By: Reed C. Fraasa, CFP®, AIF®, RLP®
“When people begin anticipating inflation, it doesn’t do you any good anymore,
because any benefit of inflation comes from the fact that you do better
than you thought you were going to do.”
Paul A. Volcker
During a recent financial review with a couple, we discussed inflation. The wife asked me, “So, what is cyclical inflation.” I used the term illustrating the difference between temporary, transitory inflation and built-in, cyclical inflation. It suddenly occurred to me that those are some fancy words. What do they mean in plain talk?
What is Cyclical Inflation?
In 1982, I had the opportunity to buy a property in Florida. Someone was subdividing a beautifully wooded tract of land. He was willing to hold the note, and I only had to make a small down payment.
I felt compelled to purchase the property because the price of land and homes had increased significantly over the prior years and the 12% interest rate on the note was very reasonable. Thirty-year mortgage rates were about 16%, and for the previous three years, inflation had been averaging about 12%, and wages were growing by about 10% annually.
Why would I have considered taking on a long-term loan at 12% a wise financial decision? Like many people at the time, I believed prices would continue to rise, and if I didn’t buy something soon, owning anything like it would be out of reach. I was anticipating hyperinflation.
Paul Volcker’s quote above is a simple description of inflation and how we need to watch it.
Volcker, an economist, was Chairman of the Federal Reserve Board from 1979 to 1987. President Jimmy Carter appointed him, and President Regan benefited from him.
Within three years of taking office, Volcker’s leadership brought over seventeen years of cyclical hyperinflation under control.
Notice how Volcker doesn’t use any fancy, technical language. He describes inflation in behavioral terms.
From 1965 to 1982, inflation was very cyclical, with swinging periods of growth and periods of recession. As the economy grew and expanded, inflation followed until the Federal Reserve Board tightened the supply of money for banks to lend while increasing the borrowing rates to the banks. The Fed’s action slowed the economy causing contraction and deflationary periods, leading the Federal Reserve to raise the money supply and cut rates again.
Mass Psychology and Run-Away Inflation
Many technical things were going on below the surface of the prior paragraph, but this is describing run-away inflation. A significant factor in run-away inflation has a basis in mass psychology. The rationale in consumers to spend more is because they believed things were going to be worse in the future rather than being surprised by how well they did in the past. The same reason compelled me to buy that tract of land (which I never did) in 1982.
As we continue to cycle through the pandemic and the economy improves, inflation will remain a news topic. Up to this point, the inflation we are experiencing appears to be primarily driven by increased demand with a lack of supply. Supply and demand are typically transitory and may reverse as inventories increase from improved supply chain and production. Residential real estate prices since the pandemic illustrate this.
Suppose you live in a New Jersey town with good schools and commuter trains to New York City. Since the pandemic started, as young families looked to move out of the city, you have seen your home price significantly increase.
If you were only one of a few sellers, you could raise your price, and you may even experience bidding wars on your home. Demand outweighing supply.
Assume that many of your neighbors then wanted to cash in on the rise in prices, and they put their homes on the market as well; prices may fall due to an oversupply outweighing demand.
Although prices have risen significantly over the past year, it appears to be a supply and demand issue.
That doesn’t mean that people will not anticipate inflation continuing and worsening. The Federal Reserve Board will let inflation run a little, which is not bad.
A little inflation is a good thing. When we have average inflation (2% to 3%), assets like stocks and real estate do well, wages continue to increase, consumer demand remains steady, and unemployment is low.
You cannot have good times without some inflation. The Personal Consumption Expenditures Pricing Index (PCE) measures consumer behavior and price changes. In 2021, the PCE rate was 5.8%, lower than the 7% CPI rate that the news media quotes. Almost double what may be ideal, but not a predictive sign of what the next twelve months may be.
The relationship of inflation to economic growth is like the volatility of stock prices to the growth of the equity markets. You cannot expect long-term equity returns without experiencing the stock market’s short-term volatility.
We all need to be prudent during these uncertain times. Just because prices have experienced hyperinflation over the past year doesn’t mean we will experience it in the next twelve months.
Many of the same consumers that thrust us into this period of hyperinflation and growth with increased discretionary spending can instead tamper their spending and save for the next twelve months.
If supplies start to outweigh demand, many items will see prices decline. By the summer, we may have more clarity and feel better about inflation as supply chain issues for all products and services should improve globally.
Until then, watch your discretionary spending and don’t feel compelled to spend funds because you think prices will be much higher in the future.
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.