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Price Inflation is Here

Price Inflation is Here

My first article on this website was over 5 years ago, Inflation Destroys Dollars. I certainly did not have any idea that the price inflation would be triggered by the government’s response to the COVID-19 pandemic. I certainly didn’t anticipate the lockdowns and supply chain disruptions back in 2016.

I know the fiscal and monetary policy pursued by the United States and virtually all the world: money printing, onerous regulations, taxes and spending, would eventually result in significant price inflation. Government response to COVID-19 has made the situation worse and pulled the day of reckoning forward but it certainly isn’t the largest factor.

Timing is always a challenge and I was quite early.

Price inflation is here and it is happening fast enough where people notice it and are actually talking about it. Depending on who you trust and how you measure it, prices are rising at a rate of 6-10% per year now. I think what is interesting is that the government’s own numbers (the CPI-U) shows inflation at 6%. This is far beyond the 2% the Federal Reserve has been calling for.


Gold and Silver as an Inflation Hedge

In Inflation Destroys Dollars I write about how gold and silver are an inflation hedge. On 16 May 2016 when I wrote that article, gold was trading at $1,252 per ounce. As I write this it is currently up to $1,864.61, an increase of 48.9%. That is an annualized return of roughly 7.5%.

On 16 May 2016 Silver was trading at $17.14. It is now trading at $25.29. That is a 47.5% increase for an annualized return of approximately 7.3%.

So, if you think that inflation has been somewhere between 4% and 8% over the past five and a half year, gold and silver have on just kept up with inflation during this timeframe. Not bad but also not great. Gold and silver remain the boring reliable hedge and that is a good thing.

Value Stocks as an Inflation Hedge

Value stocks are another asset class I mentioned in Inflation Destroys Dollars. I didn’t mention specific funds. I have made some of my own individual value stock picks with some fantastic picks, but also some not so good picks.

Vanguard’s Selected Value fund (VASVX) is a mid-cap fund that could serve as a proxy for “value stocks”. It was trading at $26.41 on 16 May 2016. It is currently at $33.39. This is a return of 26.4% and an annualized return of 4.3%. Not stellar as I would not say this has kept up with inflation.

The Vanguard Value Index is a large cap value fund (VVIAX). It started this period at $32.49 and is up to $56.68. This is a return of about 74.5% and an annualized return of 10.65%.

A final example to look at, Vanguard’s Mid-Cap Index Admiral Shares Fund (VIMAX) started in this timeframe at $150.33 and is now at $320.62. That is a total percent return of 113% and an annualized return of 14.7%. Much better.

Compare those to the Vanguard 500 (VFIAX), which started this timeframe at $184.53 and is now at $432.9. The total return of this fund was 134.6% an an annualized return of 16.77%.

So while value stock fund did beat the rate of inflation and are a good hedge, they didn’t outperform your vanilla S&P 500 index fund.

Bitcoin as an Inflation Hedge

Compared to gold and silver, Cryptocurrencies, particularly Bitcoin has had all the action.

On 16 May of 2016 a Bitcoin was trading at about $454. Today Bitcoin is trading at $64,346. That is an astounding increase of 14,073% or an annualized return of about 146%.

Clearly Bitcoin has outperformed Stocks, Gold and Silver during this timeframe in an astounding way.

I own Bitcoin and I’m not anti-bitcoin. But I’m also not a Bitcoin maximalist. I think it is possible and perhaps even likely that Bitcoin will be replaced with a superior cryptocurrency that has some combination of faster transactions, higher transaction throughput, anonymity and or additional features. In my view Bitcoin in its current state is too slow and transactions are too costly for it to work as a medium of exchange for day to day transactions. These views are very unpopular with Bitcoin maximalists that ignore or downplay Bitcoin’s weaknesses.

However, Bitcoin has provided an incredible return and far outpaces inflation.

The 14,073% return is not just a result of inflation, although it is increasingly being viewed as a safe haven alternative investment.

Bitcoin has had several great tailwinds 1) It is an emergent asset class 2) It is trendy and popular and gets media attention 3) It is viewed as a Federal Reserve / dollar debasement hedge in place of gold.

Inflation Hedges

Protecting one’s wealth and purchasing power from inflation is important. Just keeping up with inflation is not ideal either, if the assets are not tax advantages, the government will tax the “gains”, and so purchasing power is eroded.

Let’s look at a simplified example. Say you frequently buy a widget or pay a service that costs $100 per year. Say the price goes up 5% per year due to monetary inflation. You also have a $100 investment that also goes up 5% per year. You’re still not keeping up with inflation because of taxes. If your $100 investment goes up 5% to $105, the government is going to want some taxes on that $5 gain. Say you’re on the hook for 15% capital gains taxes, the government is going to take their share and leave you with a $4.25 gain.

So you now have to come up with another $0.75 to pay for the item or service. Scale this up to include all of your expenses for the year and you see that you need to not only keep up with inflation, but exceed inflation so you have the money to pay the taxes on the gains.

In order to keep up with inflation your investment would need to be in a tax advantaged account that would lower or eliminate the tax burden owed or (again assuming a 15% gains tax) you’d need the investment to go up by about 5.9%.

This also shows how insidious inflation is. Not only is money worth less, but the government taxes the gains, even if there was no gain in terms of purchasing power.

One other thing to keep in mind, in the United States at least, realized gold and silver gains are taxed at the generally higher income tax rate rather than capital gains tax rate.

