Exchange Rates

Is inflation bad?

Is inflation bad?

Because Tom Brady said so? Oh wait, wrong type of inflation.

In an excerpt below from a January 2010 letter from founder of Oaktree Capital, Howard Marks, he goes into the interplay of inflation with other macro variables and explains it much better than I could. Most importantly, I think, he talks about inflation in a historical context to give us a more informed framework to look at the present. To me, the scariest part is that any single one of these macro variables is almost impossible to predict.

If I were to try to sum up what I think Marks is saying: I think inflation can be good and bad. Whether inflation is good or bad can only be judged in the context of other macroeconomic variables. The actual question is, given the level of other macroeconomic indicators, what levels of inflation would be detrimental to the overall macroeconomy?  

January 2010 Oaktree Memo:

Inflation, Exchange Rates and Interest Rates

The macro question I get most often concerns the outlook for inflation. And as someone who lived through stagflation in the 1970s and paid interest at 22-¾%, I think it’s very much worth considering. The hyperinflation of the ’70s was sparked by the Oil Embargo of 1973. Labor contracts and benefit plans containing cost-of-living adjustments built on that to create a cost-plus cycle in which inflation lifted wages, contributing further to inflation, and so forth. Rising prices frightened people into demand-pull inflation by convincing them to stock up on goods to avoid higher prices later. And people borrowed to invest in assets like land out of a belief that no matter what interest rate they paid to finance their purchase, the asset’s price would increase at a faster rate (the epitome of inflationary thinking).

No one knew how to solve the problem. I used to go to hear “Dr. Gloom” and “Dr. Doom” (economists Al Wojnilower of First Boston and Henry Kaufman of Salomon Brothers) compete to be more depressing. They talked about how hard it would be to get inflation down to “an acceptable level.” One day, I heard someone ask for the definition of “an acceptable level.” He was told “one-third less than whatever it is at the time.”

Finally, however, in the early 1980s Paul Volcker and the Fed implemented the painful solution of significantly higher interest rates, inflation subsided, and the stock market took off. Over the next 25 years, rising inflation and interest rates were forgotten as possible sources of risk.

Today, labor in the U.S. lacks the power to demand strong wage increases or COLAs. Further, the sluggish macro picture argues against demand-pull. Strong inflation is usually associated with higher levels of prosperity and stronger demand for goods than I foresee. Finally, inflation often presupposes pricing power on the part of manufacturers, which I also don’t see.

Those are the factors that argue against an increase in inflation. However, because of other forces – primarily financial and international – it could take increasing numbers of dollars to buy a given quantity of the imported goods on which we’ve become so dependent (a.k.a. inflation).

  • As I mentioned earlier, debtors want there to be inflation so they can repay their debts with currency that’s worth less. To accomplish this, debtor nations have the ability to debase their currencies by printing more of it. For the clearest example, see “The Limits to Negativism” (October 15, 2008) on the subject of the Weimar Republic. Post-World War I Germany was assessed war reparations it couldn’t afford, so it simply over-stamped its 1,000 mark notes “1 million marks.” All of a sudden it had created enough marks to pay its debt to the world . . . and destroyed the purchasing power of its currency.
  • A dollar weakened by reduced demand for it (e.g., as a vehicle for the investment of China’s reserves) would, likewise, equate to more dollars per item bought from abroad.
  • Finally, “stores of value” like gold hold value only because people agree they will. The same goes for currencies. Profligate spending, runaway deficits and declining world position could reduce the role of the dollar as a reserve currency, again cutting into its purchasing power.

When Paul Volcker left the Fed in 1987, he was asked at his first public appearance, “Will interest rates go up or down?” He answered presciently: “Yes.” Of course, his answer is still the right one. But from today’s levels, I think rates are more likely to go up than down (there’s so little room for the latter).

Reduced faith in the dollar means it would take higher interest rates to attract non-U.S. buyers to dollar investments. And, even domestically, (a) one of these days the government will stop holding rates down and (b) higher inflation would require rates to rise to compensate for the fact that the dollars with which debts are repaid will buy less. For all these reasons, I think investors must consider the prospect of higher inflation, dollar weakness and higher interest rates.

What to do about them?

The list of possibilities is long:

  • Buy TIPS.
  • Buy floating rate debt.
  • Buy gold (but only at the “right” price, and what’s that?)
  • Buy real assets, such as commodities, oil and real estate (ditto).
  • Buy foreign currencies.
  • Make investments denominated in foreign currencies.
  • Buy the securities of companies that will be able to pass on increased costs.
  • Buy the securities of companies that own commodities, or that own assets denominated in foreign currencies.
  • Buy the securities of companies that earn their profits outside the U.S.
  • Hold cash (to invest once interest rates have risen).
  • Sell long-term bonds (and possibly go short).

These are the actions that can profit from – or that provide the flexibility to adjust to – increased inflation, a decline in the dollar and increased interest rates, all of which are interconnected. The most important one is the last one: long-term bonds could suffer worst in an inflationary, higher-rate environment, especially given today’s low starting yields.

One final point: When I provide this answer to the frequent question about inflation, I ask people whether they agree. Usually they do. Then I ask how much of their portfolio they’re willing to devote to protecting against these macro forces. If their answer is 5%, 10% or 15%, I point out that that’s pretty close to doing nothing. The question is whether you’re willing to devote at least 30-40%.

Few people are. But that’s the thing: It’s easy to say, “I’m worried about inflation.” It’s something very different to say, “I’m worried enough about inflation to do something meaningful about it.” Let me know when you decide how much you’re willing to devote.