January 13, 2022
According to the most recent inflation numbers that came out yesterday (1/13), CPI inflation is now running at 7% year-over-year. From September to December we saw a 2.2% increase, which is a 9.1% annualized rate. And it’s not all energy and food inflation. The core CPI is also elevated at 5.5% year-over-year.
What do I make of this? How persistent or transitory is this inflation bump? Should we adjust our portfolio? Or our safe withdrawal rate? Here’s a short note with my thoughts…
A favor to ask…
Before we get started, though, please make sure you check out my recent podcast appearance on “Hack Your Wealth” where I talked about inflation as well as other issues like equity valuations, floating-rate preferred shares, and crypto investing:
Transitory vs. persistent vs. permanent inflation
For the longest time, people have been telling us not to worry about inflation because it’s just transitory. Well, if someone tells me inflation is transitory and they keep telling me that every month and every quarter and every year, it eventually gets old. Late in 2021, FOMC Chairman Jerome Powell finally conceded that “it’s probably a good time to retire that word [transitory].” Note that this doesn’t mean that 7% is now going to be permanent. It simply means that the inflation shock will likely be more persistent than anyone had predicted, but at least for now, the working assumption is that in the long-term, we’ll see more contained inflation again. And the hearing in early December where this came up served as a heads-up to everyone that at the December meeting, the FOMC will project a slightly more aggressive interest rate path than before.
How long will this inflation shock persist, then?
In other words, will I get to see normal inflation again in my lifetime – to counter the classic “In the long-run, we’re all dead” issue raised by an old (now-dead) economist? Let’s check what the accumulated wisdom and prediction power of financial markets have priced in. TIPS-implied inflation rates are the spread between nominal Treasury bonds and the (real) TIPS yield, i.e., what TIPS owners will get paid over and on top of inflation. There are some problems when using this measure, of course. Notably, during market stress periods you might get “iffy” estimates because TIPS are not as liquid as Treasuries. But right now, I don’t think this objection applies.
As of January 13, here are the Yields and the implied CPI rates, all annualized, see the table below. Yes, the 5-year CPI estimate is elevated, at 2.8%. The 10-year rate is already down to 2.5%. And if we “back out” the TIPS-implied inflation rate for the years 6-10 as [1.0249^10/1.0282^5]^(1/5)-1, we get an implied inflation rate of 2.16%, not significantly different from everybody’s long-term 2% estimate. Indeed, the Federal Reserve uses the Core-PCE as their preferred inflation measure and that’s usually a bit below the CPI, this brings us right back to where we need to be!
Also, notice that this 2.16% figure for the medium-to-long-term inflation pressure is not at all outside of historical norms. If we plot the time series of TIPS-Implied CPI since 2003, we notice that 2.16 for 6-10 years ahead is below the historical average (2.25%) and certainly below some of the historical peaks (3+%). It’s about in the same ballpark as in 2018. So, if you wonder why financial markets are not yet panicking, this is it: Past inflation is “water under the bridge” and the outlook isn’t so bad.
But is this sanguine inflation picture even realistic considering the recent 7% YoY numbers? How quickly (or how slowly) do we have to move back to that 2.16% long-term figure and still be in line with the TIPS-implied measures? Glad you asked because I did some simple Excel calculations to check that. I looked at the most recent inflation figures and noted the 0.47% month-month CPI (almost 6% annualized). Let’s assume that over the next 10 years, the monthly CPI advances converge back to that 2.16% long-term target and they do so with a “half-life” of a specific number of months. I played around with different half-life parameters, and at 8 months we get future 5-year and 10-year predicted inflation numbers exactly aligned with the TIPS-implied numbers (well, within less a 0.01%, at least), see the chart below.
What’s astonishing is that even though we slowly walk the monthly inflation numbers back to the long-term target, the year-over-year measure is bound to go up for two more months and is likely to peak at 7.4% in February of 2022. That’s because we’re still rolling out the relatively benign CPI numbers in early 2021. Only later when the 8%+ annualized monthly CPI numbers from the Spring of 2021 drop off the YoY calculations would we see a decline. And a very slow one!
In other words, even in this optimistic scenario where inflation pressures slowly abate, the year-over-year numbers will get worse before they get better. And it’s going to take until 2024 for the YoY numbers to drop below 3%. The good news in all of this is that even with CPI numbers looking really rotten for quite a while, it’s still totally consistent with a relatively sanguine inflation outlook over the medium-to-long term, i.e., 5-year and 10-year TIPS-implied inflation estimates.
What does this all mean for investors?
As you all know, I’m an economist. I eat, sleep and breathe economics. And folks like me sometimes tend to annoy everyone else and pressure people into getting excited about the most recent economic trend (fad?). On inflation, I take the opposite view. We shouldn’t overreact in either direction. I’m reminded of that Bill Bengen paper circulating in late 2020, proclaiming that due to the low inflation rate at that time, we could all increase our safe withdrawal rate to 5%, even 5.5%. That didn’t age well. But even back then, I found this ludicrous and I took some of his claims to the woodchipper in “Can we raise our Safe Withdrawal Rate when inflation is low?” as part of my Safe Withdrawal Rate Series. The same goes for higher inflation: I’ll do what I’ve always done: I point to the risk of high equity valuations (much scarier than inflation!) and the potential of a bad sequence risk event. I would recommend people calibrate their safe withdrawal rates to hedge against some of the historical worst-case scenarios.
Of course, while I’m proposing we don’t do anything fundamentally different, we can certainly tweak a few of the details. The prospect of inflation certainly warrants revisiting your safe asset allocation, likely somewhere around 25% of the portfolio. Some people want to argue that due to the prospect of rising rates, it would be safer to shift out of longer-duration bonds and into short-term instruments. Well, not really: the future inflation and rate hikes and yield increases are already baked in. So, unless you worry about inflation and Fed rate hikes coming in worse than what is currently predicted, it’s already too late to make that shift. But I grant you that: if you believe that the Fed will raise rates faster than currently predicted, i.e., more than 150bps by the end of 2023, you should consider shortening your bond portfolio duration.
Another idea would be to use floating-rate instruments or fixed-to-floating rate preferred shares, as I do in part of my portfolio. Specifically, I hold a part of my margin cash in my options trading strategy in those floating rate shares, tied to the LIBOR rate. I won’t go into the details too much, but in the Hack Your Wealth Podcast I talk about that at about the 42:30 mark. I should also note that Preferred shares are significantly riskier than government bonds, so there is no free lunch, as I pointed out in Part 29, Part 30 and Part 31 of my SWR Series: Preferred shares have a significantly positive stock market correlation, they should never serve a one-for-one substitute for safe assets. But as a hedge against a nasty interest rate hike, they certainly work. Another plus is that most preferreds are issued by financial corporations whose business model often benefits from higher interest rates (ceteris paribus, at least!).
The pessimistic case
Just in case, I don’t want people to believe that I’m a Federal Reserve Cheerleader. There are certainly a few worries on my mind. They are all related to this saying/meme that many of you have probably seen or heard in one variation or another:
1: Weak men create hard times.
2: Hard times create strong men.
3: Strong men create good times.
4: Good times create weak men.
… and back to 1.
And I should stress that the quote is decades old and referred to men and in today’s world we’d probably keep that more gender-neutral. But you get the message, I hope. There are many examples of this natural cycle of building something valuable, and then complacency sets in and you squander what you built. Sometimes people go through cycles like this, sometimes corporations, even entire societies and countries. And this concept surely works for monetary policy as well. Because it, too, often goes through those 4 phases of building and squandering reputational capital:
1: A weak central bank creates out of control inflation.
2: Out of control inflation creates a hawkish central bank.
3: A hawkish central bank brings inflation expections back under contral.
4: Anchored inflation expectations create a weak and complacent central bank.
… and back to 1
For example, we were in phase 1 under Burns and Miller. Then Paul Volcker (phase 2+3) reined in inflation and every FOMC chairman/chairwoman since then has enjoyed the benefits of that strong reputation. Inflation expectations have been anchored thanks to that. Certainly, they still appear to be, as evidenced by the low long-term TIPS-implied inflation expectations. But it makes me wonder: With the easy monetary policy that started potentially as early as Greenspan post-2000 and certainly under Bernanke post-2008, have we already entered phase 4? Will phase 1 be around the corner soon? It’s too early to tell. I certainly hope we’ll navigate those uncertain times and not squander the decades-long reputation of a central bank that cares about price stability.
There was also a brilliant op-ed in the Wall Street Journal by Thomas Sargent, NYU professor and 2011 Economics Nobel Laureate (who I’ve had the honor to meet and talk to several times during my academic career), and he and his co-author make similar points: 1) rebuilding a central bank’s reputation is a lengthy and often painful process and 2) financial market estimates can be wildly off around the central bank reputation turning points. Just like me, they don’t forecast bad things to happen, they merely worry about the prospect and want to raise awareness.
So far, I’m not losing sleep over the inflation numbers. No need to run for the hills. This is all still consistent with an economy that was shut down for an extended period and the eventual reopening caused some snags and supply issues. And reckless fiscal policy, which is also bound to end soon! But not all is looking rosy. I certainly cross my fingers and hope that inflation slowly subsides. Right now, financial markets firmly believe that the inflation spike is temporary. But if incoming data points don’t support that view, market conditions will change. As the old saying goes “You can fool all the people some of the time and some of the people all the time, but you cannot fool all the people all the time.” But then again, even if we find ourselves in an inflation spiral like the 1970s and early 80s, I should be safe because my withdrawal strategy would have survived that historical period as well.
Glad you stopped by today. Please leave your comments below!
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