It’s A mistake To Address The Wrong Problem

The Bank of Canada and the Federal Reserve in the United States have, in the past week, each raised their benchmark interest rate by 0.5%. Their stated purpose is to control inflation that is coming in at the highest rates in 30 to 40 years. What do you think about that?

Opinion #1

It is about time. Rates have been far too low for more than a decade and lead people to make bad decisions. The assumption that interest rates are low and will continue to be so is irrational.

Interest rates are a price. Just like meat and eggs, the pice changes under inflationary conditions. For borrowers, the failing is described by Mark Twain.

“What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so.”

You can understand it if you think about interest rates from the lender’s side.

Interest is the price people pay to use money they have not earned themselves. The people who have earned that money are willing to lend it because they have no immediate use for it, or the income they derive from doing so may be used for further investment or spending.

If borrowing is cheap enough, borrowers will act sooner. How long would it take to earn and save enough to buy a house? If you can borrow at 2%, and houses appreciate, why would anyone wait and save? No reason is apparent except one. The future might be different.

If lenders earn 2%, pay taxes on that, and have inflation reduce the value of both the income and the capital they employed, they may refuse to play. The critical variable is the question of alternative investments. Investment flows to a place where there is a net real return after taxes. Businesses are a common choice, either through private ownership or the stock market.

People will not play when they cannot win or at least break even. When people refuse to play, does the game stop? It will end for many over-extended borrowers.

Opinion #2

Addressing interest rates does little about what causes inflation. Interest rate rise as a symptom of an underlying condition. Treating symptoms and not causes is a fool’s game.

Milton Friedman had a thought on inflation in the 1970s. Despite being 45 years old, it is true and the effects can be expected as he describes. You can see a 90-minute lecture here. It is worth your time and trouble to watch it. A quick overview.

It is always and everywhere, a monetary phenomenon. It’s always and everywhere, a result of too much money, of a more rapid increase in the quantity of money than an output. Moreover, in the modern era, the important next step is to recognize that today, governments control the quantity of money. So that as a result, inflation in the United States is made in Washington and nowhere else.

If you listen to people in Washington and talk, they will tell you that inflation is produced by greedy businessmen or it’s produced by grasping unions or it’s produced by spendthrift consumers, or maybe, it’s those terrible Arab Sheikhs who are producing it. Now, of course, businessmen are greedy. Who of us isn’t? Trade unions are grasping. Who of us isn’t? And there’s no doubt that the consumer is a spendthrift. At least every man knows that about his wife.

But none of them produce inflation for the very simple reason that neither the businessman, nor the trade union, nor the housewife has a printing press in their basement on which they can turn out those green pieces of paper we call money.

We all know government spending priorities drive the quantity of money created. Recently the government has been spending a lot.

You must ask this question: “Can you eliminate inflation without amending how governments create money and spend it?” If there is more money that has not been created by the production of something, prices will rise. The ability to buy exceeds the supply of goods and services. If Friedman is correct, it seems unlikely we can eliminate inflation because governments don’t want to restrict their spending. His key solution is for voters and the populace to make it unprofitable for politicians to act in ways that create inflation.

People everywhere act on perceived disincentives. We author political behaviour by what we ask for.

There are objections to Friedman’s thesis.

The money supply must change as the economy grows. People need capital to grow, and if there is not enough money, growth slows. That has happened, too. Controlled monetary growth presents no significant problem.

You can have supply-side inflation. You’ll see that if a major supplier disappears. Maybe a factory was destroyed by fire, or they had a lengthy strike. Sometimes they just quit the business. Until the supply is replaced, prices for the product rise.

Economy-wide, supply may be harmed by war, war reparations, pandemics, or natural disasters. In all of the above, the government’s response has been to create currency. Most hyperinflation follows this path. Economic shock, print money, have high inflation. Printing money leading to hyperinflation never instigates the problem.

A reasonable question is this simple one, “They printed stacks of money in 2020. We had a natural disaster, and yet inflation didn’t show up seriously for nearly two years. What’s up with that?”

Why now?

That question is easier to answer than you think. The government created an immense amount of money and distributed it to the people. There should have been inflation much earlier. Well, as it turns out, not really.

Why not? Inflation happens when the extra money is spent. You don’t influence prices until you buy something.  People were afraid for the future for the first 12 months, so they paid down debt or saved the money. If you don’t spend, you cannot get inflation. A more straightforward way to think about it is this. Suppose all the stimulus money was burned. We would not have inflation, would we?

When vaccines appeared, and people felt free to spend again, they had buying power from savings or credit. They used it, and demand far exceeded supply. Prices rose. Add some supply chain issues like chip production and inept management of ports, and you have a problem.

The question today is what is the long-term inflation expectation.

The future is always foggy.

The expectation of Opinion #1. If you think interest rates will cure inflation, we should expect the fed’s fund rate to exceed 5% and mortgages to reach the 10% range. Unattractive but possible

The expectation of Opinion #2. The governments will address their profligate spending and allow the money supply to grow at rates close to the change in productivity. That’s unlikely. A huge share of the budget pays for things not easily reined in. The largest are healthcare, government pensions like Old Age Security, education, a gigantic and expensive civil service, and welfare. The government has little ability to cut spending without revoking old promises.

Don’t expect people to do the right thing if they will be harmed when they do.

The bits to take away

Until the excess cash has been assimilated by the economy, inflation will be with us. There is no reasonable expectation that politicians will amend their ways.

Be very careful with debt. It doesn’t matter if the real value of the principal you owe is falling if you can’t make the payments.

Be very careful with dollar-denominated investments. You may have a larger income, a larger income tax bill, and diminished purchasing power but be worse off. Keep track of dollar-denominated assets in after-inflation terms and reassess investments based on what you find.


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I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.

Be in touch at 705-927-4770 or by email at don@moneyfyi.com.

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