Since the second half of 2021, the economic and finance world has been focused on inflation numbers that are both high and increasing. This is the first in a series where we’ll focus on what higher inflation means to you, how and why it’s being mismeasured, and what steps you can take to protect your portfolio in a high-inflation environment.
A common definition of inflation states that it’s what happens when too much money is chasing too few goods. The Federal Reserve (“the Fed”) has been pursuing two policies that have caused inflation.
First, they have kept interest rates low which encourages more business capital expenditures, consumer spending, and government borrowing; all things that increase demand for goods and services. According to the Federal Reserve Bank of New York, the Federal Funds rate (the rate at which financial institutions make overnight loans to each other) is currently .08%, or just barely above zero. This is at a historical low only challenged by the post-2008 financial crisis as seen in this chart from the same source:
The second policy is called quantitative easing. The Fed increases the money supply by creating dollars in its account and then using those newly-created dollars to buy government bonds or other assets.
The following chart is from the Federal Reserve Economic Data Base (FRED), and it shows about 60 years of money supply in the United States. You can see that in the years following the 2008 financial crisis, the rate of increase in the money supply went up, and in the last two years (during COVID), the rate of increase went up again. Congress is currently evaluating plans to increase spending in a way that ensures more dollars will have to be printed in order to fund those plans.
It’s clear that there’s now a lot more money chasing goods and services. That, combined with widely-reported supply chain issues and a huge labor shortage, has led to a massive increase in prices. That’s typically measured by the Consumer Price Index (CPI) which is intended to be an attempt to measure an overall change in prices across time.
Besides the fact that not everyone spends money on the same items, as a measuring metric, the CPI suffers from deliberate attempts to understate the level of inflation. We’ll cover that more in next week’s article. For now, here’s what the U.S. Bureau of Labor Statics shows as the official inflation rate.
Looking at the chart, it’s easy to see why we’re tying Federal Reserve policy to the increases in prices you’re seeing in your daily life. Because consumer prices can rise in real-time, but salary increases tend to come once a year, it’s easy for increases in the cost of living to outstrip after-tax wages. This is particularly true for any of you looking at large purchases.
According to the Case-Schiller U.S. National Home Price Index, the cost of the average home has increased by about 30% over the past year and a half. Looking at the Manheim Used Vehicle Value Index shows used car prices have almost doubled in the same time period. New car prices have also risen if you can find the model you want.
Let’s take the example of a couple earning $100,000 a year. Depending on the state they live in, they’re probably paying around a 30% tax rate leaving them with disposable income of about $70,000. Let’s assume this couple is prudent, and lives on $60,000 and invests the other $10,000. If they experience the current CPI inflation of 6.7%, that reduces their buying power by $4,000 a year and cuts their yearly savings/investing by 40%.
Assuming you’re dealing with housing costs (up 20% – 30%), buying a new or used car (up almost 100%), or dealing with much higher energy costs, and our once prudent couple now has the choice of dipping into their savings to maintain their current standard of living, or to start making cuts to their lifestyle. This is where dry economic statistics from the Federal Reserve press releases or the U.S. Bureau of Labor Statistics start to affect people’s home life.
To make matters worse, the Federal Reserve is reacting to rising inflation by ending the quantitative easing that is flooding the market with cash, and by raising interest rates. That typically has a negative effect on stocks in general, and high-growth stocks in particular. Those high-growth stocks are the ones that many investors have been riding to high returns over the past few years. This is also true if you own indexes like the S&P 500 or the NASDAQ 100.
So, not only does our careful couple lose the ability to save and may have a reduced quality of life, it’s likely that their stock market returns on money they have invested are going to be lower or negative in a rising interest rate environment.
In the coming weeks, we’ll cover why we think the official inflation number is under-stated, why we think the Federal Reserve isn’t doing enough to fix the problem, and most importantly, the things you can do in your portfolio to reduce your risk. And for those of you who are interested in why bonds and high-growth stocks decline when the Fed raises rates, let us know in the comments, and they could be the subject of future columns.
Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.
Gary Brode has spent three decades in the hedge fund business. Most recently, he was Managing Partner and Senior Portfolio manager for Silver Arrow Investment Management, a concentrated long-only hedge fund with options-based hedging. In 2020, he launched Deep Knowledge Investing, a research firm that works with portfolio managers, RIAs, family offices, and individuals to help them earn higher returns in the equity portion of their portfolios. The firm provides actionable high-return investment ideas with a focus on what the market is missing, and timely market commentary. DKI advised subscribers to short the market in February of 2020 just before the COVID shutdowns, producing huge gains. The firm has a large and accomplished Board of Advisors with wide expertise. Mr. Brode’s work has been featured in the Wall Street Journal and Barron’s, and in appearances on CNBC, Bloomberg West, and RealVision. Feel free to learn more at www.DeepKnowledgeInvesting.com or to contact us at IR@DeepKnowledgeInvesting.com.