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Inflation. It’s a word that gets thrown around a lot in the financial news, and when it does those financial talking heads just kind of smile and nod knowingly as if they know what the Hell it means and why it’s important.
Here’s the truth.
Almost nobody fully understands Inflation.
Inflation is fucking complicated.
In fact, try reading through the Wikipedia article on Inflation and see how far you make it before your eyes glaze over and you start thinking about checking your Facebook status. Truth be told, I was confused by Inflation for the longest time, and spent a great deal of time reading books about economic theory to try to make sense of it all.
And those books were boring. Oh, God, SO boring.
The media doesn’t really help here, breathlessly reporting every move by the Federal Reserve without bothering to explain how it actually effects people (again, because they likely don’t understand themselves).
“The Federal Reserve hiked interest rates a quarter point to combat rising inflation!”
Me: Oh, OK. If you have to “combat” something, it must be bad. High inflation is bad. Got it.
“A slowing economy is making inflation plummet, so the Federal Reserve is lowering interest rates to stimulate the economy!”
Me: Wait. Low Inflation is also bad? How can that makes sense?
“Venezuela’s inflation has hit a record 800% as the country spirals into collapse!”
Me: OK, well I know something “collapsing” is never good, and 800% sounds really high, so a REALLY high inflation rate must be REALLY bad.
“Japan remains mired in a deflationary spiral and Prime Minister Shinzo Abe has unveiled a series of economic policies to fix it.”
Me: Wait, so negative inflation is ALSO bad? What?!?
But at the same time, we can’t just ignore inflation, since it factors into how we invest. Not a day goes by that some snide reader doesn’t email us going “Oh yeah? Well let’s see how well your retirement portfolio lasts after it gets EATEN UP BY INFLATION.”
So how do we wrap our head around this thing?
Well, what really helped me was realizing that there are really two types of inflation you need to understand: Macroeconomic inflation and Personal Inflation.
This is the Inflation that newspapers and the financial media blather about. Here’s Wikipedia’s eye-wateringly boring technical definition.
Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time resulting in a loss of value of currency.
Well that clears things up.
So let’s break that shit down into something a bit more understandable.
A country’s economy, at its core, is a bunch of people doing stuff for each other. I wake up and go grab a bagel, and a baker helpfully bakes it for me. Then I catch a subway who has a driver operating it for me. Then I go to work (or at least, I USED to go to work) and write software that, hopefully, helps someone else do something useful. And greasing the wheels of this system is money. At every step, money is exchanged. And this giant swirl of people exchanging money and helping each other do things is called “The Economy.”
Got it? Great.
Well, the value of that money (i.e. how many bagels $1 buys) changes over time. This change is basically Inflation.
Now what makes inflation so complicated is that it’s affected by about a zillion different factors, often in ways that are not obvious at all. Interest rates affect it. Elections affect it. Wars affect it. Even something that happens in another country can have weird knock-on effects on your country’s inflation.
Let me give you an example.
In late 2015/early 2016, oil was the big news story in the finance media. What basically happened is that OPEC, led by Saudi Arabia, was starting to get worried that the US was starting to produce more oil domestically using a technique called fracking instead of buying it from them. So they flooded the market with oil. The insane increase in supply drove the price of oil down on the commodities market, from over $100 a barrel to somewhere around $30. The idea was to make oil so cheap that the US frackers would go out of business.
Sideswiped in this mess was Canada, where a major part of our economy is extracting oil out of the oil sands in Alberta. Currency traders correctly predicted this would fuck us over, and dumped the Canadian dollar. Our dollar went from about parity with the US greenback all the way down to $0.67.
Here’s the problem, we buy tons of shit from the US ALL THE TIME. Because Canada freezes for a third of the year, we can’t grow enough food to feed our population. So we buy food and produce from American producers. But since our currency dropped so much, all of a sudden that food started getting more expensive to buy. Which translated to higher prices at the grocery store. Which caused our inflation to pop upwards like crazy.
That’s why inflation is such a complex subject. A Saudi oil baron getting into a fight with US frackers can somehow cause a Canadian’s grocery bill to skyrocket.
So back to our original question. Is high inflation good? Or is it bad?
And like that annoying friend on Facebook who keeps kinda-breaking up with her boyfriend but then kinda-keeps seeing him, the answer is “it’s complicated.”
Negative inflation (or deflation) is bad. This is because deflation means the value of money is INCREASING over time. And while that sounds like a good thing, what it actually does is cause people not to buy things. If you knew your money could buy more goods tomorrow, you’d hold off spending it. Deflation causes an economy to grind to a halt because people hoard money.
But really high inflation is also bad. Think Venezuela, or pre-WWII Germany. Inflation of 800% or 1000% basically means that tomorrow, your money becomes worth way less. So people can’t WAIT to buy something to get rid of it. But if they’re buying stuff not because they need it, but because they have no faith in that currency, that’s not good either. Would you like to be paid in Venezuelan Bolevars right now?
So in order for an economy to be stable, inflation needs to be positive (so people spend the money rather than hoard it), not too high (so people aren’t setting it on fire for warmth), and steady. Economists have generally agreed that inflation of around 1-3% is the sweet spot.
Why Do I Care Again?
You want to invest your money in an economy where inflation is hovering around 1-3%.
Major developed countries have a central bank, whose primary job is to maintain an inflation target of 1-3%. They have many tools to do this, like adjusting interest rates, issuing debt, purchasing assets, or printing money. In the US, this is the Federal Reserve. In the UK, this is the Bank of England. In Canada, this is the Bank of Canada.
In fact, when we saw that inflation spike caused by the Saudis and their oil surge, the Bank of Canada dropped interest rates in an attempt to stimulate the economy and it worked. Our oil industry still got decimated, but other parts of our economy benefited, our dollar came back up in value and inflation stayed within the 1-3% inflation target.
So while we advocate index investing, we need to clarify to invest in indexes of countries whose central banks know how to control inflation. Because if they allow inflation to go out of control, their entire economy suffers and their index gets screwed. Examples of central banks who have demonstrated the ability to do this are Canada, the Eurozone, and of course, the US. Which is why our Workshop ETFs are all domiciled in these countries. Do NOT buy a Venezuelan Index ETF.
And secondly, inflation affects your portfolio allocation in retirement. Traditional retirement strategy dictates that after you retire, you move more and more of your portfolio into fixed income. But for reasons discussed in the last Workshop Article, this doesn’t work for early retirees. Our retirements are 60 years, not 10. And in that timeframe, inflation is a huge problem, because fixed income doesn’t scale with inflation. A bond paying $50k annually will still be paying that amount in 20 years even if food now costs 50% more (that’s 2% compounded over 20 years). But you know what DOES scale with inflation?
This is because stocks represent businesses, and businesses selling stuff to people will always adjust their price to match inflation. If a bag of chips cost $1, and inflation is running at 2%, next year that business will charge $1.02. That’s literally the definition of inflation. Stuff costs more now.
And that’s why even in retirement, we don’t advocate bringing your equity allocation below 50%. Because you need that equity to hedge against inflation. Personally, we’re sitting at 60% equity/40% fixed income ourselves, and that decision has proven to be the correct one. 2 years into retirement, our net worth is actually MORE than when we left.
So that’s Macroeconomic Inflation. Tune in next week where we will talk about Personal Inflation, and how you can control it and make it your bitch.
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Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.