Let’s Get Real

June 28, 2021
Dow: 34,283

Inflation has been the topic du jour during the last few months. For the past year, the Consumer Price Index is up 5%. Over the last 30 years, it has only been higher for a short period in 2008. Should we be concerned as investors and consumers? Persistent inflation can harm economies, and if it is not controlled, it can bring down economies and governments. We believe both inflation and deflation can be very harmful and cannot always be controlled by what many believe to be an omnipotent Federal Reserve.

Inflation is corrosive. It lowers the value of our work, our savings, and casts uncertainty on long-term financial agreements. It can reduce economic risk taking, which is essential for growth. If you are a lender or a borrower, what should you assume for the value of the dollars that will be repaid at a later date? Will the interest rate on the loan compensate for the risk of losing principal, and any unforeseen inflation, that reduces the return on the dollars that were loaned? Many equate price increases directly with inflation, although that is not always the case. Prices can change significantly in short periods of time in order to allocate scarce resources, such as when demand spikes before an economic supply chain can fully restart. This is part of the “noisy” inflation numbers we are getting now. Jerome Powell and the Fed believe the current jump in inflation is related to supply chain and reopening constraints, and will prove to be transitory. We believe it is prudent to accept this explanation until it is disproved.

Many economic indicators are adjusted for inflation to get at a “real” number, that is, the change in value or level that is not caused by inflation (or deflation). Economic growth is usually measured by a change in GDP; this is announced quarterly and is a real, or inflation-adjusted, figure. Growth over the last few decades has trended in the 2% per year range, with higher or lower figures in recoveries or rescessions. While Real GDP contracted in 2020 due to COVID-19 as parts of the economy were shut down, it is expected to grow as much as 7% or more this year. Real growth is fundamental because it is the core source of real asset growth and improvements in quality of life over time. It is also the source of real wage growth, which had been rather stagnant for decades before it began to rise in the years before COVID-19. If inflation were to stay at an elevated level, this virtuous cycle would run in reverse; investors would demand higher returns for risk, fewer new investments would be funded, risk taking and innovation would decrease, and consumer purchasing power and real wage growth would decline.

The Fed would like to keep interest rates low to keep the economy humming for an extended period of time. They do this by both taking action and through their communication about when they may take action. After their last meeting, they made policy by communicating their thoughts about the timing of changes in rates and bond purchases, both of which influence the economy. Effective market direction through communication allows them to limit actual changes in rates and bond purchases, and we believe this is their preference now. Low real interest rates, which is the rate paid after accounting for inflation, helps debtors repay the debt and decreases the cost of borrowing. Coming out of a downturn, this is good for individuals, corporations, and the government, which has borrowed heavily over the last year.

As we have said before, the economy is actually more productive now overall than it was before COVID-19. Economic output per worker is higher now than it was prior to COVID-19. Nevertheless, the economy has to continue to expand to bring unemployed and discouraged workers back into the economic fold. Keeping the economy humming is the way to do that, and, ultimately, continued investment, optimism, and economic growth should bring the benefits of real growth after inflation to more members of society.

Random thought: “All growth…is the result of risk-taking” -Jude Wanniski