Inflation Will Kill the Economy. Or it Won't.

The list of things I don’t know would stretch from here to, well, I don’t know where. I’m perfectly comfortable admitting when I don’t know something so it amuses me when “experts” claim they know exactly what’s going to happen in the future. Inflation is the most recent topic economists and self-appointed financial pundits are predicting will either result in 1970’s era stagflation – when the economy is stagnant combined with high inflation – or is simply a temporary demand and supply imbalance that will correct itself in time. Below are my thoughts on the subject, a review of how I could be wrong, and some advice on how to prepare for either outcome.

I tend to agree with the Federal Reserve that the spike in prices is temporary due to some unprecedented circumstances. There are two primary drivers of the price hikes:

1. More demand: Those of us fortunate to keep our jobs and incomes during the pandemic have cash to spend and are eager to spend it. Meet friends for dinner, enjoy a summer vacation, buy clothes visible by others from the chest down – the demand for goods and services is through the roof.
2. Less supply: The best example of a supply crunch is with vehicles, new and used. When the pandemic hit, car makers curtailed their supply chain thinking they wouldn’t be selling many new cars anytime soon. The makers of semiconductors that go into virtually every component of a car from the transmission to the air bags shifted their production to supply personal computers. When the car makers realized demand was actually surging, their suppliers couldn’t meet their need and now fewer cars are being made. Less supply, higher demand = higher prices.

People can only spend their saved cash once so eventually the increased demand should subside some – probably after this summer. The supply and demand imbalances the economy is experiencing will also balance out because that’s how markets work.

Of course, I – and the Fed – could very well be wrong because history is full of surprises and how millions of investors react to those surprises can have compounding effects that can alter events well into the future. Take the terrorist attacks on 9/11, for instance. In response to that event the Fed cut interest rates to provide liquidity to the markets, which helped drive the housing bubble, which led to the financial crisis, which created a poor jobs market, which led millions to seek a college education, which led to over $1 Trillion in student loan debt. Linking student loans to a terrorist attack isn’t actually intuitive but illustrates how events happening today can create unpredictable consequences in the future.

So, as financial planners and investment managers, how do we deal with this uncertainty? By creating a margin of safety – or room for error – for our clients. In other words, we create financial plans and investment strategies assuming everything won’t work perfectly, because nothing ever does.

I’ll delve deeper into various margin of safety strategies next time.

Steve Byars, CFP®