Expect Inflation And A Stagnant Economy

To further yesterday’s opinion on who solves problems and what ones, let’s look at some outcomes of inflation.

Given that inflation is present, how do you address it? 

It’s hard to think about causation when the symptoms are apparent and unpleasant. What will people do to deal with symptoms? Their choices will have an effect later and, in some cases, much later. Solving Symptoms is not the best approach for long-term results.

Every action today may have the effect people think they want, but it will also have secondary and later impacts that they have not considered or, they have ignored. Consequences that no one intended.

What are you doing about inflation?

Each of us will have different answers because inflation affects price alone. Demand for the newly priced object is either elastic or inelastic. Inelastic means we must buy it anyway. If you are a building contractor and your truck’s fuel price rises, you don’t have the public transportation option. You must pay the higher price. For others walking or biking to work is an option. That decision may have the secondary effect of better health. Not many price changes affect everyone in precisely the same way.

Is inflation always negative?

It depends on what you mean by negative. Suppose, in 2019, you made a $300,000 secured loan to me at a 4% fixed rate for 10 years. I pay $1,000 monthly in interest and all of the principal in 10 years. The purchasing power you gave up was $300,000, and you expected it back with interest to offset the risk, taxes, and the potential losses possible when you tie up capital for a long time. In three years since making the loan, you have received $36,000 in monthly payments, and the loan remains at $300,000. It is not the same loan now, though. Assuming the 4% interest rate included inflation at 2%, after 2 years, you expected my payment to be worth purchasing power of $961, and it was. According to the variables you used when making the loan, you expected the 36th $1,000 payment to be worth $942 of purchasing power. It was not.

It was worth just $886 because inflation had been 8.5% instead of 2% during the year. You have a measurable loss of $56 on that 36th payment alone. With inflation, the purchasing power of each payment falls, and if inflation stays at 8.5%, the final monthly payment would be worth $500 instead of the $820 expected. The principal, when returned, will be worth $150,000 instead of the $246,000 you anticipated. You have gotten back far less purchasing power than you expected.

If we ignore taxes, it is a 2-person, zero-sum game. If you lose about half your expected purchasing power, then I, as the borrower, must have gained that amount. In high inflation times, people have an incentive to borrow.

Clearly, inflation has winners and losers. Lenders will try to shorten the term of their loans to adjust to changing inflation, while borrowers will prefer fixed rates for a long time.

What is the government doing?

Economic activity that increases supply so demand won’t dominate the pricing decision is adversely affected by higher interest rates, making a deep solution less likely. Driving up interest rates to reduce demand is precisely what they did in the late 1970s. Then, it merely distorted the marketplace as some won and others lost.

What happens to lending and investing?

When the future is less predictable with rising interest rates, people tend to stop lending and buy assets that might go up in price to keep pace. Maybe a piece of vacant land, precious metals, art, or a storable commodity like oil or potash. There is no shortage of optional assets. All are outside the average person’s experience and skill set, so they are mostly avoided. Maybe you just spend your money and have memories.

The important point is no one will choose to own anything whose value is tightly connected to the nominal value of money. When people don’t want to own money, inflation appears because they buy things, and when they compete with others for scarce goods, the price increases. Over the last year or more, people have begun to not want to own money.

They don’t pay down debt because it will be cheaper to pay it in future, and they don’t invest because the future value they would require seems too high.

Investing

People invest with the expectation they will have more in the future. If they analyze that option, they use a present value idea that equates the purchasing power of what they will get back with the purchasing power they must give up now. The factor that balances the equation is the required rate of return.

Let’s look at an elementary example.

Ignore taxes because they are different for each of us and depend on the investment chosen. They matter but are beyond the example. Suppose someone says they need 3%, plus inflation, call that 2%, plus a margin for risk of 5%. In this case, you expect to earn a compound rate of return of 10%. Similar to the historic return on the New York Stock Exchange. If you invest $10,000 now, you wish to get back $26,000 in 10 years.

Now change the variables. 3% real value of your money, plus inflation at 8%, and risk at 7%. Risk is higher when you introduce higher inflation. Not all businesses whose stock you could buy will survive. That also adds the additional cost of searching for worthy investments, but let’s ignore that too. Now you demand an 18% investment return. Its projected value at the 10-year mark will be a little more than $52,000. There are not so many of those, and people are uneasy even if there seems to be one offered. It seems too much.

As a result, everything slows down. Successful businesses cannot expand as much as they would like because capital is less available, and less successful ones succumb. Fewer jobs are created, and some are lost. Prices don’t fall because supply still doesn’t match demand even though demand is suppressed.

That’s how “Stagflation” works. Stagnant growth and inflating prices.

The Reagan approach

Reagan cut taxes and reduced interest rates. Under those conditions, people expected the future to be acceptable, confidence matters, and they invested their money. Supply grew and excess demand for goods and services disappeared. People used their money to pay down debt or invest because those choices made economic sense. Neither of those choices affects the general price level, so inflation slowed.

There is a downside to that action, though. The government must cut taxes and let the purchasing power of their debt remain high. Both of those reduce their influence and their future options.

The strategic imperative. 

I have a rule of life that seems to always apply. “Never assign a task to someone so that if they successfully accomplish what you want, they will be personally harmed.” Go do these things, and if you succeed, you will be fired,” is not incredibly motivating.

Just like people, governments respond to incentives. How do we disincentivize behaviour that leads to inflation? That is the crucial question. It is a much stronger question than is, “How do we reduce inflation?”

The bit to take away

Governments have an incentive to inflate and will not do what they should to prevent it. Expect stagflation, and expect that condition to be durable. It has persisted in Japan for three decades and could do so here too. The situation is not hopeless for individuals, but it requires behaviour with which we are unfamiliar. Our learned experience is becoming obsolete. Think it through, then act.


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.shaughnessy@gmail.com.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: