FIREy Discussion about Inflation

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Inflation: A formerly dormant topic in personal finance has come to the surface thanks to the events of 2020 and 2021.   I’ve hesitated to write this piece for a while, because it involves economics and the discussion involves facts, opinions, and ultimately an unpredictable future.   The discussion on inflation can’t go without touching on politics, but I’ll make my best attempts to do so without offending anyone.

What is Inflation?

Inflation is aggregate  increase in prices of goods and services in the economy.   Inflation is measured in multiple ways, but the Consumer Price Index published by the Bureau of Labor Statistics is generally referenced when people refer to inflation.  The financial networks will also reference another measure of inflation, the Producer Price Index, which the Bureau of Labor and Statistics use to judge selling prices from manufacturers.

Is Inflation Good / Bad?

Inflation has generally been regarded by the Federal Reserve (and politicians) as a delicate balance.   If inflation is too high, the population will be upset over paying noticeable higher prices each year.   If inflation is negative (deflation), it presents a different set of risks.   A small amount of inflation is generally considered acceptable in an economy.   In the United States, the Federal Reserve is mandated with managing inflation in the economy and sets an inflation target.

These were not $18.99 last year..

What is the Inflation Target?

The Federal Reserve openly targets a 2% inflation target per year, with more recent comments stating a 2% to 3% inflation target is acceptable.   In other words, the goal of the Federal Reserve is to cause prices in aggregate to increase by 2% per year.   Conversely, this means a dollar earned by a worker or a dollar held in savings loses 2% of it’s value per year.   

What’s happened recently?

The consumer price index reported a gain of 6.2% from October 2020 to October 2021, the largest gain on record since 1990.   Categories tied to consumer’s three biggest expenses, shelter, transportation, and food all gained at a pace higher than the rate of inflation.   Consumers are reminded of the rapid price increases when they go to buy a home, get a rent renewal notice, fill up at the pump, go to the grocery store, or need to buy a vehicle.  

Politicians on the right side of the aisle are (opportunistically) getting vocal about inflation, either as an actual concern or because it’s the only option they have while in the minority.  Politicians on the left are downplaying or passing off concerns around inflation by stating they are transitory, the result of supply chain shortages, and oil price conspiracies, while championing wage growth. Who’s right?  The real answer probably lies somewhere between the two positions.

Why is Inflation So High?   

(Warning:  This will be facts with opinions.  Given this is only a few thousand word blog post, I am sure there will be additional facts, opinions, and perspectives omitted in the name of brevity.  There are PhDs in economics who write book size research papers on this.)

Inflation is a combination of the total monetary supply and the velocity of money.   The quantity theory of money states the money supply multiplied by the velocity of money will equal the price level multiplied by real gross domestic product.   That’s a fancy way of saying the total dollars in the economy multiplied by the number of times a dollar changes hands (velocity of money) equals the price levels in the economy.   The total money supply, as calculated by the Federal Reserve’s M2 is shown below.

When the various federal, state, and local governments reacted to the novel coronavirus in March of 2020, the velocity of money was sharply reduced.   People stopped normal activities and stayed at home.   Service and entertainment based businesses stopped.   Miles driven dropped dramatically.  The total amount of money changing hands slowed.  

The government responded immediately with various policies to prevent a wide scale economic crisis at the individual level, primarily through Enhanced Unemployment Benefits for those who were laid off and Paycheck Protection Program to encourage businesses not to lay off workers and fund a portion of their salary. However, these policies did not necessarily increase the money supply.

Enter the Federal Reserve

The Federal Reserve is the Central Bank of the United States.   It was created in 1913 after a series of financial panics and its roles and responsibilities with managing the economy have been expanded over the last century.

Prior to the Federal Reserve, the US Treasury could only get dollars in one of two ways:  Through tax revenue or through borrowing money on the open market.   If the government borrows a dollar in the market to send a dollar to a consumer, it doesn’t create any money.   (It may increase the velocity of money because the consumer is more likely to exchange that dollar than an investor, but that’s a side note).

The Federal Reserve can be the purchaser of United States Treasury debt, along with other debt.   With the United States dollar being backed by “the full faith and credit of the United States”, the Federal Reserve making a bond purchase is the creation of money.   How much money the Federal Reserve creates is measured by its balance sheet

On January 1st, 2020, the Federal Reserve had roughly $4.2 trillion dollars on its balance sheet, 75% of which was accumulated in response to the financial crisis in 2008.   As of the end of September, 2021, that amount was over $8.4 trillion dollars.    The Federal Reserve has created $4.2 trillion dollars in a 21 month period in an attempt to manage the economy.   In order to buy that much debt, it bought not only United States Treasury debt, but mortgage backed debt and corporate debt.  This lowered rates for mortgage and corporate borrowers and allowed companies that may have otherwise failed to issue debt. Inflation has increased, but not proportionately to the amount of debt that’s been purchased.   Why?   The velocity of money.   Individuals and companies now have more money, but aren’t exchanging money at the rate they were prior to the pandemic. 

In fact, monetary velocity has been declining since it peaked in 1996.    Why?   The US population is aging and older people spend less money.   Peak household spending occurs between the ages of 25 and 50, thanks to a combination of high incomes and household expense pressures (the old adage of kids are expensive….)  1996 enjoyed peak monetary velocity because the highest birth rate years ever enjoyed by the United States were in their peak spending years.   

Bank of America research even put out this chart, overlaying the birth rate 25yrs forward with the inflation rate:  

Inflation:  So What is Short Term and What Is Long Term?

This is the biggest debate going on in our country.  Everyone should think about what is temporary and permanent when it comes to inflation.  If the inflation is temporary, does that mean prices go back down to 2019 levels or does it mean next year it just won’t go back up as much? Personally I think there are both short term and long term inflation pressures to consider.

What do I think are short term inflation contributors?

Excess Savings:   The Savings Rate in the United States shot up because there were less things to spend money on, especially in the services and travel sectors .  There’s a portion of the population that views the savings created as excess and will be spending those dollars.

Child Tax Credit:   In 2021, the Child Tax Credit was changed to a monthly advance instead of a year end payment.   This means most families will get the tax credit they usually receive in February / March of each year advanced to them each month.   For 2021, families would have received the 2020 credit when they filed and also begin receiving the credit they usually wait for February / March of the following year to receive.   This essentially doubled the payment for 2021. The effects of this should slow after March of 2022, when people do not receive the large payment after filing taxes they’ve become accustomed to receiving.

Student Loan Pause:    Student Loan Debt: Stats by Age, Income, and Percentile (  According to data aggregated by, Student Loans totaled $1.7tril in 2019.  Most of the country’s student loan debt is owned by households between the ages of 25-40 and these households are enjoying a higher than average income (the education was successful!)  Effectively households who were most likely and able to make discretionary expenses got a significant boost in discretionary income thanks to the pause.   The payments weren’t eliminated forever, but this pulled forward spending in 2021 at the expense of payments at the end of the loans.   

More reading:  What Is the Current Student Debt Situation? – People’s Policy Project (

Other Stimulative Measures:   There were numerous other policy measures passed that in themselves may not be inflationary.  These include the Paycheck Protection Program, Direct Stimulus Payments, and various grants to State and Local Governments.  These programs helped boost the velocity of money, encouraging people and businesses to spend. That combined with the Federal Reserve purchases the debt issued to fund the programs created inflation.  

What are the More Unknown Inflationary Pressures?

What’s longer term is more difficult to figure out.   Below are the issues that I don’t expect resolve in the next twelve months:

Total Monetary Supply:   What is the consequence of such a rapid increase in the money supply?   Just how fast will velocity return as people “get back to normal”.   Recently retail sales were running 20% higher than the same period in 2019, suggesting spending is more than “back to normal”. However, the the Federal Reserve continues to implement *emergency* measures, including $120 billion in bond purchases a month and near zero interest rates. Only in the last month has the Federal Reserve began slowing these purchases and has yet to raise interest rates.

Declining Birth Rate = Wage Pressure.    The declining birth rate in the United States will be a constant theme, it’s a tremendous risk to the country, especially given the state of immigration policy. Low wage jobs typically have two employee profiles, new to the workforce (under 30) or people of normal retirement age that work part time to supplement income.   Two things are reducing this demographic at the same time:   The Birth Rate declining after 1994 means there are fewer people under the age of 27 relative to the population than in the history of the country.   The 1946 cohort turned 75 this year and are faced with an age where their skills aren’t valued in the workforce (unless you want to run for federal office!).   Add in the health risks to an older population working a service job over the last two years, an increase in deaths for those above 65 over the past twenty one months, and the results are labor squeeze. 

This is good for the remaining low wage employee, provided their income can go up faster than inflation.   The economic debate is the wage gains are good for the lower wage employee, but these households are likely to spend a larger percentage of their income on food, housing, and transportation than a higher income household. These goods are under more pressure than the overall inflation number, presenting cost pressures. (Whether or not wage gains for low income households are outpacing the inflation impacts are currently in the “political opinion” phase. The wage gains and price increases are still recent and more data over the coming months and years will answer this debate)

There is a solution for this issue, but it is politically untenable.   November 6th, 2021 marks 35 years since the last comprehensive and bipartisan immigration package was passed in the country.  I’m not here to state an opinion about immigration, but merely to point out that choices have consequences.   If you have a smaller pool of employees available to work low wage jobs and a country chooses to not want to increase it’s population via immigration, there is a consequence.  There are not a shortage of working age adults willing to come to the United States, as full time work at $15/hour is equal to more than $30,000/year, which provides an employee an income that’s in the top 5% in the world.