Are Gold and Silver Great Inflation Hedges Anymore

Gold and silver might not be very good inflation hedges anymore. If I owned gold or silver I wouldn’t sell unless I needed to rebalance my portfolio. I would expect these assets to at least keep pace with inflation, but unless the demand for gold and silver increases in excess of new supply, I don’t think gold and silver will beat inflation in the way needed in order to truly hedge for inflation when accounting for taxes. While it has produced a positive return in excess of inflation, it certainly hasn’t been a fantastic play over the last five and half years since I started

What Causes Inflation?

What Causes Inflation?

I remember hearing about inflation as a kid and I remember asking “Why are my savings worth less each year?” What I was really asking was “What causes inflation?”

I might have gotten an answer about rising prices or more dollars in circulation but I didn’t understand. When I got older I did my own research and now understand the mechanics and causes of inflation.

Today I Explain What Causes Inflation

But before I do I want to make sure we’re on the same page regarding what Inflation is.

Inflation and Price Inflation are often used interchangeably, but it makes more sense to separate them out because one is the cause and the other is the effect.

Let’s define some terms:

Inflation: An increase in the money supply. An increase in the money supply is a fancy way of saying there are more dollars in existence than before.

Price Inflation: Rising prices as result of an increase in the money supply.

Inflating the money supply causes rising prices

An Example of the Effects of Inflation

Causes of InflationImagine everyone woke up one morning to find their bank account balances had doubled. The money supply had been inflated by a factor of 2!

Some people would choose to buy goods and services with their new-found “wealth”. But there aren’t more goods and services in the economy. Thus, consumers will bid up prices.

Basic laws of economics tell us that when demand increases and supply does not, prices rise.

Prices would then be higher as a result of the increase in the money supply in what is properly called Price Inflation.

What Causes Inflation?

Inflation is caused by creating new dollars. But who is creating these new dollars and how do they do it?

New dollars are created by banks.

The main bank responsible for inflation is the US Federal Reserve. But virtually all other banks also cause inflation via Fractional Reserve Banking.

The Federal Reserve Inflates the Money Supply

The US government spends much more than it brings in via taxes. To make up the difference the US treasury borrows money by issuing debt in the form of bonds.

This debt, these bonds, are then bought by investors, foreign governments, pension funds, and the central bank of the United States called the Federal Reserve.

If the debt was purchased with existing money this would not be inflationary. However, the US Federal Reserve conjures money out of thin air to buy US bonds. How do they conjure money?

They simply create deposits in the Federal Reserve accounts. Imagine if you could go into your bank account and type in that you now had 1 million more dollars. You’d be creating money out of thin air! That is what the Federal Reserve does.

The Fed has inflated the money supply. The Fed caused inflation by creating new dollars.

Using this this freshly minted money the Fed buys US government bonds. The US government then takes the dollars it got from the bonds it sold and spends it on tanks, government employee salaries, national parks, welfare, social security payments, you name it.

This new money that was created out of thin air by the Fed flows through the government into the economy and bids up the prices of goods and services for everyone else.

This resultant rise in prices is one of the effects of inflation.

A Second Cause of Inflation: Fractional Reserve Banking

Another cause of inflation is fraction reserve banking.

Fractional reserve banking means that banks do not have to keep all of their depositor’s funds available for withdrawal. Banks only have to keep a fraction (or portion) of their clients funds in reserve.

When you despot $100 into your checking account it doesn’t go into a vault and sit there. The bank loans that money out to other people or uses it to buy stocks, or bonds, or other investments.

Now banks aren’t allowed to loan out and invest all of their depositors money. After all, if you were to go to an ATM, you need to be able to withdraw cash, or when you write a check to pay your mortgage, the bank needs to send that money to your landlady.

Banks estimate how much money people will spend and withdraw over a given time and they keep that amount in reserve.

There are also regulations in place that dictate the amount of liquid dollars a bank must have in reserve. This is known as the reserve requirement. The reserve requirement is set by the Fed.

If the reserve requirement is 10%, that means that for every $100 in deposits, a bank can loan out $90. So, if you deposit a $100 bill into your checking account, the bank will loan out $90.

The person who received that $90 might spend it on a new pair of shoes. So they give $90 to the cobbler (shoemaker). The cobbler then deposits the $90 back into the bank, which can then be loaned out again. So the bank could make an additional $81 loan. This process repeats itself again and again and that $100 deposit, with a 10% reserve requirement, could become nearly $900 floating around the economy with only $100 in reserves in the bank.

So that little $100 bill has now become $1,000.

If you’re a more visual person you can check out this handy fractional reserve calculator.

So by not holding 100% of deposits in reserve, banks increase the money supply and cause inflation.

Do you have a better understanding of Inflation now?

The actions of the Federal Reserve and Banks cause inflation. I personally don’t like that my dollars are worth less each year because banks only hold fractional reserves and because the Fed prints money out of thin air.

This knowledge has led me to hold some money in gold. Unlike dollars banks can’t create gold by typing in numbers into a computer.

It also goes to show that if everyone were to try to withdraw their money from the bank at once the system would collapse. Don’t count on the FDIC, which is supposed to back up the banks, because it is undercapitalized. This knowledge leads me to hold some money in physical cash.Bubbles are one of the Effects of Inflation

As I mentioned in a previous article the increase in money supply has caused dollars to be worth half a much since the year 2000.

Another one of the effects of inflation is the creation of bubbles (like the housing bubble of 2008) and the misallocation of resources. But that is a topic for another article.