A Tale of Two Inflations (Or Charles Dickens Meets Janet Yellen)

With the U.S. currently experiencing very low levels of inflation, why does it still feel like things cost more every year?

In simple terms, inflation (or lack thereof) is the natural result of a never-ending competition between the value of money and the value of the goods and services that money can buy. If there’s a static amount of money and a static amount of goods and services, we don’t usually see much inflation, because buyers and sellers find a natural balance. When more people want a particular product than there is to go around, the price typically rises.  The available money competes (bids) to buy those goods. When this happens on an individual product level, we call the process “supply and demand”, but when it happens across an entire economy, we simply call it “inflation”.

Inflation (as opposed to “deflation”, or falling prices) has been a fixture of the financial world for centuries, because throughout most of history the demand for goods and services (and the amount of money available) has outweighed the supply of those goods and services. This makes sense as it is easier to create new people and new money than it is to create new land and new natural resources. Additionally, the modern fractional reserve banking system that we now take for granted is itself inherently inflationary; early bankers realized that depositors were unlikely to demand their money back all at once and bankers could therefore earn extra money by lending out a portion of those funds, thus effectively putting more money to work in the economy than actually existed. The inner workings of the banking system are a hoot, aren't they?

Modern day inflation dynamics are obviously more complicated than they were in the Renaissance era, but for our purposes the key to understanding today’s domestic inflation is determining whether money is being hoarded or being put to work.  The latter theme resonates throughout history. When the Spanish brought home and spent massive amounts of silver from the prolific “silver mountain” mines of Potosi in the mid 1500’s, it triggered a wave of inflation that lasted a century. More recently, the post WWI German Weimar Republic printed so much money that people had to wheelbarrow cash to the grocery store to get a few days’ worth of food. This type of inflation is the one most of us are familiar with and it is relatively easy to understand. If there is more and more of one thing (money) actively trying to purchase a stable amount of another good or service (food, in the German example), something has to give.

Many investors and market participants anticipated dramatic levels of inflation since the beginning of the Federal Reserve’s Quantitative Easing program, a policy that is now being emulated around the world. The Federal Reserve purchased massive amounts of bonds from banks, effectively putting lots of new money into the banking system with the expectation that those dollars would eventually be lent out and circulated. Yet domestic inflation has barely budged an inch. How can creating more money in one instance lead to rampant inflation while in another it doesn’t move the needle? The main reason is that once the new money was created, it was effectively stuffed under the mattress by banks. Had the federal government, in lieu of the Federal Reserve’s asset purchases (QE), spent the same amount of money on public works projects, those dollars would likely have found their way into the real economy and presumably would have caused the inflation that many expected.  

So with inflation at a very tame level, why does it still seem like everything costs more every day? The answer depends on who you ask.

Ask a Millennial how inflation is impacting them and you might hear “I hadn’t really noticed.” Ask a retiree on a fixed income how inflation is impacting them and you’ll likely get a resounding “a lot!” Just like the saying, “you are what you eat,” your inflation is what you buy.

For example, if you’re a laptop-toting, cord-cutting (meaning not a cable subscriber), Uber-riding, Netflix-watching, Southwest Airlines-flying Millennial, inflation hasn’t impacted you dramatically. In fact, many products and services utilized by young people (like digital technologies and services, consumer electronics, entertainment, travel, clothing, etc.) are going down in price every year. But few retirees would say their cost of living has seen a similar decrease. Quite to the contrary, retirees are facing dramatically higher inflation than their children and grandchildren. Why? Look at the areas that have seen the most inflation in recent years and you’ll see price increases in necessary items that hit retirees especially hard. Healthcare, pharmaceuticals and food are three major contributors to this “retiree inflation”. 

Trends in "Excess" Health Inflation via the Bureau of Economic Analysis

Although everyone has to eat, groceries tend to make up a larger portion of discretionary income for retirees than younger people. Healthcare and pharmaceutical price increases are the real elephants in the inflation room, though. These price increases have tended to outpace overall inflation for decades. While the gap between healthcare inflation and general inflation is shrinking, healthcare costs are still escalating faster than the broader inflation basket. And barring some major political or social reform, this trend is likely to continue into the near future.

So what’s an investor who is experiencing unofficially high inflation to do?

Arbor Wealth’s belief has been for many years and remains that the best defense against creeping inflation is a solid dividend paying offense. Even if investors don’t currently need dividend income, in years like this one where markets are essentially flat dividends represent a large portion of total return. But buying dividend payers alone isn’t enough. We endeavor to own companies that are growing their dividends sustainably over time. And how do we know if dividend growth is sustainable? There are a number of factors (balance sheet strength, solid and dependable cash flow, limited or manageable debt, etc.) but by far the most important is pricing power. By focusing on businesses with pricing power, or the ability to continually raise prices to combat inflation, we attempt to match price increases that our clients experience as consumers tit-for-tat with price increases as the owners of businesses.

So the next time you’re at a store and see a price increase in your favorite product made by a company you own, take heart in knowing those dollars will come full circle back to you soon enough.

Best regards,
Patrick R. McDowell, CFP®, AIF®