Summary

• There will always be a tug of war between inflation and deflation.
• Neither, when moving both slowly and to a limited extent, will arouse a surfeit of fear and loathing.
• Good luck finding that golden mean.
• Here is where we stand today and the effect it has on your portfolio.

The too-close correlation between the two | Dzmitry Dzemidovich/iStock via Getty Images

“Inflation is caused by too much money chasing after too few goods.” – Milton Friedman

Thomas Sowell once wrote of Milton Friedman, one of his professors at the University of Chicago, that he “was one of the very few intellectuals with both genius and common sense. He could express himself at the highest analytical levels to his fellow economists…and be understood by people who knew nothing about economics.”

I think the Friedman quote above makes that abundantly clear. You can listen to 100 different economists tell you all the arcane ins and outs of what inflation really is, but at the end of their explications and intonements from on high, you are no closer to an understanding of what the heck they are thinking -- and perhaps they are not either!

Dr. Friedman is also the economist who provided us with these insights:

“The government solution to a problem is usually as bad as the problem.”

“There is nothing as permanent as a temporary government program.”

It seems we have ample *present* evidence of the truth of these two statements. Regrettably, The US government decided, ostensibly to prevent the economy from grinding to a halt, that they would simply print and circulate more money than was necessary to solve the COVID-19 pandemic crisis. Showing no faith whatsoever in the integrity and innovation of American citizens, the government, via the Federal Reserve and the US Treasury, decided that we all needed to be taken care of by a benevolent federal government.

That money was distributed at a time when travel, dining out, taking any kind of public conveyance, etc. was severely constrained. So what happened? Americans squirreled all that money away against the time when they would be able to travel, dine out, fly and train and drive anywhere they wanted.

The problem is that the United States has offshored so much manufacturing -- and even services -- in quest of the lowest bidder for everything that now, when we can't get that stuff to our shores, and now that we are able to travel, dine out, fly and train and drive anywhere we want, we all of us are bidding up prices.

If our central government were constrained in its ministrations to the rest of us, there are three factors evident in every transaction. This is no different than it was in the pre-written-history caveman days. Imagine Og, in one clan, and Blik, in another, wanting to exchange something each possessed for something the other had.

First, each of them had to work to get that object of the others’ desire. Let’s say Og’s clan slayed a mastodon and ate their fill. Before it could spoil, they really needed to do something with it. Blik’s clan, on the other hand, was literally dying for some food. Fortunately, Blik was a fine craftsman who made the best obsidian knives. Obsidian knives were in great demand. They were the sharpest blades of all but they were also incredibly brittle, so there was always a demand for new ones.

This first step, too often left out of the “What is inflation?” conundrum, is that each person had something of value that they had earned via hard work, dangerous work or exacting work.

The next step in this prehistoric barter transaction was to recognize that each individual, as representative of his entire clan, has to negotiate to get maximum benefit. However, they also had to realize they could not cheat the other completely (spoiled meat, a knife that broke on gentle use, etc.) because that would ruin all hope of honest trade in the future. Adam Smith would later think of this as the Invisible Hand, especially as it relates to all the members of both clans who contributed to the effort.

It is really no different today, except perhaps for the "Too Visible" hand of government.

Income is either earned by work or by governmental dole; either way, one gets something called money. That money has no value except for what it can buy. Stuffing it under a mattress does not keep the hunger wolf away from the door. So we use that money to buy (hence, the “demand” for) a good or service. Those goods or those services delivered (“supplied”) gives the seller income to then demand a supply of something nearer and dearer to their own needs. Rinse and repeat.

The rub comes, of course, when there are imbalances in either the demand or supply side. Inflation results when there is *either* too much demand or too little supply. Most often, it is some combination of the two. That is exactly the situation we find ourselves in today. We have both to a serious degree.

In America, we are in the midst of what I believe is a temporary spike in inflation to the highest level it has been in 40 or so years. There is a massive tug of war between demand and supply.

Why do I believe this is a temporary spike? First, because the solution to inflation is inflation. If home prices get so out of line that no one can afford them, prices fall. We only have to go back a baker’s dozen years to have experienced that. If stock prices, climb into the stratosphere, FOLD becomes the order of the day, not FOMO. [You will likely recognize FOMO, Fear Of Missing Out. I have coined the term FOLD for the opposite reaction: Fear Of Losing Dollars.]

Putting this instance of our present-day inflation as simply as Dr. Friedman might, “When Federal policy juicing meets restricted supply, inflation is the result.”

I believe this spike is temporary and need not frighten us from all investing because both of these issues are already being solved. I was writing my concerns about inflation beginning a year ago when the Fed was still saying it was “transitory.” I pounded the table saying it was not. But now, a year later, when the rest of us can plainly see that more offshore manufacturing is reopening (= greater supply) and less cash is being flung out the doors of the Treasury (= less amount of cash for demand) I see an equilibrium coming into view.

The Fed has finally acknowledged that inflation is not transitory and is determined to plunge ahead with a likely 50 basis point raise in May and, if the current betting holds, a 75-basis point rise in June and perhaps July.

The Fed’s cudgel of choice in all this is the “federal funds rate,” which is the interest rate at which banks and other depository institutions lend money to each other (usually on an overnight basis.) By controlling this key factor in what rates banks must pay (and thenceforth pass along, of course) raising this rate makes it more expensive to borrow, plain and simple.

The Fed missed what the rest of us were experiencing firsthand a year ago (inflation in food, energy, water, electricity, rents, and just about everything else.) It is now trying to make up for that failure by tightening at just the wrong time and likely by the wrong amount.

Why do I say this? The labor market is improving every day. More people are returning to work, fewer people are collecting unemployment benefits.

Of course, government could still mess this up. For example, proposals to forgive all student debt are not merely an affront to us poorer kids who had to work our way through college, they are inflationary and discriminatory. The money goes to those who can afford college. Whether we do such things out of a misplaced sense of guilt or compassion, the effect is the same. Some segment of society just got a $40,000, $50,000 or more “raise” over their working career.

Not only is the labor market improving in the USA, but our many offshore suppliers are getting their arms around Covid and reopening manufacturing. The obvious exception is China, but even that is good news in one important sense. As in common sense.

I recently answered a good friend’s request that I comment on an article about the ascendance of China and the demise of the US as an economic power with these words:

“I believe this furious volume of similar articles with the PRC trying to assume the role of primary supplier to the US and the resulting supply chain bottleneck has chastened… American companies nearsightedly looking at a billion Chinese consumers as free manna from heaven.

“Not only do we now know this is a one-way street for China, but we also are beginning to realize that many points of export to the US are better than one. India also has a billion workers ready to work for the same wages or less than today's China. Indonesia, Brazil, Nigeria and Bangladesh add another billion. In addition to workers, these will all be more likely consumers of some US exports -- particularly agricultural and high tech -- as their work leads to a higher standard of living.”

The supply chains are reopening. Better, US companies are scrambling to diversify sourcing – all to the benefit of many nations until now overshadowed or overpowered by the alleged Chinese economic miracle. Supply is coming much quicker than the Fed realizes.

How about the demand side of the equation?

“Been down so long, it looks like up to me.” Demand is leveling out. We don’t see it as easily only because we are coming from such an unusually low level of supply. Traditionally, when demand rose, supply rose along with it. That has not happened this time. My calculus here is simple: If the world gets its arms around Covid and its many variants, more people work. More people working equals more supply produced. More supply produced equals, at a point none of us know will happen, equilibrium -- for about a split second. After that, it will fluctuate around the usual level of equilibrium, never perfectly there but always coming back to some sort of stasis.

Everyone is following the latest pearls of wisdom emanating from today’s version of Og’s cave – the Federal Open Market Committee meetings. I would suggest that where inflation goes in 2022 is less about how many times the Federal Reserve will raise rates or how fast they might shrink their balance sheet, but rather what happens with demand and what happens with supply.

I said earlier that inflation is the cure for inflation. When individuals and companies see higher inflation, they reevaluate their budgets, leading many to slow their spending. Lower demand will result – just when the supply is increasing, leading inflation on a downward curve.

What Does This Mean For Your Portfolio?

This is a question only each individual can decide. For me, and for the model portfolio at our Investor’s Edge Marketplace site, it means the Energy and Materials sectors, both of which typically do quite well as inflation worries mount up and continuing up to the middle stages of inflation winding down. At this point, I and my subscribers are looking for quality companies and ETFs that stress positive cash flow, low price/earnings, price/book and price/sales ratios and have real revenues – not revenues that promise to come. We also own a position in the ProShares UltraShort 20+ Year Treasury ETF (TBT) and many other defensive-for-now positions.

I invite your questions and comments.

Good investing.