When I was studying economics, both as an undergraduate and a graduate student, the one economic problem that fascinated me was high inflation. The reason was that I would think of how I would survive if the prices of everything were rising but my pay wasn’t. I was also very interested as to where it came from and how it was recently brought down throughout the rich world to a point when so many countries actually have negative rates.

There is renewed talk from some commentators about inflation returning. I want to explore why there is a rational argument as to why we may see inflation returning in the coming years but also what we can do now to prepare for it and try to lessen the blow.

The Inflation That Wasn’t in 2008

I admit that back during the financial crisis, I was in the camp that expected to see a return of inflation. Quantitative easing was a new and little tested strategy which had not been attempted on a large economy that wasn’t going through demographic shrinkage. I made my moves, which I will describe below, to hedge for the possibility of either higher inflation or higher rates or both, but they never appeared.

There were a number of reasons that this happened and the low rates coupled with low inflation wasn’t just a boon for the economy overall, it propped up asset bubbles that either enriched a small few, or locked huge numbers of buyers out of certain assets. To understand why inflation may return, it may help to understand first why inflation didn’t return despite all the “printing” by the Fed. Although there is still much debate as to why inflation didn’t return despite quantitative easing and rates at zero, these are some of the typical arguments.

1. Technology – I cant help but use the example of our phones to describe this one as advanced by Alan Greenspan himself. Just the simple computing power we have in each of our smartphones would have cost over a million dollars in 1991. Now it can be bought for $1,000 or even less. That doesn’t even mention the products that the phone has replaced: the camera, fax machine, video camera, audio recorder, the radio, typewriter, and in many cases, the computer itself. Only a few years ago I was using a computer to create this website and these posts and now I do most of it completely from my phone. The phone is just one example but it has managed to increase our output without too much upward pressure on wages which contributes to inflation.Source: geckoandfly.com
2. The Global Supply Chain – There is another theory that the low inflation that rich countries have been seeing is due to the massive increase in globalization that we have experienced over the past 30 years. I will use the example of the smart phone again, specifically the iPhone. There were some rumblings a few years ago about why China and other countries employ so many people to make iPhones and why they can’t be made in America. By way of looking at the simple cost of parts, yes it would be more expensive to make it here. One author recently estimated it would cost $2,000 if made in the US. But that figure assumes we would have enough skilled workers to meet the demand for the phones and we probably don’t. Apple goes to China not for the cheap workers but the vast amount of skilled workers in manufacturing. It’s really one of the global sources for this talent that is business friendly. There have been a number of studies that purport that global supply chains have no effect on domestic inflation but this just doesn’t make intuitive sense in my opinion. When a business makes a decision to move production to another country they need to know it can be built, shipped reliably and they want it to be cheaper than at home for the hassle, and they usually get that due to the lower labor costs in other countries. Just look at how Ford moved production to Mexico a few years ago to shave the price of some of its models down.
3. Central Bank Independence – Central banks being able to set their own policy rates for the good of the economy is a relatively new concept. Politicians are aware of how interest rates and temporarily boost an economy. For example, The Bank of England only received its independence in 1997. Margaret Thatcher used her tenor to raise and lower interest rates at will, first to break inflation and later lowering them to get re-elected. This used to be quite commonplace in the US as well. Despite a Fed and Treasury accord signed in 1956, presidents continued to meddle with the Fed until the Volcker-Greenspan era from the late 70’s to the early 2000’s.In addition, the inflation target although arbitrary at 2%, gives a semblance of order and offers even more predictability signaling to the market when inflation starts to ramp up.

There is also some evidence that demographics and the old age dependency ratio can contribute to low inflation but I won’t get into the details of that here. Intuitively it also makes sense: more retirees will hold more stable bonds and they will drive the price down of these keep rates low. At the same time, there is a shrinkage of productive workers in the economy so demand falls off, keeping inflation down.

Why This May Change This Time

The reason I think this may turn out to be different this time is due to a few factors.

1. The Global Supply Chain Will Fracture – Companies are already looking at on-shoring certain jobs and businesses which will eventually lead to the opposite effect we saw when some jobs left: higher costs and higher prices. There is a counterpoint to this that automation can take some of this pain away but given the traumatic experience businesses are going through now, many may not want to bet that supply chains will not get shut down in the future and on-shore to hedge their bets. We are starting to see what a shortage of workers can do to meat prices. Although this is more due to the virus, it’s an example of what can happen to supply chains when one component is knocked out.
2. Central Bank Independence – You May have seen the chart of US debt to GDP popping up again recently. This is because we are now seeing the highest level of debt relative to GDP that we have experienced since WWII. In the coming years, the focus will shift to how to repay this, especially if interest rates start to rise. There are two choices politicians will have: raise taxes significantly or inflate their way out of the debt. Neither one will be enjoyable although the tax option at least offers a predictable path that wouldn’t hurt the poor as much.

Given the current state of political affairs, it would not surprise me if there started to be a grassroots movement to inflate our way out of this, similar to what was done post WWII, which mixed inflation and higher taxes to reduce the debt.

So How to Protect Yourself

If you want to hedge against inflation, there are a few things you can do, but this will depend on your financial ability to do so. As always, the rich are best set up to hedge for and even profit from, inflation. For the rest of us though, these are some strategies that are available to many:

1. Get a Fixed Rate Mortgage – The longer the better. I look at a 30 year fixed rate mortgage as a 30 year bet against inflation staying low. As inflation increase, the value of your mortgage decreases and you may see the nominal value of your home increase at the same time. Fixed rate payers are some of the big winners when it comes to inflation so if inflation is your worry, this may be a good bet.
2. Commodities – Oil has grabbed headlines recently in a negative way but hard commodities do well when inflation is persistent. Ways to invest in these include investing directly in gold ETF’s or purchasing oil sector ETF’s such as VDE. The short term will remain volatile but inflation would push these investments higher.
3. Substituting – Here we can use the example of meat. Since meat is getting more expensive, rather than insisting on eating meat often, the easiest solution is to switch to plant based options such as Beyond Meat or the many competitors who may flood this market should demand for plant based substitutes keep growing at the pace it has. This is an easy strategy that can be implemented on a daily basis with some careful planning and will save you from being severely impacted by higher prices.
4. Foreign Bonds – You want to be careful here. When I say this, I mean foreign bonds denominated in other stable currencies, where the countries have low inflation and a low debt to GDP that makes their debt manageable. During the crisis, we saw a flight to quality for these types of bonds and currencies, think Japanese and Swiss government bonds. A few niche markets like these could benefit from inflation in dollars. You want to make sure the country you choose doesn’t have problems itself though.

So these are some of my potential solutions should we see things get ugly and inflation rise. Even if things don’t, as we saw post 2008, the quantitative easing still had profound effects on certain parts of the market. It helped prop up house prices which may provide much of the cause as to why homes are still unaffordable for younger buyers now. Corporate companies binged on debt (as well as the government) and left themselves open to bankruptcy, especially given the current downturn.

You will also notice that I left out crypto. The reason being that I still don’t believe this is an asset that, as yet, can be accurately priced. No one knows what it’s worth so the argument that it’s an investment or store of value is flimsy, especially when the price fluctuates so wildly with nothing to back it.

So if inflation reappears, what other products or strategies do you think could help everyday people hedge inflation if it comes?

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