All right, this is The Investor Coaching Show. Talking investing, financial planning, retirement planning. Sometimes get into explaining stuff that just seems beyond explanation sometimes. Don’t tell anybody I don’t have guts to step into stuff that gets a little complicated. So, somebody asks a question about inflation.
So, hey, by the way, if you have a question for the show and you want to run it by me, go to paulwinkler.com/question. Ask whatever happens to be on your mind. You know, if it’s “something I’ve always wondered about this…” or, “I wonder how this works…” just ask. Cause I never know what’s on people’s minds. Some of these questions have been really fun. I enjoy it a lot.
So Michael is asking a question with the US Treasury Department seemingly printing money 24/7/365, as our nation’s debt continues to mount higher and higher, why hasn’t inflation accelerated?
And, apparently, he said (you watch more movies than I do) Denzel Washington’s character in Philadelphia said, “Explain this to me like I’m. . .” (I did watch that movie actually.) “Explain this to me like I’m a four-year-old.” Okay. Michael, I’m not going to explain it like you’re a four-year- old cause I’m going to tell you a four-year-old would never get this. I would lose them at the gate.
So, actually, it was interesting because there was an article about this in the Wall Street Journal. And now, I’m going to give you my explanation, but I’m going to talk about what the Wall Street Journal had to say because I think it’s interesting.
“Everything screams inflation” is basically what they’re saying. What your question is implying is that everything is screaming that we’re going to have inflation. Why haven’t we had it is your question, but this person in the WSJ is saying it’s coming. “We’re gonna have it,” blah, blah, blah. Right? So this article is interesting because it was talking about how we could be at this generational turning point of finance and politics, economics, international relations, demography, and labor, all shifting to supporting inflation. After forty years of policies that give priority to this fight against prices, it’s . . . things are changing. It’s going to be something that is big that investors just haven’t seen.
And he puts it this way in the article, “investors are woefully unprepared for such a shfit, perhaps because such historic turning points have proven remarkably hard to spot.” And I’m going to tell you, it’s the same thing now. And you say, “Well, it’s been historically hard to spot.” Well, what makes you think it’s going to be different now? We have better access to information. We have better access to information about just about anything you want. So to predict exactly how things are going to play out. Good luck with that. But you know, I’ll talk a little bit about what you do and how you respond to these types of things? But I want to explain what’s going on here because a lot of people are predicting that inflation is coming.
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What’s Really Happening with Inflation
Central banks are spending a lot of money.
The government is doling out money, giving it out to people that are not working and people that have been affected by the pandemic and all of that stuff. What’s happening is that the central banks—which are led by the Federal Reserve— are now less concerned about inflation.
What have they done in the past to stave off inflation?
Well, one is to increase interest rates. Now, if you increase interest rates, then people borrow less. When they borrow less, they spend less money, right? And then you don’t have prices going up because people aren’t spending, so inflation has always been too much money chasing too few goods. And that’s the idea behind it. There’s just lots of money out there. And there aren’t as many goods.
So, therefore, the value of money is less because there’s lots of it.
And you know the value of the goods, the prices go up because people that are selling the stuff demand more money for their stuff. So what’s happening is the Federal Reserve, says the article, hasn’t been as worried about it, and they have various tools in their bag of tricks to try to stave off inflation. And they don’t seem to be as worried about it.
The federal reserve’s target of inflation is 2%.
But what’s happened in recent years, you’ve had inflation below 2% at some points, and it’s made them a little bit nervous. Now what they’re doing is they’re saying, “well, target is 2% but it’s been lower for many years, so we’re more than okay having some inflation to overshoot that target in order to make up for the years that it was under the target.”
So are we going to have hyperinflation because they’re not really watching it as close as one of the questions being asked? And another thing that’s being talked about is, has politics shifted even to spend more money now and pay less later?
If you look back in history, we’ve seen people being very concerned about balanced budgets and making sure that the money coming in is balancing the money going out. But we see that not necessarily under recent administrations. And they point out in this article, [JA1] Donald Trump took this to new levels with a record peace-time deficit to finance corporate tax cuts. And then Joe Biden willing to spend more. And while the next big spending bills come with taxes attached, they said here, polls show that the public love the stimulus checks.