The Housing Inventory Issue:

I’m bullish in the short term and bearish 5+ years out on housing prices.   Housing was underbuilt from 2010 to 2019 while we now have demographic issues both restricting supply and driving demand.  Add in the short term pressures created by the pandemic such as twelve to eighteen months of restricting foreclosures, lower 30 year mortgage rates due to the Federal Reserve buying mortgage backed securities, and demand for space thanks to work from home, and the country has experienced a shock to both the demand and supply side of an otherwise quiet market.  This has been particularly frustrating to me as someone who was planning on buying a home outright and has watched prices run away from me in coastal markets.  I’m still cautious when it comes to housing, as the country is now rapidly accelerating new housing starts and building inventory into some demographic headwinds. This topic and research will likely get it’s own post in the near future.

Inflation Is Everywhere, so What Can I Do About It?

Since this site is primarily written around early retirement and investing, I’ll stick to those two topics about what you can do about inflation.   For those who are still working, there has never been a better time to test the employment market.   Update your resume, update LinkedIn, and connect with your network and let them know you might be interested in moving.   Figure out your value in the market and get paid.  The supply of jobs relative to people available to fill them is near an all time high.   

If you know where you want to be for the next decade and a half, go ahead and buy a home with a thirty year fixed rate mortgage.   A fixed debt amount paid for in future dollars is a great hedge against inflation and a fifteen year hold period gets a buyer past the historically worst decline and recoveries you can find in the real estate market.  However before you buy, make sure you intend on staying in a property. According to the National Association of Realtors, the median home ownership length in the United States was 13 years as of 2020. This means more than half of today’s home buyers will not be living in the same home thirteen years from now. The transaction costs in selling a home can range from 6-10% of the total sale price.

Investing:   This is being written in early December of 2021 and I believe there is elevated risk in all asset classes.     Equities are trading at near record price to earnings multiples while unprofitable companies flow into the IPO market.   Income producing real estate is priced at historical highs, equaling minimal cash flow relative to the price.  Bonds have experienced a strong thirty year run thanks to declining interest rates, but this performance could reverse if rates move in the opposite direction.  Cash provides flexibility, but lost over 6% of it’s purchasing power over the last year due to inflation.   The equity markets are also enjoying a record amount of margin borrowings fueling current valuations, which can cause selling pressure to turn into sharp declines. 

Assets that Beat Inflation:  There are only two assets proven to beat inflation over an extended period of time:  Equity ownership in companies and ownership in income producing properties.   An investor must own a good portion of one or both of these assets to beat inflation.  This doesn’t mean the ride will be easy, as both of the assets could experience a decade of near zero returns at the current values.

Assets that Provide Flexibility:   An early retiree or soon to be early retiree should hold a cash and short term bond allocation to provide for short and medium term spending needs.   These assets are primarily meant to provide flexibility and to cover living expenses to not have to sell equities / real estate for spending needs over the next couple of years.   Personally we have a cash allocation, a treasury inflation protected bond fund, and a corporate bond fund that all provide funds for a monthly budget.   Individuals can also buy up to $10,000/year in Treasury Inflation Protected Bonds directly from the US Treasury’s site, as of November 2021 these bonds are paying 7.1%.

Assets that provide a Risk Hedge:  Specifically for me, this means owning US Treasury Bonds purchased through Fidelity.   These bonds pay a low interest rate, but are held to hedge against the elevated risk in the equity market.   In general, when risk based assets start falling in value, demand for risk free assets such as treasury bonds goes up.  This bids the price of the bonds up and interest rates down.  Long term treasury bonds also provide a hedge against deflation, the risk of a long term decline in prices, since a $1,000 bond bought today guarantees both interest and the return of the original $1,000 in the future.  While this is a minimal risk, the long term demographic trends and decline in velocity of money leave this possibility open.  

Wrapping It All Up

For investors and early retirees under the age of 50, we are getting our first real experience with inflation in our lifetime.   How high will it be?  How long will it last?  What will be the governmental response and what are the consequences from said response?  We must confront this new risk and decide if we make any new or different decisions because of this risk.   Personally, I’m remaining balanced in our investment approach:  78% Equities, 20% Cash and Bonds, and 2% in Private Real Estate.  In that allocation, I’m owning what I believe is the higher quality side of both the equity and bond market:  Companies that have profit and cash flow along treasury bonds.   Staying away from some of the high growth, unprofitable companies may cost me a few percent in return, but this approach should afford me a lower risk portfolio.

To steal a line from a famous investor, we can’t predict the future, but we can prepare.

Further Reading:  Oaktree Capital:  Winds of Change

One Reply to “FIREy Discussion about Inflation”

  1. Interesting post and very timely!

    With inflation where it is it does make cash in low or no interest accounts really expensive.

    I tend to leave the checking account pretty high just for convenience purposes but I’ve decided I need to put that money to work given inflation. Same with the savings account that was kind of a parking lot for funds, I just emptied that today and invested it.

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