CONSERVE. PLAN. GROW.®
March 1, 2023
Inflation has been a part of human society as long as goods and services have been exchanged for one another. In ancient Rome, emperors and senators actively tried to manage inflation by striking the ideal balance between money supply and growth. In the thirteenth century, King John of England reduced the amount of silver in coinage, which then led to a period of high inflation.
In the broadest terms, inflation occurs when an overall increase in prices is accompanied by a decline in the purchasing value of money. The issue itself has been succinctly defined by Nobel Prize-winning U.S. economist Milton Friedman: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Although inflation is, in many ways, as old as money itself, it became a more serious concern due to the gold standard, which was previously the basis for the international monetary system beginning in the 1870s. The gold standard was introduced to stabilize economies and to keep inflation under control. By tying money supply to a nation’s gold reserves, the amount of money in circulation was effectively limited. This gave central banks tools to use to attempt to influence inflation, but ultimately the period from the 1870s through the Second World War was marked by a period of very high inflation volatility.
At the end of World War II, as it became clear the Allies would emerge victorious, representatives from the U.S. and 43 nations met at Bretton Woods, New Hampshire in 1944 to normalize financial relations. The result was a quasi-gold standard. Currency other than the U.S. dollar would have a fixed parity to the dollar, making it the world’s reserve currency. The post- war period until the 1970s was marked generally by a more stable inflationary environment.
This system lasted for almost 30 years, until President Richard Nixon in 1973 announced the U.S. would no longer convert dollars to gold, effectively ending the gold standard for good. The U.S. dollar, however, remained the world’s reserve currency. In the years that followed, inflation became a more prominent concern in the U.S., dominating news headlines throughout the 1970s.
In the 1970s, federal spending increased steadily to fund the Vietnam War and President Johnson’s Great Society social programs. The 1973 OPEC oil embargo tripled the price of crude oil, at a time when the U.S. economy was more reliant on petroleum than it is now. The 1979 oil crisis, which was primarily caused by the drop in production after the Islamic Revolution in Iran, exacerbated inflation once again and punctuated a decade marked by severe inflation.
In between, Nixon took the U.S. off the gold standard, growth was slow, and economy went through two recessions from 1974-75 and 1979-1982. At the time, many economists believed the Federal Reserve did not act fast enough to minimize the impact of inflation on American consumers and investors.
This combination of factors ultimately led to stagflation, which is the unwelcome combination of high inflation and economic stagnation. In 1979, Paul Volcker was nominated Chairman of the Federal Reserve, and subsequently raised interest rates to a nearly unthinkable 19%. Such harsh measures worked, eventually, and led to the annual inflation rate of 13.5% in 1980 dropping to 3.2% by 1983. Inflation has since been mostly low and stable, with the most notable exception to this trend occurring around the Great Recession in 2008-09.
Over the last couple of years, inflation has again become a major concern after a sustained period of inflation stability. Recalling Milton Friedman’s words about the relationship between money supply and inflation brings greater clarity to our current inflationary period. Inflation peaked last year in June at an annual rate of 9.1%. In response, the Fed increased rates in 2022 at the fastest pace in decades, and we have thankfully started to see the rate of inflation moderate, with the most recent CPI print in January of 6.4%.
Our current bout of inflation was caused, in large part, by one of the most unique situations we have faced in modern history: the COVID-19 pandemic. Decades of globalization leading up to the pandemic promoted ever more intertwined economies, and suddenly, countries across the globe mandated the shutdown of large swaths of economy activity in response to the health crisis. To offset this limitation of economic activity, the federal government enacted a series of historic fiscal stimulus programs. As measured by percentage of GDP, the 2020 and 2021 fiscal stimulus programs totaled more than four times the amount provided in the aftermath of the 2008 financial crisis. Federal Reserve data shows that the money supply increased 42% over a period of 22 months. This massive stimulus and increased liquidity simply could not be absorbed by the economy, and ultimately led to the current inflationary environment.
As the Fed continues raising rates in 2023, albeit a slower pace, there are signs of progress being made in the fight against inflation. The price of lumber and used cars, for example, are both well off their highs from recent years. At the same time, a very tight labor market has continued to keep prices in the “services” economy elevated. Quelling inflation is a process, however, and additional progress must be made before the Fed can declare victory.
As advisors, it’s important to remain focused on promoting successful client outcomes across a variety of economic environments. In our planning work, one way we do this is by incorporating a variety of hypothetical negative financial factors into planning projections. We cannot predict the future, of course, but this exercise helps us evaluate the impact of various economic environments on a client’s long-term plan. From a portfolio construction standpoint, selecting durable, high-quality companies that can be successful during different economic environments remains a core tenant of our process. Although high inflation has been an unwelcome development, the resulting higher interest rates have brought better opportunities for fixed income investors. For example, 2007 was the last time that we’ve seen the 6-month U.S. Treasury Bill with a yield greater than 5%, as we do today. While there is truth to the unattributed quote declaring that “inflation is the time when those who have saved for a rainy day get soaked,” we continue to look for opportunities to keep clients well positioned for the future.
If you have questions about inflation or its impact on your long-term planning, we invite you to please reach out to us for guidance.