Where Is Inflation Headed?

Amidst everything being done to steady the economy during this crisis, a common question is arising: what will this do to inflation? Inflation is an interesting phenomenon and one that is hard to define, let alone forecast. The levels of government debt lead many people to wonder if adding $2.2T to our already growing annual budget deficit will send us into a hyper-inflationary environment. From a portfolio perspective, the natural response to this discussion is how to protect investments or even profit from an inflationary environment.

Inflation is somewhat of a hot button topic as we watch things like education and healthcare costs increase at a dizzying pace. On the flip side, nobody is complaining about the fact that a gallon of gas costs roughly half of what it did 12 years ago nor that you can buy a 65” flat-screen TV for roughly the same price as the 27” version I had in my college dorm room in 2004 (needless to say, the picture quality is slightly better now, too). The Federal Reserve targets an inflation level of 2% as part of their policy. They watch the Personal Consumption Expenditures price index (PCE) which reports on the annual change in prices of a basket of goods and services. There is also the Consumer Price Index (CPI) that is released by the Bureau of Labor Statistics and tends to report higher inflation. You may ask why they would actually want prices to increase and the answer is that, sinister conspiracy theories aside, the opposite problem (deflation) is much worse.

Exhibit 1:

The $64,000 question, or $22.72T question, is, “what will a rapidly increasing government debt level do to our inflation?” Over the last 20 years, the relationship has been nebulous at best. As you can see in Exhibit 1, the increasing absolute level (panel 2) and percent of GDP (panel 1) led to a decrease in the rate of inflation. In fact, the kink in each curve that occurred in 2009 at the depths of the Global Financial Crisis corresponds with a plummeting of the year-over-year inflation rate. These levels might be fine, but what if we doubled our debt total as a percent of GDP? Japan’s economy is currently in that situation and they are doing everything possible to keep their heads above water in the deflationary pool. Let me pause for a second and clarify that I am in no way saying “print away and all will be ok.” I’m merely looking at available data to try and make sense of our situation.

Please allow me to opine for a moment about why people get so worried about government debt. First, the headline number is jaw-droppingly large. It’s almost incomprehensible how much $1T represents, let alone 23 times that. Our minds extrapolate this into a conclusion that it must be a very big problem. Second, a common mistake is to make the analogy to household debt and say, “oh my, that would be a lot of credit card debt!” The problem is, the average household doesn’t have the ability to print money that is readily accepted for goods and services throughout the world, not legally at least. A common technique I like to apply when thinking about this kind of stuff is the idea of a spectrum with opposite extremes. At one end is zero government debt and at the other is an infinite supply. I think we all can agree that infinity sounds like a bad idea, but what about zero? Andrew Jackson successfully paid off every last penny of government debt in 1835 by selling off government land. Bad idea. This was followed shortly by a real estate bubble and the Panic of 1837 which we had to issue debt to combat. The Treasury market is one of the most liquid in the world and it forms the backbone of our financial infrastructure—getting rid of it would not be a great idea.

Exhibit 2:

Let’s now assume that there absolutely will be high inflation and naturally you want to protect against it or even profit from it. Gold is one of the first places an investor looks in this situation. The logic is sound: if gold is priced in dollars and a dollar is worth less than it used to be it should be an easy trade, right? Gold is an asset just like any other which abides by the laws of supply and demand. Those forces can drive the price of gold in unexpected directions even during periods of inflation. As you can see in Exhibit 2, the correlation of the price of gold to the CPI fluctuates wildly from negative to positive. Good luck timing that.

One of the other options is Treasury Inflation-Protected Securities (TIPS). The principal amount on TIPS is systematically adjusted according to the CPI and the coupon rate pays interest on that higher base. Zero credit risk, inflation protection, and interest? Where do I sign? For starters, the coupon is lower than the coupon on a similar U.S. Treasury bond. Then there is the notion of opportunity cost. You are making an implicit bet about future inflation when deciding to invest in TIPS. If inflation over the time held is less than what the market was pricing in when you bought the bonds, you would have been better served to be in normal Treasury bonds. Think of TIPS as an insurance policy against unexpected future inflation. You may not have a need for that insurance if inflation doesn’t manifest, but if it makes you sleep better at night, TIPS are an attractive option.

The global economy is a complex machine with an untold number of variables. I would caution against assuming a linear path from now to some point in the future using a handful of data points. Also realize that economics is unlike other sciences that are bound by absolute laws. Economics is based on theories that are constantly evolving with human behavior. As always, focus on what you can control as we move forward in these uncertain times.