the personal dos and don’ts of managing higher interest rates and making good decisions concerning your investments during recessionary times.

If you have questions, concerns, or would like to review your personal retirement situation, please click here to schedule a complimentary consultation.

It’s Not as Bad as You Might Think

The stock market recently went through another correction. During the last quarter of 2018, media outlets were happily giving bad news day in and day out. At its worst, the market fell almost 3% on Christmas Eve alone. From all-time highs in September to the Christmas Day low, the market had taken a nearly 20% tumble. As usual, many investors agreed that it was finally a good time to panic. During Christmas break, I heard a nationally syndicated talk show host giving advice to his listeners. He warned them he had pulled out of the market altogether and they would be wise to do the same. He should have read Scott’s book before making such a rash decision.

Since Christmas, the market has rebounded and is already flirting with the all-time highs that are so common in a normal market. It doesn’t always happen exactly this way (if you blinked this time, you might have missed it), but the pattern is usually similar. I wonder if our talk show host friend will wait until the market is about to plunge again before putting his money confidently back into the market just in time to see another drop in the value of his portfolio.

Whenever we get into another one of these temporary downturns there is a tendency to question the stability of the market that we are dealing with. Why would we put our money into this “house of cards”? It feels like there is no end to the bad news and we’ve already missed out on the opportunity to get out while the getting was good.

The reality is the stock market is just a group of companies making goods or services people need and want. If they can make a profit on what they do, the value of their stock will rise over time. The price of a stock follows the profits of the company it represents. Not every day, not every quarter, but over time.

Since the bottom of the 2008-2009 recession, the stock market has returned nearly 300% to those who were patient. That’s just over 14% per year. With all the bad news that we’ve had over the past 10 years, how is it possible that companies could have been so profitable?

Let me start with the most obvious reason. In 2007, Apple came out with a new technology – the iPhone. Since then, smartphones have been adopted at such a rate that even our preteens can’t survive without them. The efficiencies that nearly every worker, from the CEO to the delivery person have gained with their smartphones are incredible. Reports are created, shared, edited, and presented all via a mobile device.

A CEO can manage the many aspects of his business at the touch of a screen. When he has a meeting across the country it takes him minutes to book his flight and travel arrangements – a task that took much longer in the past. When he lands, he can request an Uber on his phone and knows the second it pulls up to get him to the next meeting. While on route, he can have video/phone calls with those who need a face to face meeting, but not a handshake.

The FedEx driver gets time-saving data on the most recent crash or traffic jam, and the best secondary route all updated in real-time. He uses his phone to scan each item for a more efficient drop. He also takes a picture of the package when he delivers it. The photo is automatically sent to the customer to secure the package before it can be stolen. This saves money for customer support hunting down or replacing lost items. It also creates a better customer experience.

A farmer can monitor his crops using mobile technology and drones. He can pinpoint the need for fertilizer or herbicide and deploy them using the drone. With the right equipment, he can even run his tractors and irrigation from the comfort of his home office or wherever else he might be working that day.

Many companies have expanded on this mobile technology to make the consumer’s (and the company’s) life easier. Processes that used to require many manual steps have become, in many cases, an app allowing the customer to interact with the company almost completely digitally. We rent movies using an app, or just stream them directly from the company’s website. We use an app to refill prescriptions and drive up to pick up the filled prescription, or even have it delivered directly with the rest of our mail. We also do much of our shopping using apps. This way of doing business is potentially so much more profitable since a company can thrive without a large and well-lit store front in a prime (expensive) location.

Imagine an inventor or engineer with a revolutionary idea. The technology and systems exist now that enable the inventor to create their invention on their computer and send the schematic to a company that can custom build their idea. Or even better, the inventor can use their own 3-D printer to build the idea then they can test and refine on the spot. What took years of trials, testing and manufacturing expenses can be done in a matter of hours at a fraction of the cost.

A doctor can have a live video conference with a patient from hundreds of miles away with the ability to diagnose and treat the patient in much the same way they could in person. Using robotic technology, they can even operate on a patient remotely. This gives the doctor the ability to be so much more efficient with their time and see the patients that they can best help.

There are so many more examples of time and money-saving technologies and processes that have been created or refined in just the past 10 years. The US energy industry has had a complete revolution. Health care is making strides on many fronts creating a healthier and longer-lasting workforce. When you think about it, it’s no wonder companies across industries are seeing profits increase over time.

