Should We Worry About Inflation?

Oh boy inflation, what a fun topic. I’ve both wanted to write about this for a while and also dreaded it. Again, I have some time, so let’s see how this goes. Don’t worry, I won’t mention Bitcoin once.

I’m hearing people say the same things like, “rates are low right now, time to buy a house”, “the market is so overvalued right now, but I can’t invest in bonds because rates are so low”, “if the government keeps printing money, it will devalue our currency, or, inflation”, and “what are TIPS? I should buy TIPS”. Fair points, let’s address all of these things, but first a little macro economic background to set the stage. This might be review for a lot of folks, but it’s important to understand what Congress is doing when they approve a $2tr stimulus (let’s hope it’s $3tr!) and what part the Fed plays, as the Fed is responsible for inflation and adjusting economic activity to keep the markets and employment healthy. The Fed is especially important right now.

The Federal Reserve is responsible for managing the money supply in the United States. They have basically three levers they can pull to influence economic activity:

  • Bank reserve ratio requirements: Banks are required to maintain a percentage of deposits as reserves – meaning cash – every day on their balance sheet. By increasing the deposit requirement, banks maintain stronger balance sheets to protect against defaults and withdrawals, but lending activity slows. Then vice versa.
  • Overnight discount rate: This is the interest rate the fed charges banks to lend them money overnight in order to maintain required reserve ratios. By increasing the rate at which banks borrow from the Fed, rates across the entire yield curve react accordingly. Low rates stimulates economic activity via increased borrowing, but it also creates a weak dollar. To increase demand for the dollar, the Fed can increase rates which may decrease inflation. The correlation between interest rates and inflation is much more nuanced than is worth getting into here – think about the cost of imports increasing with the decreasing value of the dollar.
  • Open market operations: The Fed manages the buying and selling of government securities, namely Treasury Bonds, but they can buy and sell other securities. If Congress approves an increase in debt, the Fed can buy Treasury bonds on the open market by crediting the accounts of these private dealers. These private dealers now have more money to lend out. When the Fed sells Treasury bonds, money is taken out of the economy and the Fed pays the stated rate on the bond to the bond holder. As you can imagine, this process works in lockstep with the overnight discount rate.

The Treasury Department is responsible for actually printing money. The US Treasury collects tax dollars and uses those tax dollars to pay for government services and pay down its debt. When times are tough, the Fed buys securities on the open market, usually sold by major banks and comprise home, auto, and any other type of mortgage / loan. Instead of purchasing it with their balance sheet, they just sort of adjust the electronic cash balance these banks have with the Fed. And voila! More money is about to be put into circulation. It’s also obvious why everyone should want to be a bank. When the economy rumbles, the Fed buys shaky loans from banks to stimulate economic activity and reduce the chance of a loan default spiral and they do it with new money. No wonder bankers’ bonuses are so high.

Printing money is something that cannot be undone. If the money supply increases dramatically, demand for goods increases. As demand increases, prices increase as there are more dollars chasing the same goods. This is how hyperinflation begins and when it starts its near impossible to stop. Countries that cannot get a handle on inflation often peg their currency to the dollar to stabilize runaway inflation. And when that fails, you get Venezuela.

So why would the Fed want to curtail inflation? To protect the wealth of rich people…well and to provide stable prices for the rest of the economy. Inflation happens when demand for goods outpace supply. The price of goods increase in response to higher demand and the value of dollars in your bank account are not as valuable as they were before demand increased. As economic activity increases through lending, people buy more things at a faster rate and the price of these goods goes up. Again, this is pretty nuanced and I’m not convinced any economic models really reflect how fast production global production supply chains adapt to changing demand and how that influences inflation. Innovation, lowering costs of production, and just-in-time delivery can offset inflation, and most likely has the last decade as rates have stayed extremely low. Hence every broker you meet will tell you “rates are at an all time low, it’s a great time to buy a house”. I’m not saying they’re wrong, but there’s a lot more to it than that. Rates might not be raised significantly in the next 20 years and they may even go negative. That’s the current status of Japan.

To curb inflation, the Fed can sell Treasury Bonds to decrease the money supply. The Treasury has an obligation to pay back these bonds in the future. If inflation stays low, which is generally healthy for the economy, the cost of increasing the national debt erodes the government’s ability to pay for operating and securing the country. If they increase inflation via the mechanisms above, it hurts the accumulated wealth of anyone holding dollars, but it makes paying off debt a whole lot cheaper. Remember, as rates go up, bond prices go down. So if you’re holding fixed rate bonds and the rates increase, the par value of your bonds goes down. If inflation goes up, the Fed may raise rates to try and bring it back down. Not a lot of room for bond holders to get out alive.

That was fun. Let’s look at our current state, starting with money supply. The Fed really has no idea how much money is out there. They estimate it via monitoring the M1, M2 and MZM.

  • M1 is the money supply of currency in circulation (actual dollars)
  • M2 includes M1 in addition to saving deposits, certificates of deposit (less than $100,000), and money market deposits for individuals.
  • MZM (money with zero maturity) is the broadest component and consists of the supply of financial assets redeemable at par on demand. I usually skip this one and randomly pick either M1 or M2. It’s really about the change over time.

