What to do as inflation raises its ugly head again

Milton Friedman had some great advice.

What number do you use for an estimate of long-range inflation? When I began my unexpected retirement in late 2015, I prepared my formal retirement plans and plugged in an initial estimate of 2 percent.

The Federal Reserve, the nation’s central bank, had set its formal inflation target in January 2012 at 2 percent and in three years had yet to reach that target. In fact, the average inflation as measured by one core inflation measure, excluding food and energy, had run about 1.8 percent for the 10 years prior.

I really believed that the era of high inflation was in the history books. Other retirees and financial planners were using a 3 percent inflation in their plans to be a little conservative. But surely, we would never return to the levels of the Great Inflation of the 1970s and early 1980s.

The accompanying chart, from the Saint Louis Fed’s FRED data base, shows inflation is running hot, at levels not seen in 40 years. The Bureau of Labor Statistic’s Consumer Price Index in January 2022 was 7.5 percent from the prior year. The Bureau of Economic Analysis reported its personal consumption expenditures (PCE) price index for January — which is the Federal Reserve’s preferred measure — and it came in at 6.1 percent. The chart shows two additional measures based on the PCE, including core PCE, excluding food and energy, and trimmed mean PCE, which the Dallas Fed calculates by excluding each month’s highest and lowest price fluctuations.

Why are there so many different measures of inflation? The most popular CPI is based on a survey of what the average urban worker would spend for a specific basket of goods. The PCE is a broader measure of consumer spending by all consumers, businesses, and non-profits. It is not limited to just urban markets and, of interest to retirees, it includes a higher percentage of health care spending than the CPI.

The core inflation readings excluding food and energy is not because economists don’t fuel up their car or put food on their table. It is thought to be a smoother projection of overall inflation trends by excluding the volatile food and energy inflation readings. Likewise, the trimmed mean PCE attempts to smooth out the line to identify longer term trends.

The Federal Reserve’s inflation target, though, is an average 2 percent PCE — including food and energy — but over time, allowing for years of below 2 percent but followed by tolerating periods above 2 percent so long as the average stays at 2 percent.

Prior to 2012, the Fed did not publicly commit to an inflation target, but since taming the Great Inflation, the Fed had averaged about a 2 percent reading through its monetary policy. But look at the far left of the chart to see where we were 40 years ago.

Inflation zig-zagged to a peak of 14.5 percent on the CPI scale in March 1980. Fed Chair Paul Volcker led an aggressive campaign to tackle inflation by raising the cost of borrowing even higher than inflation. The Fed did this through trades in the market for the Federal Funds rate. This is the rate that banks charge each other for overnight lending, and when this rate goes up, all other loan rates go up too. Overnight, buying a house, or a car, or new equipment for your business became much more expensive.

Volcker and the Fed used monetary policy to increase the Fed Funds effective rate to 22 percent, which led to back-to-back recessions, but as you can see, inflation came down and stayed down for nearly 40 years.

It sure looked like the beast was tamed. In fact, it had only gone into hiding and now that it is rearing its ugly head after 40 years, it looks like a lot of people forgot just how inflation works.

Some politicians are coming up with all sorts of reasons for why our current inflation is just transitory and not a bad thing.

Speaker Nancy Pelosi told ABC News that her Democratic agenda was responsible and it was a good thing. “And part of the consequences of all of that investment,” she told us, “the infrastructure bill and the rest, is that more people have jobs and, therefore, inflation goes up.”

President Biden told NBC News: “Let’s look at the reasons for the inflation. The reason for the inflation is the supply chains were cut off.”

Even researchers at the Chicago Federal Reserve said the high number of job-swappers, who were quitting and moving to higher paying jobs, was leading to higher inflation! And still others like Senator Bernie Sanders blamed greedy meat-packers and oil companies.

Yet, these politicians and even the Federal Reserve has seemed to forget the lessons of the great economist Milton Friedman. In 1970, he said,

“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

Now, I’m not an economist, and I can’t even play one on TV, but when I read that, it means that monetary policy is the cause of inflation. Not workers, not capitalists, not even fiscal spending — unless that fiscal spending is fueled by the Fed’s printing press!

Easy monetary policy leads to inflation, and only tighter monetary policy can fix it.

I worry that means that the last eight years of near-zero interest rates and quantitative easing, which refers to the Fed buying assets to expand the quantity of money, is going to show up in higher inflation rates for years to come without tighter policy action now.

Milton Friedman had a few other notable lessons that we may have forgotten. One is his first famous observation in 1960 that monetary policy operates with a long and variable lag.

His research, updated again in the 1970s, found that adjustments in monetary policy would not see results in prices for up to two years. That means we should not expect any immediate fix to our inflation problems from the Fed. Anything the Fed does this year will not have an effect for a couple years from now.

And about those lags? If inflation is always and everywhere a monetary phenomenon, has the Fed figured out how long and how variable the lags might have been for its loose zero-bound policy in the past decade? Could this current bout of inflation be the long and variable lag from that easy money zero-bound strategy and a dramatically larger Fed balance sheet?