The Impact of Inflation
There’s something they are missing about inflation, though.
Let’s say that you have, all of a sudden, lots of inflation in the future. Well, then the government doesn’t worry about spending as much because if you have more inflation, then the value of the dollar goes down and you’re repaying those debts with deflated dollars. You know? So if all of a sudden in the future it takes $20 to buy what $1 used to buy. Let me put it this way, let’s say you have a debt that doesn’t come due for twenty years or longer and now when the debt is owed you have $20 that used to purchase what $1 did, then it’s easier to pay off that debt.
You got more money because there’s more money out there because the money supply has increased.
And, therefore, paying off that debt is not a big deal right now. And remember I gave an example (Remember, Paul, explain it like you’re talking to a four-year-old), even though I know who this is, and he’s not a four-year-old, very intelligent guy, but you know, let’s look at it this way.
I had a client, he ran a company, and his son was working in the company. Dad started the company, and I will never forget the conversation they had. And the conversation went something like this. He said, “Dad, why don’t you pay off your mortgage? Why do you keep this stupid mortgage? Why don’t you pay it off?” And the dad goes, “Listen, son. Let me tell you something. You know what my mortgage payment is?” And he goes, “Well, no.” He goes, “Well, my mortgage payment is like, it was like $200.” It was ridiculously low. And his son’s like, “Are you kidding me? That’s all?” And he goes, “No, let me tell you something. When I took out the mortgage, $200 was a lot of money. So, yeah, what has happened is over the years I borrowed money and at a low interest rate for a long period of time.
And the value of the dollar went down. So it looks like I’m paying back next to nothing. But when I first started the mortgage, it was a lot of money.” So that’s one way of looking at it that way.
Now another thing that is happening is globalization.
And they pointed out in the Journal that it is “out of fashion.” Well, what does that mean? Well, if you look at the free trade agreements they’ve proliferated over the past several decades. And then that increased competition, and it held down prices, but literally some of that’s been reversing recently.
You see more tariffs now. Why does that matter? Well, think about it this way. You know, let’s say that you have one person that is an engineer and another person is an accountant and another is a physician, and they all do really good work at what they do. And they’re all very skilled at what they do. Now, let’s say that, all of a sudden, you decided that they didn’t want to trade with each other. The physician wanted to do his own taxes and do his own engineering work, or the accountant wanted to do his own medical work or whatever. I’m going to go watch YouTube videos and get up to speed on this.
And the reality of it is, can they maybe pull off being able to do this, some of their own tax work or some of their own engineering work, and you know, maybe even study some things on the websites for medical? Yeah, I suppose they could, but they probably wouldn’t be very good at it, number one. They probably get subpar results. It would take them longer. You know?
So if you have somebody that is good at something, they can get it done more rapidly than somebody that doesn’t know anything.
Cause the person that doesn’t know anything has to go study in order to become confident and proficient in being able to do that thing. Well, either because you’re spending so much time now, now you can’t do what you actually do competently.
Well, think of that as economies around the world. If you have the United States, and let’s say that we’re really good at certain things, certain tasks, but you have another country that’s really good at, let’s say we’re, we’re good at services. That’s what we do. Well, maybe we are good at coming up with new ideas and new patents and things like that. Whereas another country’s good at manufacturing or another country has got good, maybe have natural resources, which are great. And they have lots of, you know, mining materials and things like that. Then, for us to find those same materials, it’s going to take a lot of digging and a lot more looking around here in the United States, but we can maybe find it at higher cost, and that drives up expenses.
So you see how globalization—when we are trading more freely with other countries— that can have a downward impact on costs. That’s an area of concern.
And having a more protectionist agenda actually comes with a cost is really what they’re saying here.
Now another thing, demographics were worsening the situation. Now in essence demographics, birth rates, you know, if you look at countries like China, you know, they’re close to peak population. They’re saying the US in the past decade recorded the slowest population growth since the 1930s, and when workers have less competition, they can demand more for their labor as fear of factories moving elsewhere is reduced. So that would be inflationary is what they’re saying here.
You know, you’ve got fewer workers, they can demand more money, right?
But at the same time, they’re not noticing here is that in these cases, if you have fewer workers, there’s less demand for stuff, right? So you can have a deflationary impact on the economy if the economy slows down, because there are fewer people, and you don’t have as much growth in the economy. That can actually have a downward effect on interest rates and inflation rates, which are correlated. So not necessarily all there is to the story right there. So that’s another thing.
So why is it maybe inflationary?
Well, because there are fewer workers, they’re saying, but on the other side, there’s something that is anti-inflationary , which would tell you why maybe we’re not having as much inflation. You see what I mean? Now em powered [JA2] labor puts upward pressure on wages and prices. Now, if you have labor and because maybe unions are strengthened because of who’s in the White House, then they can, you know, they have more power to go on strike or negotiate for higher wages. So, therefore, it’ll have an upward increase on those wages.
But that still remains to be seen if it will happen. So you can’t necessarily say that’s definitely going to be inflationary.
The Money Supply
Now, what is some of the monetary reasoning behind why we’re not seeing inflation? Monetary means money supply.
So if you think about it, what does the Federal Reserve do?
They are helping with money, money supply, and the control of money supply is part of their job. One of their focuses is on inflation rates, and full employment is another thing that they have, this dual mandate, those two things.
So why don’t we see this huge inflation?
Well, number one, when we have had some financial institution issues in the past, think 2008—the financial institution collapse—what happened is you had a lot of economic uncertainty. And when you have a lot of economic uncertainty, it creates weak demand for goods, right? So, you know, people don’t want to spend as much; they’re a little bit nervous. They get a little bit more scared, a little bit more gun-shy now than they were before.
So what’s happening is that businesses and people have been hoarding money.
They’ve been holding back. They haven’t been spending the new money that’s been flowing into the system, you know? So when you don’t have these people in businesses spending money and they’re trying to save a little bit more, then you have a low cost of capital. If there’s lots of money, the cost for that money is lower. Okay.
So remember I said that inflation rates and interest rates are highly correlated.
So that would have a downward pull on interest rates right there. So hence the reason we’ve seen very low, long- and short-term interest rates. And if you look at the financial sector, they were in huge trouble. Remember TARP? Troubled Asset Relief Program. And these banks had, they had collateralized loans against assets that weren’t worth a whole lot. And the government came in and said, “Hey, we’ll buy the assets.” And that helped out. And literally the government got all their money back for that.
It was an amazing program because people were really, really so scared about it. And I remember having to go on some of these TV shows and say, “Hey, quit worrying about this.” You know, cause people were panic-stricken over this whole thing back in ’08. And I was trying to talk people off the ledge because I saw what was going on. I saw what they were doing, and it made some sense to me, believe it or not. Well, what happened is the financial sector got this money, but they retained a lot of it. They had excess reserves.
So what’s the reserve?
So when you put money in a bank, the bank has to hold money back, and then they lend it back out. You have this thing called velocity of money. And in English, what that is, you put $100,000 in the bank. And the bank holds $10,000 back. And then they lend $90,000 out. And the money flows through the economy. And it goes around and 70,000 ends up coming back into the bank. When $70,000 gets deposited back in the bank, they hold back 10%, $7,000. And then they lend $63,000 back out. And then that money flows to the economy. And then $50,000 ends back up in the bank, and they hold a reserve requirement. You know, let’s say $5,000 or 10% of that money.
And this happens a multiple of times. It’s a money multiplier effect is basically what it is. Well, what happened is money flowed back in. You know, let’s say the Federal Reserve buying some of these bonds and you had this whole program going on where they were buying bonds off of the banks.
And what happened is the banks held back the reserves. They didn’t lend it back out. And that actually has a negative impact on having lots of inflation. You know, it’s not deflationary. So that’s another reason that it happened.
Now, another thing is, like I said, you got population growth stagnant that limits the economic growth. A
nd then you look at M2, you have money supply. M1 is cash and checking deposits, M2 takes into account cash, checking, deposit, savings, money markets, mutual funds, time deposits. It’s a more complete view of the money supply. And that measurement of money supply is really critical in forecasting inflation.