Remember, when the Treasury prints, say $1bn and buys mortgages from banks, the banks are only required to keep the reserve ratio in cash. If that’s, say, 10%, the banks can lend out $900mm. The $900mm is then lent out again and again. So printing $1bn can actually increase the money supply by up to $10bn. Yikes!

Here’s a chart to illustrate how the money multiplier works

When economic activity seizes up, M1 decreases because people borrow less. Less lending means fewer dollars in circulation. So that $1bn above might only translate to $2bn. Let’s have a look at the M1 over the past 60 years.

With M1, we look for sharp velocity increases to indicate risk of inflation. But note the recessions, starting in the 80s we start to see sharp decreases in the velocity of M1. We are in unprecedented times. Zero in on the most recent drop. I don’t think we need to zoom in on the chart, but look how the decrease in M1 corresponds with record household savings:

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While the Fed attempts to indirectly guide the economy through open market operations, Congress has the ability to influence it directly, and they should do more. As shown in the charts above, we are not currently at risk of increased inflation, but we have a ticking time bomb with increased savings accounts and a dramatic drop in the velocity of money. If it spikes, we will experience inflation. In my last post regarding the K-Shaped recovery, we showed how people earning $60k or more have only experienced a 3% decline in overall wages while folks earning less than $60k have experienced a 17% decrease in wages. The folks earning less than $60k are not saving, they are spending because they need to. So by giving money directly to those who need it most, we will increase economic activity, start to bring the velocity of M1 back to pre-pandemic levels and we will not put money straight into the savings accounts of bankers and tech bros. Wouldn’t you know it, it seems like the numbers are pointing towards helping the broader economy rather than just dumping it on the rich and letting the scraps fall to the floor.

However, when things open up, all the savers may all spend money at the same time and buy the same things. That is inflation folks. Also, no one is going to donate it to small businesses. So maybe here’s where Congress steps up. That’s my $.02; I’m aware no one asked.

So back to inflation. Is it a problem? Probably not. M1 and M2 money supply is so low another $2tr injected into the economy won’t increase the velocity and supply of money enough to trigger a significant increase in the price of household items, like a 5G iPhone. The reason is because the money being injected into the economy is mainly going to prop up banks’ balance sheet and won’t enter the money supply. We are probably more at risk of deflation than inflation if spending doesn’t recover, though it is expected to.

The real risk is low, or negative, interest rates. If we have negative interest rates and increase our debt to GDP ratio to pay for the cluster fuck that is the US right now, our debt obligations will actually increase over time. We don’t want the Fed to pay people to borrow from them. Also, if people still do not borrow money then the Fed is out of open market tactics to stimulate economic activity and the economy could fall into a deflationary spiral. The ECB also lowered rates in June 2014 due to a weak Euro. Negative rates encourage bond holders to rebalance their portfolio towards longer term maturities and provides incentive for riskier investments with cheap capital. Banks will struggle, but in the US they always seem to have the edge.

So why not distribute more money to those affected by the downturn and rebalance the economy. I think if we don’t do that we’re headed for anarchy. Again, just my $.02.

Rates are likely to stay low for a long time, so buying bonds is not as risky as you think and it’s a perfectly fine place to diversify. In 1997 the US introduced Treasury Inflation-Protected Securities (TIPS) as a product hedge against inflation. The principal value of a TIPS bond is adjusted based on inflation and subsequently the coupon payments are based on the adjusted principal value. They are a neat little product and make up about 2% of global financial assets. TIPS and commodities have historically been used as hedges against inflation.

If you buy equities, keep riding the tech and essential goods wave. Stay away from anything affected by the quarantine. I know real estate prices are going up and rent is going down, but I think buying anything thing that can be rent seeking will be long-term beneficial. If the government allows the K Shaped chasm to continue, income will bifurcate between those lucky enough to be on the top part of the K and those not. When the quarantine is over, those on top will have money to burn (actually if they did burn it that would help inflation) and those on the bottom will have depleted their savings. There will be an increase in renters close to economic activity centers who need to earn. Real estate prices will probably keep going up, so buy now and rent next year.

There is an interesting phenomenon here: buying a house has never been cheaper, but prices keep going up. Since supply is limited, so prices keep going up and a low interest rate just means you need to take out a bigger mortgage. If rates stay low, prices go up, and new home construction stays low, then home prices stay high. Buy now before prices get higher assuming the Fed keeps the rates locked in, which they will do for as long as it takes for the economy to return to pre-pandemic growth, M1 velocity to violently reverse its trend down, and inflation / CPI actually starts to increase.

All of this sounds pretty grim, and I really think it is. Rebalancing the economy is important for the Average Median American and we don’t track many / any statistics that represent the economic health of the Median American. The stock market sure doesn’t track that. Nor does GDP, unemployment, median earnings, or minimum wage. If we’re using poverty as metric to measure the health of the economy we are doing the whole economy thing very fucking wrong. So Fed, make some more metrics. People optimize towards the metrics they are looking at, so choose some better ones. The rest of you, manage your investments and don’t worry too much about inflation.

