$1.9 trillion in economic stimulus on top of $2.9 trillion in 2020. Will almost $5 trillion of economic stimulus – printing money – reignite inflation, and if so, what can we do about that? When I came to the United States in the Fall of 1979, with $200, inflation in the United Kingdom was 13.4%. Down from a high of 24% in 1975. Things weren’t much better here, though. In fact, in 1980 inflation hit 13.5%. Now, 13.5% can chew up two hundred dollars pretty darn fast.
Paul Volcker, who was put in charge of the Federal Reserve by Jimmy Carter and retained, in his wisdom, by Ronald Reagan when he was elected, broke the back of inflation. He did it in the 1980s through significant interest rate hikes. He took the Fed Funds Rate up to 20% in June of 1981. Prime rate of 21.5%. Can you imagine a home mortgage at 20%? He set the table for many years – two decades of economic growth – 1980s, the 1990s. But it took significant economic and political capital and courage to make it happen. And Ronald Reagan had a lot of political capital. The subsequent long-term drop in interest rates and inflation that continued over the subsequent 20 years, really embedded itself in the American – and even the global – psyche. In fact, interest rates were at an all-time low in April of 2020 with an effective Fed Funds Rate of 0.05%. Effectively zero. In fact, we call it “ZIRP” – zero interest rate policy. And we are very firmly in the grips of ZIRP today. Investors in that 20, actually in the 40-year period, really enjoyed the best of both worlds. Long-term stock market gains, and almost as good bond market gains as a result of falling interest rates. Homeowners no longer saw their mortgage chewed up by inflation, but they got to see such significant valuation increases that now our young people struggle to be able to buy their first home.
So there are really three scenarios that we’re dealing with today. First is the scenario that was of great risk a year ago, but seems to be fading pretty significantly. And that is that we actually slip into a depression – a deflationary environment. But with $5 trillion out there, that’s not high on the risk list. But frankly, after watching the last, the Great Recession of 2008, there was a clear and present danger that insufficient action would occur to stop the economy, the global economy, from slipping into a global depression. That would have been devastating for equities. Devastating for economies, the world over. Think 1929. It took a world war to get out of that. Fortunately, that risk has faded. The great risk is over.
We have two risks now. Or two scenarios, I should say. One interest rates stay low, inflation stays low. That’s pretty much the Goldilocks scenario. And if the Fed and the government can make that work, we really don’t have anything more to add. Second, of at least equal risk, is that interest rates stay low, but inflation starts to take off as a result of an increase in the velocity of money, which is really too much detail for today’s conversation. If that happens, a couple of things happen: one, the housing market, if not collapses, will stagnate. People can afford these beautiful homes because interest rates are so low. If you bring interest rates from three and a half to 7%, you almost double the house payment on a 30 year mortgage. Well that just prices everyone out of the market. Values collapse. Resale collapses. In the bond market we’re risking the same thing. Interest rates start to climb because inflation, bonds will collapse. Our portfolios as a result are very much focused on short-term bonds.
There is a kind of bond that can protect you against this. And this is called treasury inflation-protected securities (TIPS). We are beginning to insert short-term TIPS into the portfolio. TIPS that are not that sensitive to interest rates climbing, but are very sensitive to inflation. Now for those of a high risk tolerance, or a higher risk tolerance and therefore not much in the way of bonds, but a lot in equities, studies show us that for every 4% in TIPS that you put in a portfolio, you can get the same or equivalent inflation protection, using about 1% of commodities. And so for those clients, we’re going to put just a small taste of commodities that are very volatile, but in a rising inflation environment and in a growing economy, commodities tend to fare well. It’s a medicine. We don’t want too much medicine. We don’t want to “OD” on them. We don’t want to get whiplash. But a trillion here, a trillion there – in today’s world, we’re beginning to talk about real money. We wish you the best of investment success.