Should you be worried about
If you have been following the financial news, there has been a lot of talk about inflation. The term the Federal Reserve is using is “transitory inflation,” meaning that they believe the current inflation figures that we are experiencing are temporary and that they will normalize soon.
What is inflation, and why should you be worried about it? To put it simply, inflation is the deterioration or decline of a given currency’s purchasing power over time. The 50-year average for inflation is 3.9%, but this includes the high inflation we experienced during the late-70s and early-80s. Over the past thirty years, rates have averaged closer to 2.5%. As you can see in the chart, rates were at close to zero percent in early 2020 and began this year below 1.5%. The past two months, we have seen inflation rates pop up to 5.4%, a 13-year high.
Some people worry that our inflation rates will continue to grow or at the very least remain at these high levels. While I don’t agree= with their fears, it’s important to understand the impact to your buying power if rates remain at these elevated levels, if they go back to the 50-year averages, or if they drop back down to levels we’ve seen over the past thirty years. As you can see from the chart provided, if rates remain at 5.4%, we would all lose 42.61% of our buying power over the next ten years and more than two-thirds of our buying power over the next ten years.
The other way of saying it is something that costs you $1 today would cost you more than $3 in twenty years if rates remain this high. The lower rates we’ve experienced in recent years mean that you’ve lost less than 25% of your buying power over the past ten years, and you’d need only $1.66 in twenty years to buy a good worth $1 today.
Why are we seeing a spike in inflation rates?
We are having shortages in microchips which is having a huge impact on auto factories in North America and Europe. The auto manufacturers have had to cut production with no guidance on when things might improve. This forced up the price of used cars, as the migration of our population out of cities and into the suburbs created a demand that outstripped the supply.
The increase in price of used cars was the single largest contributor to our soaring inflation rates. As you can see from the chart, we experienced three straight months of significant price increases in used car prices. July’s reading points towards a normalization of this contributor to our inflation figures.
Our worldwide pandemic forced governments throughout the world to make the tough decision to shut down their economies and to have their populations “shelter-in-place” in an attempt to limit the spread of this unknown virus. Most major economies created stimulus programs to bolster their economies and provided unparalleled benefits to those in need. As we reopen our economy, we are seeing the growth provided by the stimulus programs. Unfortunately, we have seen higher unemployment, as some eligible workers remain at home rather than returning to the workplace. In some cases, it is financially better for some of these unemployed workers to remain at home rather than take a pay cut to go back to work. Some are waiting for their children to return to school, so they don’t have the financial burden of child care. Others are simply geographically dislocated from their employment. Whatever the case might be, the lack of workers is having an impact on our supply chain.
As you can see in the chart provided, we saw the price of lumber drop by almost 50% as a result of the economic shutdown. As our economy began to open, there was a huge demand on housing in the suburbs. Lumber mills had not fully opened, which created a demand that far outweighed the supply. We saw a 600% increase in lumber prices. Now that mills have opened and demand has subsided, lumber prices have drifted back to their pre-pandemic prices.
What Can Be Done About It?
The Federal Reserve is tasked with the job of trying to keep our economy on the straight and narrow. We want to see the economy grow, but not so much as to have high inflation. However, if you try to control inflation too much, you run the risk of pushing the economy into a recession. Neither situation is good. Inflation creates a loss of buying power; recessions cause the loss of investable assets. We want a “Goldilocks” like economy. Not too hot (inflation), not too cold (recession)… give me something right in between.
One of the most impactful ways of controlling inflation is through lending rates. Money that is used to service debt can’t be used to buy goods and services. This takes money out of the economy, thus slowing down economic growth and inflation. The Federal Reserve can impact lending rates in many ways. The two most common ways are: buying/selling treasuries and raising or lowering Fed Fund rates.
If the Federal Reserve is buying U.S. treasuries, it’s creating more demand, pushing prices up and yields down. This makes borrowing cheaper, stimulating the economy. When the Fed sells their treasuries, it pushes prices down and yields up, making borrowing more expensive… thus, slowing down our economy. Many lenders use the 10-year treasury as the marker of their lending. As you can see from the chart provided, the 10-year treasury is above the all-time lows in yield experienced during the pandemic, but rates are still below all other time periods over the past 100 years.
The Federal Reserve’s most common option is to raise
Fed Fund rates. This typically pushes short-term and
long-term rates up in unison with the increase. Higher
rates mean a higher cost to borrowers, slowing down our
economy and lowering inflation rates.
As you can see from the Fed Funds Yield probability
charts provided, there appears to be no probability of
the Fed raising rates in 2021. There is less than a 25%
chance of them making a move by July 27, 2022. If they
do make a move, it most likely would be to increase rates
by only 25 basis points. There is almost a 60% chance
that the Fed won’t make a move in the next 18 months.
If they were to make a move, it looks like it would only
be ¼% with less than a 10% chance of a ½% hike.
What should this all mean to you? Our government strongly believes that the inflation we are experiencing is due to stimulus, which is temporary, and supply chain disruption, which is also temporary. Investors mostly agree. As we’ve shown in previous presentations, the price of gold is down on the year, and the dollar has appreciated in value. This is the exact opposite of what should be going on if we were experiencing a truly inflationary environment.
What If Polaris is Wrong?
Investing with complete certainty in markets where no such assurances can be given is simply arrogant. We have conviction in our beliefs that our current inflation figures are transitory, but we are taking a “wait and see” stance. If we don’t see inflation rates subside over the next few months, we will shift our portfolios and recommendations to defend against it. While we don’t think we will be put in this position, we have a game plan in place and ready to be executed should the need arise.