When the Great Recession began, the Fed’s balance sheet was about $800 billion and consisted mostly of Treasury bills. Now it is nearly $9 trillion and contains many long-term mortgage-backed securities and Treasury bonds.

So what am I doing about higher inflation rates? Well, the short answer is not much. I’m not the Fed! It turns out that might be the best action to take: Not much!

I am reminded of a famous quote attributed to Vanguard’s John Bogle, President Dwight Eisenhower, Adlai Stevenson, and even the White Rabbit in Alice in Wonderland. They all offered this sage advice: Instead of the more common panicky advice to “Don’t just stand there, do something!” they all advised,

“Don’t just do something, stand there!”

Sometimes, the worse action to take is any action. Instead, pause and consider your long-term strategy.

I manage my unexpected retirement with a do-it-yourself retirement plan that includes three time buckets and three tax buckets. Bucket One includes cash and equivalents equal to three years of expenses. Bucket Two includes assets that equal another five years of expenses. And Bucket Three includes long-term assets I need for more than eight years from now. Most of my equity holdings are in Bucket Three.

In March 2020, when the Big Unknown was COVID-19, some people panicked and sold stocks into the sharp market decline. But I didn’t. I knew my three-bucket strategy had the cash I needed for expenses for the next three years. So I let my long-term investments stand. The market quickly regained all of its losses and more.

In fact, the only thing I did during that uncertain time was to complete a small Roth conversion to move some money from my traditional IRA to a Roth IRA. So when the market did return, the Roth investments grew tax-free.

Another principle for managing my investments is to focus on things I can control. I cannot control high inflation or geopolitical risks. But I can continue to focus on the expense ratios I pay for my investments. Earlier this year, had decided to sell off my last two actively managed funds Vanguard’s Wellesley Income and Wellington Funds. Both are great funds, but with expense ratios that are four times what I want to spend on low-cost index funds. I pay 0.22 percent for Wellesley Income, and although I only pay 0.16 percent for Wellington Fund in an Admiral class, Schwab will not let me add to this holding. I can only buy the higher-priced Investor class at that 0.22 percent cost. So, I’m selling both this year in favor of low-cost ETFs.

I cannot predict what direction the market will take as a result of inflation or war, but I can predict that I will save hundreds of dollars each year by choosing these index funds.

I will also stick to my long-range plans to rebalance my portfolio over my bucket strategy. I began the year by selling assets to ensure I have enough cash for the next three years. That means I continue to sit on a cash cushion of about 10 percent of total assets. I will continue to rebalance to about 7 percent cash by the end of this year, giving me some wiggle room to buy equities when markets pull back.

I am currently about 50/50 equity to fixed income, and I am targeting to end this year with a 60/40 asset allocation. I will do that on a quarterly basis to move more of my assets from cash and bonds to equity. But I’m not going to try to do that all at once. I cannot time the market, but I can move in agile steps toward that goal.

Under no circumstances will I need to sell equities into a bear market. So, I will take my time. In the words of John Bogle or the White Rabbit, I’ll just stand there.

On inflation, I am also standing pat with a conservative 3 percent target for my long-term financial projections, until I know what the Fed will do this year to respond to rising inflation. We will know in a few weeks what the Federal Open Market Committee, the Federal Reserve’s group of policymakers, will do.

The actions that the FOMC takes at its next meeting March 15–16, 2022, will determine if the public will continue to view its 2 percent inflation target as credible. If the public does believe the FOMC will stay committed to systematic monetary policy, then inflation expectations will become unanchored. That is, if the public comes to believe that the Fed will not do what is necessary to preserve price stability — then inflation can rise even more quickly.

The last time that happened in the Great Inflation of the 1970s, it took those back-to-back recessions and a steep rise in interest rates under Paul Volcker to restore control of inflation.

While some Fed watchers might like a “shock and awe” campaign of rapidly rising Fed Fund target rates, starting with a half-point or more in March, recent history suggests otherwise.

The FOMC has moved rapidly to lower rates in response to economic shocks, but the policymakers have generally raised rates by quarter-point moves.

For instance, the FOMC dropped the Fed Funds target to near zero to respond to the COVID crisis, from 1.75 percent in March 2020. But, the last time the FOMC tightened policy from 2017 to 2018, the committee did so with a slow and steady series of quarter-point moves.

This next meeting of the FOMC will also include a Summary of Economic Projections by all Fed policymakers and it will include a dot-plot of estimates for the Fed Funds rate. That will give us a hint of how many rate increases we can expect this year and next.

Finally, I’ll recall one other famous quote from Milton Friedman that we should all remember:

“…we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and, as a result, in danger of preventing it from making the contribution that it is capable of making.”

So when some folks are trying to get the Fed to become more woke and green, perhaps we should instead ask the Fed to do the one thing it can do. Let’s hope the Fed policymakers remember the words of Milton Friedman and focus on controlling inflation.