Well, if you actually look at M2, it’s been fairly stable, you know, so it takes into account all of these different things.
So we haven’t really seen that huge increase in the money supply, the empty money supply. Now, you know, some people will say, well, you know, we have seen some inflation. The stock market has gone up significantly and how you can make a case about the housing market, but there were some reasons. And behind that stock market now, you know, one area of the market, large US stocks, you know, high compared to higher prices, compared to earnings higher prices, compared to book value.
But most areas of the stock market, like international markets and small companies and value companies and, merging, you see tremendously high prices compared to any of those things.
We Can’t Predict the Future
So when you hear that, it’s like, “Oh, the stock market’s in a bubble, blah, blah, blah.” And I go, “Which market?
You got so many different markets. And if you’re all focused on large US stocks, you’re looking for trouble.” Anyway, I know. So the idea being that we’ve had all of this inflationary pressure that just came into two sectors—the stock market and the housing market—is it’s kind of short-sighted. But the whole idea behind inflation, too much money chasing too few goods. And the other thing that you have to think about is this too much money chasing too few goods, you also have to look at production capacity.
If you have an increase in production capacity, whereas we have the ability to produce more things with fewer resources, that can also be deflationary as well.
So there are a lot of things that have created this scenario, where we haven’t necessarily seen all of this huge amount of inflation in our economy, just because we think, Oh my goodness, the government’s spending all this money. It’s going to lead all this inflation.
I remember being an economics student back in the 1980s. And we were just told that government borrowing was going to crowd out other borrowers, and it was going to increase interest rates, and interest rates did nothing but decline over the next thirty years.
So people’s ability to predict this stuff? Pretty bad.
Now, am I saying that there absolutely will not be inflation? No, I am not saying that now.
But how do we protect ourselves?
Let’s get down to the bottom line as investors. How do we protect ourselves against what if we have inflation? Well, you know, that’s why we always talk about owning stocks. What are stocks? Stocks are companies. Companies are the entities that raise prices. And when you own stocks, you own the entities that could be raising prices in the future. Hence that helps protect against it. The other thing, and this can’t be overstated, is really broad diversification. We typically don’t see very much broad diversification in people’s investment portfolios.
And this is one of the reasons that having too many eggs in one basket can be really dangerous.
Because if this ends up happening . . . let’s say this comes to pass, what people are worried about. You and I don’t know what areas of the market are going to really do well. If you look at the 1980s, you’ll look at some areas of the market that went up like ten-fold. Areas where, three-, four-, five-fold, and you had increases in them. But I sure would have wanted to have something in that area that actually went up by ten times to protect me against the inflation that we saw in the 1980s. So it’s really, really important.
And having too much money in fixed income investments is another problem. I see this a lot where people put their money in cash and they think they’re safe because they don’t have market risk, but they’re taking on the full brunt of inflation risk when you have too much money in fixed income investments like CDs and annuities and bonds and things like that. So you really, really have to be careful and make sure to protect yourself. That you have that broad diversification.
So great question, Michael, I appreciate that. So talking about inflation, deflation, and protecting yourself.
If we have inflation, biggest thing people were worried about for so long was deflation, prices going down, that pumping more money into the economy seemed like a better move. And that’s literally what the Fed was really engaged in. So you can really hear people talking about being concerned about inflation, except for people that didn’t necessarily have a strong economic background. Let me just put it that way. You know, you’ll hear people that say, “Oh, this is going to be inflationary,” and then going go, well, you don’t really quite grasp what’s going on.
If you did, you’d realize that there were a lot of reasons to be worried about deflation if you really get down to it.
The Multiplier Effect
Okay. So what’s another thing that can be done?
Well, this multiplier effect that I talked about. Yeah. So remember if you’re putting money into a bank, and they hold a reserve requirement, there’s a multiplier effect. They lend some of it back out, and some of it ends up back in the bank, and then some of it gets lent out, some of it ends up back in the bank, and it gets lent out and gets back in the bank. That’s a multiplier; a dollar is being used multiple times. So, therefore, what happens is you have this multiplier effect causing a dollar being used seven, eight, nine, ten times.
So it has the effect of increasing the money supply.
So if you hold the multiplier constant and you’re increasing the money supply and that money is being used in the economy, yeah you could see where we would have an increase in inflation and inflationary pressures. The reality of it is, if you look in recent years, it’s actually there. The multiplier has been decreasing. So we’re not getting that increase in money supply. Therefore, we’re not getting the commensurate increase in inflationary pressures, you know? So that’s something important to think about as well.
So if we take all of these different things, and we think about all these different processes that can affect inflation, you can see how complicated it really is. It’s way more complicated than we give it credit for.
And what we tend to do, it’s because we’re human, we tend to only focus on one or two things because we don’t have the mental capacity to take all of these things and weekly process how all of these various factors can affect the economy and affect inflation.
You know, so you’ll have somebody who goes out and puts out a blog or puts out some information, writes an article, and they have part of the story. But the reality of it is they only have a tiny, tiny fraction of everything that’s knowable and predictable. And the reality of it is, they may be really, really intelligent, but they don’t have all of the information. They can’t; there’s too much information out there to be had. I mean, it’s just kind of like if we think about the world of investing, you know, trying to value stock and trying to figure out which company is better than another. When I’m trying to figure out which company I do invest in, and I go, “Wow, I think this company is really, really good. I think I’m going to buy it.”
Remember there’s a seller on the other side of the trade, right? They’re willing to get rid of that stock.
History of US Stocks vs. International Stocks
And you know, if I’m looking at investing more money in a certain area of the economy, there are people that are willing to sell that area of the economy or sell stocks in that area, the economy, or that sector, or that asset class.
If I’m looking at selling, there’s a buyer on the other side. And the reality of it is, we all have a lot of information that we’re processing. And you know, this is an example I’ve given many times as to why it’s so stinking difficult to pick companies that are going to do better than the market. I had somebody say this to me this week and said, you know, they were talking to this broker and the broker says, “Oh yeah, you know, really US stocks do better than international stocks.”
That’s basically what the broker, the advisor told this person. And I said, “Whoa, wait a minute. Okay. So you’re saying just invest in US stocks because they provide higher rates of return than international stocks.” Yeah. That’s, that’s what he said. I said, “Okay.” So I wouldn’t necessarily go talk to the advisor about this. It’s like talk to the wall, but you know, you can say to the person, Oh, so let’s say we’ve got two companies. And I use the example of Nestlé and Hershey. You know, both chocolate companies, one’s an international firm, Nestlé. One is a US firm, Hershey. So you’re telling me that companies like Hershey, just, are so dumb and they are so ill-advised that they want to pay more to use your money than their counterparts overseas. They’re just, they’re just not very smart. They want to pay more to use your money. No, it doesn’t make any sense. You know, if you look back through history, you’ll see that the rates of return are very similar between US markets and international markets.
Very similar, actually, with small companies, international small companies, it’s a little bit higher with international than it is US. Large companies, it’s actually about the same. And if you look at the short run, though, and you look at the last ten years, yeah. You’d look at it and go, yeah, US better, no question about it versus international. But that’s what the problem is. You can’t just look at the short run. If we were looking only at the 1970s, we would have said US stocks worthless, no good. Looking at the early ’80s, and it was forget international. Then looking at the late ’80s, it was forget US. Look at the ’90s,
it was all forget international again. And looking at the 2000s, forget about US. That was back and forth. And there’s no rhyme or reason; you can’t figure it out. And you can’t necessarily predict, you know, what’s going to happen when it’s going to happen. But the reality of it is, long run: very, very similar. But because investment advisors are trained to look at short-term past performance because they’re selling investments and they’re selling their services. And that’s basically what we do to attract people, right? That’s not we as in me, but that’s what you do if you want to attract investors, you give them this hope that they’re going to get really high returns.
How do we get them to believe that we have the ability to predict a future and that we can get higher returns for them? Show them good short-term past performance. And that’s basically what they do.
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