Should You Worry About Inflation?

A lot of physician investors are worried about inflation right now. I don’t think they need to be worried about it. Inflation is actually the desired state of the economy when it is low and consistent (because the alternatives are much worse).

I want to calm your nerves about inflation because I don’t think it is that big of a deal. To do so, let’s look at desired inflation and then discuss a book I found from 1981 that shows what can go wrong if you just focus on a narrow view of inflation.

First, why do we want inflation in the economy?

 

What is Desired Inflation?

Funny that people try to predict future inflation rates.

Don’t get me wrong, inflation concerns those considering or in retirement, but what can you do about it?

Let’s start by trying to understand what the interest rate “should” be in the first place. Here is a hint: it is not zero. Some amount of inflation is good for the economy!

What is “desired” inflation?

 

Why is there inflation?

Let’s keep it simple. Theoretically, we like “low” inflation because this is the best way to prevent deflation. And that is why there is inflation.

There is inflation because it is halfway between the economy-killers of deflation and hyperinflation.

 

 

Look at my line graph above. The left is deflation, and the right is hyperinflation.

Technically deflation is any negative interest rate. Deflation kills the economy. Think of it this way: if something is going to be x% cheaper next week or next year, why would you ever buy it today?

And that is the economy-killing key of deflation. You will never buy anything today because it will be cheaper tomorrow. If no one spends any money today, tomorrow never comes, and prices continue their downward spiral due to a lack of demand. Even zero percent annual inflation is bad because we want to encourage people to spend money today, not tomorrow.

So Zero percent interest rate is “too low.” It is below our “desired” inflation.

I won’t get into hyperinflation, but anything over 20% is “bad.”

Finally, “desired” inflation is somewhere between 2-5%. So let’s talk about that.

 

What is “Good” Inflation?

So, since we don’t want hyperinflation or deflation, we want the interest rate to be somewhere above zero.

Does that make sense? An economy with no inflation teeters too close to the wrecking point, which is deflation, so we tolerate “low” inflation levels.

Thus “low” inflation is “good” because it best prevents killing the entire economy and maybe the culture.

Desired inflation is probably 2-3%. But it is also ok if it is 3-5% over long periods. That can happen, and you can plan for that type of inflation with a good retirement plan. Even 10% inflation over a few years is ok. Part of it depends on the sequence of inflation risk (which is similar to sequence of returns risk)

The issue with inflation in the 10-20% range is that it is unstable. Right, that means if you are running that “hot,” you are too close to hyperinflation (and likely have economic or political instability to boot). We discuss this scenario below when I discuss this crazy book I found.

So, desired inflation is essentially homeostasis for the economy. We want to keep the body temperature of the economy (the inflation rate) in the normal range so that we don’t get hypothermia (deflation) and develop multi-system organ failure (failures of banking and credit systems). We don’t get hyperthermia (hyperinflation) and develop a fever (prices going up so quickly that you must buy them today, which increases demand, increasing prices).

At either end, there is a feedback loop that destroys the economy. It is a negative feedback loop that deflates away your economy on one end and a positive feedback loop that makes goods unaffordable on the other.

What Will Future Interest Rates Be?

What will happen to interest rates in the future?

I can tell you exactly what will happen to interest rates in the future. They will go up, and they will go down!

This is like predicting how much rain you will get next summer. You can likely predict the average temperature and rainfall next summer, but that doesn’t tell you exactly how much dry grass you will have next summer. And how bad the fire season will be.

So, I know the average changes in interest rates a year from now; I just don’t know if it will be a hot and dry summer or a wet and cool one. Or maybe there will be a tornado or flood, which means next summer will be a wreck. But, of course, that happens too with exogenous shocks like coronavirus, wars, and weather.

Also, like weather, there is the climate. Over millennia, areas of the earth have warmed and cooled differentially. This has happened over the decades with the economy. The last 40 years have been a period of lowering interest rates and thus great for bonds.

What will the next 40 years bring?

 

What Will Future Interest Rates Be?

Theoretically, credit is less expensive now than in the past. It is easier to collect your debts now than 1000 years ago; thus, you need less interest to loan out money.

Since you require less interest to loan out money (because there is a much higher chance you will get your money back now than in the past), interest rates on money are less expensive now than historically.

Over the last 100 years, the average interest rate has been about 3%. Future interest rates will be about 3%, or they will be higher or lower.

 

Summary- “Good” Inflation

Well, there you have it. We control inflation when it is in the desired range. When it is not, the government is sure to step in and wreck the already tumbling block tower.

We desire “good” inflation because it is better than the alternatives.

Inflation will continue to be normal for the extended future. If it is not normal for more than a year or two, start planning for the end of the economy. Or at least understand what they were thinking in the 80’s.

 

What To Do About Inflation?

Next, let’s look at a book from 1981 to figure out what to do about inflation.

You can see I found this book (for $1), and it was ten bucks back when distributed in 1981. Given inflation, what would be closer to 30 bucks now; definitely not worth it (though it is for sale for $135 on the book site). Not also it is by the editors of Hard Money Digest (which, thankfully, seems to have gone out of business prior to the internet as there is little to find out about them).

Here is the introduction from the preference:

The only thing that now seems as certain as death and taxes is inflation. Americans of all ages, social classes, and incomes now take for granted an inflation rate that certainly exceeds 10 percent and probably is closer to 12 percent per year. Now that everyone has accepted the harsh reality of a constant high rate of inflation, the key question becomes: How can each individual protect himself?

Here are some thought errors I found in the book:

Recency Bias

Assuming that since inflation is high and equities performed poorly for a decade, that would continue into the future.

Mistaken Root Cause

Assuming that the Fed is the cause of inflation through money printing when no one actually knows what causes inflation (seriously, it is that complicated and non-linear).

Wacko Assumtions

The book says you should assume inflation stays at 10% per year for the future. Wow. Who benefits from such a claim? Maybe people who sell hard assets?

Don’t Buy Bonds

They suggest just buying shorter-duration assets as they might keep pace with inflation. They say to avoid US treasuries. Ironic because you could lock in 10+ percent 30-year bonds at the time. Anyone who got those loved their life for the next 30 years. The problem is that they thought the future will resemble the past and got stuck in short-term thinking.

Don’t Buy Stocks

Just because equities performed poorly for the last decade, they suggested avoiding them. Seriously?

So No Stocks or Bonds?

Yup, buy real assets such as precious metals, real estate, antiques, and collectibles. And, of course, lots of gold and silver.

Finally, they say to work less so you pay less in taxes.

 

Summary – Should You Worry About Inflation?

In summary, inflation is ok. It is ok that it is 8-10% for a few years, and it is better than the alternatives.

What should you do about it? Well, first off, don’t read books that are trying to sell you something that fixes a problem based on recency bias.

Remember in general, what worked well last year won’t work well this year because whatever edge is arbitraged away.

The risk of inflation should inform every decision you make when investing, as it is a large concern for those expecting to live off their nest egg at some point. However, short-term tips for asset-liability matching are indicated, but beyond that, the key is diversification and exposure to equities in the long haul.

And yes, you really do need bonds in your portfolio. The duration of those is a little more tricky and worth another blog.

Inflation happens. Expect it. But unless we live through another 70s – 80s, expect what worked then to not work now. Don’t overthink stuff that makes headlines, as it is there to sell advertising; stick with your plan.