Tina and the V, K, and L Recovery

I’m going to break with my usual pattern of gambling and talk a bit more about a broader portfolio strategy. I started investing in options this year for a few reasons – 1. Vegas isn’t fun right now, 2. there is (was) gold out there and 3. TINA. Ahh TINA. For those of you who don’t know who, or what, TINA is, its a silly acronym for There is No Alternative. With markets at all-time highs, the largest stimulus package in history and the general feeling that things are not alright, there seems to be no safe place to invest today for the long-term. Are we under threat of inflation, deflation, a second dip, the lost decade similar to Japan, or being pushed towards extremism and class segmentation via the winners and the losers of this pandemic? Yeah, all of those things, but you don’t have to worry about most of them. We are certainly not in a state of TINA. Normal investments still function despite the wackiness of this market.

The K Shaped Recovery

There’s been a lot of talk about a V Shaped recovery. Softbank had a hilarious 10K that showed how their investments were going to recover.

Well isn’t that a pretty picture? Does everyone else feel like the world is doing this? Some of you do probably, others don’t. It’s utter fantasy for most Americans. We are most likely going to experience both the L Shaped recovery and the K Shaped recovery. I say we are going to experience both because when you aggregate all economic activity, we are likely in for a slow and steady recovery. However, when you break down the recovery by industry, you see a much different story. Industry would be known as a control variable in a regression, and control variables can uncover very important underlying trends that invalidate aggregate trends and conclusions. Here’s what an L-Shaped recovery looks like.

In all likelihood, forecasts for the Covid-19 recovery are much too rosy. Compared to other recessions we are more likely to recover more slowly as illustrated by the Bloomberg chart above. But let’s look at what is most likely happening if you control for industry.

That chart isn’t even quite right. Tech is significantly outperforming even where it was prior to the recession and the S&P is slightly up or even on the year. Other industries are very much struggling and many will never recover.

The stock market, especially stock market indices, are not great indicators of the economic health of Americans. Albeit this blog is about investing, so maybe that’s not of interest, but let’s see how Americans are actually doing. It’s important to reconcile what we see, feel, and hear to economic indicators and eventually to how we invest.

Here are a few charts that show the chasm of our time. Check out Really cool interactive charts. Here are a few I made on the site:

It’s a pretty sad chart. Higher income, probably white collar workers are working comfortably from home, while lower income folks are experiencing large decrease in wages; wages are still down 17.5% from pre-lockdown times. From a moral and more compassionate standpoint, we need a second stimulus to support small businesses and those who lost their jobs or wages due to haphazard quarantine restrictions. Here’s a chart showing how small businesses have faired:

These charts are pretty self explanatory. Regarding investing opportunities, it’s important to remember indices like the Dow, S&P, and Nasdaq do not include any of these small business and are generally not experiencing anywhere near the same struggles as local businesses. As Americans, we see small businesses struggle every day: been to restaurant or salon recently? So go support small business, but don’t freak out over your portfolio.

Don’t Fear the Election

In short, I’m not afraid of any instability regarding a contentious election. This isn’t a political blog, but I think it’s no secret Biden is winning at the polls. It’s also no secret both candidates, one more loudly than the other, expect issues counting votes, which could delay the results and potentially put the election in the Supreme Court’s hands. I’m also not freaking out about that.

A Bloomberg article is showing the market is pricing in a Biden win. I’m trying not to be political, but there are believable arguments that a Democratic or Republican party win would be good for the markets. If the Dems win, increased tax revenues paired with increased public spending could help speed recovery, especially in areas that have been slow to recover (it’s not the New Deal, but that worked, didn’t it? Don’t say it didn’t, just don’t). If the Republicans win, it will likely be more of the same lax policies and lower corporate taxes. We know the market likes that (see K Shape above).

Here’s my play going into the election. I’m not selling anything. I’m currently short VXX options expiring 10/30. I’m well in the money now, so at or near expiration I’m either going to actually exercise or just reverse my position and go long VXX in case the election is the shit show these politicians have promised us. A smooth transition of power will most likely be a non-event for the market. Long VXX gives you a nice hedge against chaos. If VXX doesn’t spike, sell on the 4th and take out what you can. Hedging means losing money to protect against unlikely, but possible, events. Remember that.

What the market really needs is for Congress to pass a large stimulus bill. Amazingly, while Republicans have been dragging their feet over concerns of printing too much money and increasing the size of government, Trump recently broke ranks and suggested his own stimulus package, albeit it was completely implausible and overtly political. He made his point: the market wants another stimulus. That means Trump wants it. The Dems want it by default. So, I’d stay long equities through the election. I recently took out a long position in Apple and Google and I have calls that are printing on NIO. By the way, if you’re wondering how to find stocks that move 10% per day, go no further than r/wallstreetbets and scan the comments for something not completely ridiculous. There is no good advice there, but you’ll at least find what is likely to move. Then check out the fundamentals and see if you can stomach puts on things like Gamestop or calls anything that looks like Tesla.