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The 5% Solution

INFLATION spelled out using wooden letter tiles going up direction on white surface background.

One thing that many economic historians often overlook is that one’s worldview is shaped by life experiences.  That includes matters like love, marriage and divorce, money and savings and attitudes toward political risk – to name a few.  If our values, likes and dislikes are shaped by our experiences, it stands to reason that our perceptions of what the future might hold could be largely informed by what we have already experienced.  That’s especially true of the things we experience in our formative years.

 

In the summer of 2021, for the first time in over a generation, there’s been some talk of inflation being a going concern.    Inflation was wrestled to the ground in the 1980s and hasn’t been heard from since – until now.  As the debate rages about the degree to which we should be concerned (if at all) about inflation coming back in a meaningful way, it is noteworthy that while there are credible economists on both sides of the debate, virtually everyone in the “inflation will be a problem” camp is at least 70 years old.  Stated differently, those people who experienced inflation in their adult lives are concerned and those who did not are not.

 

For about 30 years now, the goal of central banks in the west has been one of price stability, which they define as inflation at 2%, give or take 1%.  Basically, anything between 1% and 3% is okay.  Now, we’ve experienced inflation above 3% for a couple of quarters and people naturally wonder what that might mean.  Central Bankers have been assuring us that the uptick is “transitory”, that it is just a situation where awful data from the early days of the COVID crisis is working its way through the system.  Nothing to see here.  Move along.

 

Although I am technically old enough to remember inflation, I never had to deal with it personally or directly.  I was a teenager when my parents built the family home on their property in 1979.  I heard about their astronomical, double-digit mortgage rates, but never had to experience anything of the sort as the payor.  My sense is that young people – especially millennials – cannot relate to anything close to what I’m about to say: the inflation rates, and therefore the mortgage rates and interest rates you have experienced throughout your entire lives, may not be around for much longer.  Furthermore, if that is true, the consequences could be enormous.

 

As mentioned, there are competing views on inflation.  I have not come down on either side, but I enjoy the exchange of ideas.  If the doves are right and the inflation we’re seeing now is little more than a passing phase, there’s not much to say because little will change.  If, however, real inflation is coming sooner than later and for longer than just a phase, we need to prepare.  What constitutes ‘real inflation’, you may ask.  My guess is something like 5%.  At that level, no one can pretend that the inflation rate is not a concern and does not need to be dealt with.  For this discussion to be meaningful, inflation needs to be at least 2% above the high end of the traditional range and to stay there for at least a year.  At that point, both the logic behind it being transitory and the facile dismissal of it being above the target by an inconsequential amount disappear.  At that level, something needs to give.

 

The Bank of Canada absolutely would not want to be the first to blink, but if inflation got to and stayed at (say) 5% by August, 2022, it would have no choice but to signal that rate hikes would be on the immediate horizon.  Anyone with a line of credit, floating mortgage, leverage loan or margin account would feel the pinch.  The term that central bankers use when they bring interest rates back from the floor to their more traditional level is “normalization”. The overnight rate would have to go from essentially zero to something like 2% or 3% to normalize in a meaningful way.  As a result, the interest you are paying on any debt would go up by 2% to 3% as well, since chartered banks merely pass the rate hikes through to their valued customers.  Anyone with a fixed rate mortgage would have to renew at some point, as well.  In short, anyone who has any debt of any kind will have to prepare for far more significant payments as a result of the rate hikes that were deemed necessary to stave off the inflation that no one had seen in about 30 years. In general terms, here are some probable consequences of a rate hike:

 

  • Small businesses would need to pay more every month on loans
  • Any business that relies on people on the edge of solvency will lose clients / business because of client cash flow being diverted
  • Inflation hurts returns because real returns drop. What matters is real returns (those above inflation).  At 5% inflation, a 7% return is about the same as 2% with no inflation.  People tend to look at nominal returns (7% vs. 2%) but the numbers are essentially identical from a financial planning / purchasing power perspective.
  • Real estate prices would almost certainly drop because people buy based on their ability to make monthly payments. When mortgage interest goes up due to inflation, real estate prices drop.

 

Here’s the scary part.  There are some who are concerned about the policy initiatives taken by national governments throughout the world.  The pandemic has caused all of them to cut rates to essentially zero and to send cheques to the millions of people who have seen their livelihoods compromised as a result.  Politicians don’t want to say so directly, but the concept they are employing is something called Modern Monetary Theory (MMT) – or as cheeky commentators like to say: More Money Today.  This has never been tried before and the political leaders all have their fingers crossed behind their backs.  The thinking with MMT is that government (i.e., their central banks) can print money indefinitely without truly bankrupting the economy because the cost of carrying the debt is negligible when rates are essentially zero. If the economy is growing fast enough, the debt load is immaterial.  The problem is – you guessed it – inflation.  If inflation caused by printing money rears its head and becomes a thing, then rates need to be raised to reign it in.

 

History is full of examples where entire economies were ruined by runaway inflation.  If inflation really did spin out of control, double digit price increases year over year would not be a stretch.  There are still relatively few people who think 5% inflation is likely, although many acknowledge it is possible.  Very few think double-digit inflation is likely to happen again.  My advice is to watch the news carefully and to develop a strong habit of saving.  Until now, we’ve all had the luxury of spending more on discretionary goods, services, and experiences.  One way or another, for an indefinite period, prices will very likely be going up.  Forewarned is forearmed.

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