How to invest in an inflationary economy

A true look at recent inflation and what it means for you

 

After the last financial crisis, the US government began a program of quantitative easing (QE), aka printing money.

As a refresher, QE is when the Fed bolsters its balance sheet by buying treasuries to keep interest rates low. It’s like if you or I printing dollars to pay off our credit cards.

At the time, I wrote about the dangers of inflation this would cause. Almost everyone expected that the inflation we would see would be consumer inflation, i.e., when the price of goods goes up, sometimes rapidly. After all, you can’t pump dollars into the economy through artificially low interest rates without those dollars flowing into goods and raising prices. It’s pretty simple economics.

The official inflation stance

Yet, according to the official measurements of inflation, there hasn’t been much consumer inflation. As you can see from this chart by Statistica, it’s actually historically lower.




How could this be?

The first thing to explain this is that inflation is happening, but it’s not most readily apparent because of the way the US government measures inflation. As the old saying goes, “There are three kinds of lies: lies, damn lies, and statistics.” What does this mean? Simply that governments can use statistics to tell any story they want by manipulating the numbers. In this case, since 1990, it’s been clear that the government wants to tell the story that inflation is low.

A different look at inflation

Traditionally, inflation was measured by a fixed basket of goods period after period. This basket of goods was an agreed upon basket of what it would take to have a good standard of living.
But as shadowstats.com writes, that formula was changed in 1990 to match a popular academic concept called “constant level of satisfaction,” as a “true cost of living concept.”

The general argument was that changing relative costs of goods would result in consumer substitution of less-expensive goods for more-expensive goods. Allowing for a substitution of goods within the formerly fixed-basket, the maximization of the “utility” of money held by consumers would allow attainment of “constant level of satisfaction” for the consumer. This type of inflation-measure is more appropriate for the GDP concept—where it is used today—measuring shifting weightings with actual consumption, rather than with the fixed weightings needed to assess the costs of maintaining a constant standard of living

In simple terms, the statisticians made the assumption that if you were buying steak you would switch to less expensive hamburger if the price went up. This allowed the government to constantly switch the goods in the basket in order to manipulate the inflation rate to a lower rate, rather than to track the same goods each period.

Why would they do this? Shadowstats.com gets into the details, but basically it was a way for the government to save money by, for instance, not having to increase Social Security payouts to match true inflation.

Matching the 1980 measurement method against the 1990 method, it’s easy to see why.












Looking at this chart, you can see that inflation over the last couple years has been hovering around 10%, among the highest it’s been since the 1980s, when the calculation was changed. Of course you don’t really need to be told this. Almost everyone I know feels the fact that prices have gone up for pretty basic things.
But outside of the argument of how to calculate inflation, there is another indicator that this flow of cash from QE had resulted in significant inflation, and that is asset inflation.

Measuring inflation by asset prices

As Bloomberg reports, “Quantitative easing, which saw major central banks buying government bonds outright and quadrupling their balance sheets since 2008 to $15 trillion, has boosted asset prices across the board.”

Writer Jean-Michael Paul continues, “From 2008 to 2015, the nominal value of the global stock of investable assets has increased by about 40 percent, to over $500 trillion from over $350 trillion. Yet the real assets behind these numbers changed little, reflecting, in effect, the asset-inflationary nature of quantitative easing.”

Because assets are not tracked in a basket of goods, it becomes easy to look at them objectively and see their inflationary results, especially when compared to things like earnings.

In this case, the stock market has skyrocketed but there has not been performance behind the companies represented on the stock market to justify the rapid and record growth. Currently the price to value ratio for stocks is about 60% higher than average. But there are plenty of people who want to use statistics to suppress that too.

What high inflation means for you

Establishing that inflation is high, the question becomes, what does it mean for you and what should you do about it?

First, it’s important to understand that inflation can make you poorer. For instance, employees are hurt by inflation because they can only sell their time, and time generally does not hedge against inflation well. Raises, if they come at all, generally come on an annual basis after inflation—not with it. And when inflation is underreported, raises hardly come at all.

Additionally, people who are deep in credit card debt or who have interest ARM loans are hurt by inflation because the Fed generally raises interest rates to combat inflation. Much bad debt is based on adjustable interest rates that go up during times of inflation, making debt payments more expensive. Some of you are probably experiencing this right now.

Finally, people who play by the old rules of money are hurt by inflation because they believe it is wise and prudent to save money in the bank. But the bank is smart, not dumb. And the bank plays by the new rules of money. They pay interest on money that doesn’t keep up with inflation. Money loses purchasing power as the bank uses your money to make more money.

Using inflation to get richer

The good news is that inflation doesn’t have to make you poorer. In fact, you can use it to get richer. I use a very simple formula to get richer from inflation: leverage and hedging.

I play the bank’s game. I borrow money from the bank at a fixed rate, buy a cash flowing asset that covers the debt payment, and using less of my own money increases my return on investment.
In an inflationary economy, if the debt payment is fixed, it becomes less of a cost as the dollar loses purchasing power and my investments and income grow.

The reason my investments and income grow is because I purchase assets that hedge against inflation. For instance, in inflationary economies, rents generally rise. When I purchase investment property, the debt payment stays the same while my rents rise due to inflation. This creates more cash flow. I owe the bank only the agreed payment. The rising costs for rent flow straight into my pocket.
The same thing happens for businesses. As the cost of goods rise for consumers, businesses can adjust their pricing and benefit from inflation.

This works because business owners and investors aren’t selling time. They’re selling product that hedges against inflation. They are in control. Employees aren’t in control of their product—time—nor are they in control of their money (the bank or mutual fund is).

One other thing I do to hedge against inflation is invest in commodities. Generally that has been oil, gold, and silver. These are great investments when there is inflation. They’re not great when there’s deflation.

Therefore, while I believe they are good investments for me, they’re not good investments for everyone—especially people who are still learning about the economy and investing who may not be able to react quickly to changing economic conditions.

At the end of the day, what I’ve been preaching all along—invest for cash flow—is the safest and soundest strategy that will serve you well in an inflationary economy. It’s a sure way to grow richer.

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