We've Been Here Before

 

For my kids, this is definitely a soapbox post I hope they'll read, if for no other reason than to humor their old man:

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We've been here before. Well, maybe you haven't, but those in my generation have. I'm speaking from an economic perspective, and with the purpose of giving you some thinking juice as you make financial decisions in the near future. Since you've never lived in an economy with high inflation, those decisions can make the difference between staying awake at night wondering how you're going to get through the next month, and sleeping with sheep dancing in your head.

The Experience

When we were starting on the building of our nest, borrowing to buy cars, homes, occasional dinners out, ski vacations, baby cribs, diapers and Gerbers Ham and Gravy with Plume Juice, we experienced what it was like to live from month to month. House mortgage, car loan, and credit card interest rates were in the neighborhood of 12 to 18%. Inflation was running at more than 14%, meaning that every $10 you earned in January was worth around $9 in December. It was safe to assume we were spending as much on interest as on all other goods and services in those days. I remember several sleepless nights at the end of many a month.

The History

    KEY TAKEAWAYS

• Periods of rapid inflation occur when the prices of goods and services in an economy suddenly rise, eroding the purchasing power of savings.
• The 1970s saw some of the highest rates of inflation in the United States in recent history, with interest rates rising in turn to nearly 20%.
• Central bank policy, the abandonment of the gold standard, Keynesian economic policy, and market psychology all contributed to this decade of high inflation.

The Vietnam war placed a lot of pressure on the U.S. treasury. Simultaneously, President Johnson spent generously to fund his vision of a Great Society. Inheriting a recession, President Nixon and congress agreed on a big expansion of Social Security. The resulting budget deficits made foreign holders of the U.S. dollar nervous, causing a run on the dollar. When the president broke the link between the dollar and gold, it quickly devalued, further stimulating inflation.

He also imposed price and wage controls in 1971, fueling  double-digit inflation once those controls were removed. In the meantime, Nixon made full employment the priority, promoting growth in the short-term with cheap money, accepting inflation if necessary. 

Following his reelection, the inflation wildfire caught, doubling to 8% in 1973, and working its way up to 14% by 1980. In an effort to stem decade long erosion of buying power, the fed tightened money with interest rates up to 20%, pricing people out of new homes and cars, and initiating a recession and driving unemployment to 10%.  

Parallels

          

By the most common and relevant metric of relative government debt - debt as a percent of GDP - U.S. debt blew through 100% of GDP. That's almost as high as just after WWII, which until then was  the highest period in previous history. This compares with 79% in 2019 and 35% in 2007, before the Great Recession. 

The federal budget deficit is projected to be $2.3 trillion in 2021, or 10.3% of GDP, compared to a 50 year average of 3.3%. That's BEFORE the proposed additional relief spending of $1.9 trillion.  

Money is cheap, as the federal funds rate bounced below the inflation rate over the last decade. This pushes up asset prices, another historical precursor to inflation increases. Most recently, the Federal Reserve has been buying these assets to prevent price erosion and a loss of confidence in the stock market. To do so, they've floated (printed) a lot of new money, which works as long as the dollar remains stable and foreign markets value U.S. treasuries (bonds sold by the U.S. to finance debt).

The difference between our experience in the 80's and today is that consumer prices, the more traditional measure of inflation, remain quite low. Asset prices, on the other hand, are climbing rapidly. Raw materials, homes, stocks are all escalating behind the scenes. I can't imagine this won't eventually be reflected in consumer prices, especially as politics focus on imports, which are most responsible for keeping prices low.

Evidence 

• Copper prices are up 56%. The S&P Case-Shiller Home price index is up 9.5%. Freight prices are up 215%; soybeans, 54%, lumber 117%.  - Wall Street Journal, February 21, 2021  

• FENTON TOWNSHIP, Mich. — The viral pandemic has triggered a cascade of price hikes throughout America’s auto industry — a surge that has made both new and used vehicles unaffordable for many.  -  Pioneer Press, February 24, 2021   

• The nonpartisan Congressional Budget Office has said that raising the minimum wage to $15 by 2025 could deliver raises for 27 million workers and lift 900,000 Americans above the poverty threshold, but it could cost 1.4 million Americans their jobs over the next four years.  
  $15 Minimum-Wage Setback Tests Biden’s Ability to Unite Democrats -  Wall Street Journal, February 27, 2021

That last one was included to remind you of one of the primary contributors to the 80's experience - government wage controls.

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The Converse Scenario

In talking about this hypothesis - that we're in for another round of high inflation like recent generations have never seen - a friend of mine in the financial industry offered his contrary short term view. 

 KEY TAKEAWAYS

• We're just now emerging from a traditional two-quarter recession, inspired by the pandemic). Rapid growth will lead us out, fueled by the highest savings rates in many decades, and pent up demand.
• While asset values in some classes of stock are high, that's not the case for the broader market - especially small cap stocks. They still carry average to low P/E ratios, and are valued at recession levels.
• There's plenty of money available to be borrowed, and recent price increases will cool as supply chains stabilize, suggesting a balance in supply and demand.
• The fed is committed to maintaining very low short term interest rates. 

This bodes well for investors. And maybe for savers, though it doesn't take long for inflation rates to outstrip savings returns. Not sure what it does for folks who run a close margin between income and expenses when fuel costs, hard and soft goods prices, rents, and taxes increase.

Five years ago, just after my retirement, I was certain we were going to enter a recession, that interest rates would be going up, and stocks would go down. I predicted that just about every year since then. No recession (at least before the pandemic), and interest rates have never been lower. Just proves predicting economic direction is a fools game. This friend thinks the next 12 to 18 months should be healthy for investors while interest rates and inflation remain contained. Could be.

So now what?

So what should you do as relatively early wage earners and family equity builders? Well, as a highly trained and deeply experienced financial advisor (not) I would say, design your finances for the intermediate future. What does that mean?

• Reduce, eliminate, and avoid any short term, variable (and especially revolving) debt. 
• Anticipate any big purchases that will require debt.
• Start living within a budget that reprices inputs (like fuel costs, durable goods, staples, etc.)
• Establish and maintain a larger contingency nest egg.
• Keep feeding your tax deferred savings programs (401k or IRA) as much as you can.

You've probably already paid down your credit card and other revolving debt. Keep it that way. Don't incur ANY more of it. Credit card balances at zero for the foreseeable future, if possible.

If you anticipate needing to borrow for a major durable good purchase (like a car, major appliance, furniture, etc.), buy it now with fixed rate debt. Don't wait.

If you have a car lease maturing soon, convert it into a long term loan as soon as possible. If you think you need to buy a new car in the next few years, do it now, even though prices seem to be going through the roof. If you need to lease that car, get the longest term lease you can.

Model what would happen to your spending if gas went to $4.00 a gallon, and heating gas tripled in price. If your effective federal income tax rate went up by 3 percentage points (from 24% to 27%, for example).

Stay on top of your payroll reduction rates for federal and state income taxes. If inflation and tax rates increase (and they will) folks often get caught deducting too little too late, resulting in sizable tax obligations come tax season.

Bottom line is to develop an inflation mind-set before it effects your family budget. Use the unexpected gains (i.e. stimulus checks and bonuses) to set yourself up for that eventuality. If you do, and my friend is right about the next year or two, and I'm wrong (again), you won't be any worse off, other than having  more fixed debt than you might otherwise have had. On the other hand, if inflation catches you by surprise, it might be too late to take those steps that help you sleep at night.