The United States has injected over $3 trillion into the economy and it’s debating even more. How will that impact inflation? Being an election year, the administration is a little bit more willing to prime the pump through November, than maybe in a more traditional year. Will this pump priming trigger inflation? Those of us who remember the 1970s know that inflation can be a scourge. It saps your purchasing power, destroys the value of a fixed income. There’s reason to fear inflation. But to understand inflation we need to understand what drives inflation. As any freshman Economics student will tell you, inflation is really too many dollars chasing too few goods. But there are two saucers of inflation.
One is Demand-Pull inflation. Money times velocity equals the money supply – the availability of money. What is velocity? Velocity is how many times a year the money is spent. So simplistically, if the velocity of money drops by 50%, you actually have to increase the quantity of money by hundred percent to offset the impact on the economy. That’s rather a dramatic example, but in 2008 that’s exactly what they did. The velocity of money collapsed. They kept pumping more money in and sure enough, we saw no inflation. They nailed it.
There’s also Cost-Push inflation, which may also be a consequence of today’s environment. You know, when the underlying cost structure of providing goods and surfaces goes up, then prices will rise to match that cost structure. Virus mitigation, insourcing, social distancing, breakdown in global supply routes and trade routes: all of these can result in Cost-Push inflation. So, the current shutdown has reduced the velocity of money. Ergo, we needed more money to stave off deflation.
Deflation is always the greater, more immediate threat. It is very hard to get rid of, very damaging to an economy. If the policy is successful as velocity of money rices, the supply of that money actually has to be reduced to stop inflation. This is where things get tricky. In the period between 2008 and 2018, the Fed actually did a great job. Today’s quantitative easing has resulted in interest rates at historic lows. Now this mitigates the cost of actually funding the debt that’s being incurred, but removing this money from the economy actually costs the taxpayer. It costs the taxpayer in higher interest rates on the debt. If there’s slowed economic growth it costs the taxpayer in terms of reduced tax revenues. And it can crimp growth. So there’s always the temptation to pull the money out too slowly, igniting Demand-Pull inflation. Inflation does provide a mechanism by which we can monetize this debt. In fact, calls will surely be made to allow a higher level of inflation, maybe four to five percent as a means to avoid sharply higher taxes to pay for the stimulus.
Investors are in an interesting conundrum right now. We have significant uncertainty, substantial short-term volatility, and actually in the near-term deflation risk. However, should they be successful with this pump priming – 2021, mid-2021, maybe 2022 – we would expect to see rising inflation and interest rate costs. Assets tend to outperform liabilities in an inflationary environment. Houses, any kind of commodity, bonds, mortgages – they’re diluted by inflation. In fact, this may not be the best time to prepay your mortgage if you’ve got a wonderfully low interest rate. If you like to prepay the mortgage, maybe just save the money. At least till we see what happens next. These are unusual times. Investors right now are climbing a wall of fear. With extreme valuations on the one hand, and “I don’t want to get left behind” on the other. Proceed with extreme caution. Stay healthy. We wish you the best of investing success.
Paul is the founder and CEO of Avion Wealth, LLC. He leads a team of wealth managers in building and executing financial plans for high net worth individuals and families. Contact Avion Wealth to speak with a financial advisor.