Of course, there are many places that still need improvement and obstacles that need to be surmounted. We see negative headlines every single day outlining the next challenge to overcome. If you read or watch everything out there, you’re likely to be overwhelmed. But those are the interesting (if morbid) tidbits that sell news time each day. They don’t represent the seemingly ordinary but real increase in productivity and standard of living that we see evolving around us at ever increasing rates. Don’t get bogged down by each new negative piece of news you hear. It’s not nearly as bad as you might think.

If you are getting close to retirement and will have at least $500,000 saved at retirement, click here to request a complimentary copy of Scott’s new book: Plan on Living!

This Time Really Isn’t Different: What to do When the Stock Market Crashes

Anytime the blended price of America’s 500 largest companies (S&P 500) drops by 34%, you know that there is something significantly wrong going on. This is the fourth time we have experienced this magnitude of decline in my thirty-four year career and every time such an event comes around, we tend to surmise that, “this time it is different”. We conclude this because the details of each crisis are fundamentally different from anything we have before faced.

Thus, the COVID-19 pandemic, and the economic panic it has engendered, seems entirely unique in our history. Moreover, we are without historical precedent as the equity markets become unmoored from valuation fundamentals. We have no idea how the pandemic will affect the earnings of corporations nor how much future dividends will be cut. Furthermore, we don’t really have an idea how long it will take for the economy to stabilize and return to a sustainable path of growth. We are mired in a bog of uncertainty as to how the immediate future will play out.

During times of uncertainty and fear, human nature defaults to the conclusion that our current crisis is fundamentally, and even fatally, different from past bear market episodes. That has always been human nature’s rationale for not staying the course and selling out in a panic. This fear of uncertainty caused the epic selloff in February and March when the stock market dropped 34% in thirty three days.

As I think about the three analogous bear markets of this magnitude that I have experienced during my tenure, I recognize that even though each is radically different in its particulars, each was fleeting in its long term effects once we got through them. The three events I am referring to are the Global Financial Crisis of 2008-09, the terrorist attacks of September 11, 2001 and the stock market crash of 1987.

Global Financial Crisis of 2008-09

During the Global Crisis of 2008-09 the world’s financial system found itself over-leveraged and holding trillions of dollars of worthless mortgage derivatives. Under this burden, the credit system broke. Many of the nation’s largest banks, brokerage firms and insurance companies were teetering on the brink of bankruptcy. In response, the S&P 500 declined 57%, making it the worst equity wipeout since the Great Depression. Liquidity was gradually restored, bad loans were written off and from the market trough of March 2009 to the market’s peak in February of 2020 the S&P index delivered an annualized return of 16.7% and stood almost five times higher in 2020 than its 2009 level.

The Stock Market Crash Following 9/11

As the nation reeled from the events of 9/11, Americans feared that World War III had begun. We waited for the next surprise attack fearing that the next one might be nuclear. The stock market was closed for a week and America was convinced that life as we knew it would forever be changed. We will never forget what transpired on that infamous day yet, economically and financially, 9/11 ended up being just a temporary distraction.

Black Monday, October 1987

On a beautiful fall day in October of 1987, the stock market had its single worst day in recorded history. The S&P 500 plummeted on Black Monday by 23%. Nobody understood the drop and we all wondered if this was our generation’s crash of 1929 and the ushering in of our very own Great Depression. I remember a couple of investors shooting their stock brokers while other distraught investors jumped from buildings and bridges. As disturbing as the events of Black Monday were, the stock market quickly rebounded, ushering the unprecedented growth that was experienced from the date of that crisis until the year 2000.

Today it is difficult if not impossible to envision that the financial effects of the COVID-19 pandemic will soon be a distant memory, a mere paragraph in a history book that will be added with the other Black Swan events of our times. This will happen because there simply is no other option. There are 330 million hungry American consumers and almost 7 billion additional consumers worldwide that will keep the market’s permanently marching on to new heights. The human race is too adaptable, too motivated, and too ingenious to let terrorism, viruses, or come what may derail our progress. There will be other crisis, there always are, but history has proven that whenever the human race is faced with a challenge, we ultimately overcome the challenge and move on.

Thus, the lesson of this crisis, as well as every other crisis past and future, is that although the exact nature of every crisis is unique, the resulting economic and financial impact of these crisis are remarkably similar and remarkably negligible. Long term investors cannot allow themselves to buy into the most destructive and expensive phrase ever uttered….. this time is different. “This time is different” will forever be the anthem of the failed investor and we can’t allow that phrase to creep into our psyche. History has proven that it is a losing proposition to bet against the ingenuity and indomitable spirit of the human race to succeed. We will overcome COVID-19, and this soon will become just another blip on a chart.

Stay the course, and remember that this time really isn’t different!