August 2021 Economic Report

By Scott GardnerIn my previous report, I said that I believed the Fed “will not touch interest rates for the foreseeable future, which means that 2021 will likely be a year of higher-than-usual inflation.” Since that report, the Fed has made some announcements which make me think that my previous statement will be the understatement of the year!In June of this year, Fed Chairman Jerome Powell announced that they aren’t planning on increasing the fed funds rate until 2023 despite the recent uptick in inflation.On its surface, this policy change doesn’t sound so bad, but the results can seriously affect investors, savers, and retirees over the next few years. Fed Policy ChangeMy previous analysis and assumptions were made on the basis that the Fed would maintain its monetary policy. However, Jerome Powell has stated that the Fed has changed its monetary policy to push towards “Maximum Employment” because of the previous recession’s tepid employment recovery.Maximum employment is an economic concept that aims to attain the highest level of employment that the economy can sustain while maintaining a stable inflation rate.With this policy change, the Fed has stated that there will be a “transitory” and “temporary” higher-than-usual inflation rate.So here’s what that means in Layman’s terms:The Fed will keep interest rates crazy low for the next 18-36 months to incentivize borrowing and stimulate economic growth.With financing, people can buy a lot more than they usually could—this will trigger inflation as demand spikes and manufacturing cannot keep up.Conceptually, high demand for goods and services over an extended period will cause companies to increase their manufacturing capacities, resulting in higher employment and stabilizing inflation as manufacturers meet that demand. How Asia WorksI recently read a book called How Asia Works by Joe Studwell—which I highly recommend. In the book, he breaks down the effects of the monetary policies of each of Asia’s major countries over the past several hundred years.Studwell points out that certain countries have used low/negative interest rates as a tool to incentivize nascent industries to borrow and increase exports with the intended result of transitioning their country from an agrarian economy to a manufacturing economy.As has been demonstrated in Asia, countries that incentivize borrowing and exportation through low-interest rates see increased inflation rates, cost of living increases, more expensive labor, and small businesses struggling to keep up.Despite these apparent negatives, a prolonged low-interest-rate environment typically improves living conditions across the board, and it can have long-term economic benefits as long as it is tapered once the strategy target has been realized.While I have applied the lessons learned from Asia’s economic experiments to the Fed’s recent policy change, there is one significant issue—these monetary experiments have never been done on a mature economy before! Flawed TheoryModern governments generally use the principles outlined in the Keynesian economic theory when creating monetary policy. Keynesian economics places the role of the government in the middle of influencing economic growth.The issue with this is that Keynesian economics can be used to explain many functions of the economic engine accurately, but it cannot accurately describe everything—this leaves areas of economic policy up to educated guessing.An example of this is that Keynesian economics uses the Phillips Curve to explain the relationship between inflation and unemployment—when inflation is low, unemployment is high, and vice versa. However, in the 1970s, both inflation and unemployment were high, and countries came up with different solutions to end it.If Keynesian economics were 100% accurate, stagflation couldn’t exist, and all countries would come to similar solutions to address economic issues.The Fed has stated that they are in uncharted territory—that means they are guessing on the long-term effects of their current policy. Potential DangersWith so many unknowns in the current policy change, there is some potential that investments, savings, and retirement might be negatively impacted.Before I go into these, I want to point out that I am not a doomsdayer—I think that the United State’s best days are still ahead, albeit with some bumps along the road. I also believe it is wise to identify, and prepare for, potential dangers rather than react to them when it might be too late.In no particular order, here are some potential dangers and side-effects of the current policy on your investments, savings, and retirement:InflationFor the next 2-4 years, I can see that inflation can become a significant issue.As shown on the CPI chart, inflation is on a strong upswing. Based on the Fed’s policy changes, I think that inflation will be a multi-year issue. As of last month’s CPI reading, cash holdings are losing roughly 1% of purchasing power per month. Failure to do something with your cash could erode its purchasing power up to 12%+ per year. When projecting retirement, most financial advisors use an assumed range of 2-4% for inflation. One of the problems with significant inflation is that it can destroy your current retirement plan and push out retirement for years.Tax Bracket. Unless the government increases its tax brackets to accommodate higher wages, many more people in the United States may find themselves in a higher tax bracket. As history has shown, people tend to borrow a lot of money during times with low interest rates. The law of Diminishing Marginal Returns is an economic theory that states that you can only borrow so much before it starts hurting you. This means that borrowers can become significantly overleveraged and that any small increase in the Fed interest rate can potentially trigger massive defaults, economic hiccups, and a deep recession.BondsWith the Fed stating that they are going to keep interest rates low for at least several more years, it leaves bonds very little room to grow. And, when the Fed decides to increase interest rates, it will lower the market value of any bonds held in your portfolio.StagflationIn the 1970s, poor monetary policy and the oil crisis created stagflation here in the United States—a period of high inflation with high unemployment.I don’t believe this is a likely scenario, but the current policy change doesn’t adequately address the potential effect of outside countries on the United States economy, which makes this a possibility.Overuse of Quantitative EasingIn 2008, the central bank came out with a cool new tool called Quantitative Easing (QE). QE is when the central bank prints cash to buy private assets.QE is really just an accounting trick that swaps one asset for another. It has the desired effect of liquidating illiquid assets so that money can be used elsewhere in the economy and supporting key markets. The downside is that when the Fed sells its assets back to the private market, the change in the asset’s value will cause inflationary or deflationary pressures depending on how the asset has appreciated or depreciated in value.For QE to be done effectively, the Fed must purchase assets during an economic crisis and sell them back before a subsequent crisis. However, the Fed has not been effectively unwinding its assets.The Fed’s balance sheet is the indicator of how much QE has gone on. Prior to 2008, the Fed kept roughly $900 billion on its balance sheet. As of today, the Fed’s balance sheet stands at $8.3 trillion, which means that $7.2 trillion of private assets have been purchased by the Fed since 2008!While this is not a problem today, undoing the “asset purchases” has the potential of causing a significant problem when it is sold back to the private market.For this potential issue, there is nothing you can do except for (1) elect fiscally conservative leaders and (2) be cognizant of when the Fed is making or undoing “asset purchases.”Automation & OutsourcingThe Fed’s new policy says that they are going to keep the pedal to the metal until they reach “Maximum Employment.” But what if this is a fleeting goal?At roughly $15/hour, it makes more economic sense for an employer to look for automation and outsourcing to cheaper countries than to employ an individual.With inflationary pressures pushing wages higher and businesses increasing their prices to accommodate the higher overhead costs, you’re likely to see a lot more automation and outsourcing of manual, low-skill positions.If you’re into eating out as much as I am, you’ll notice that many of the cash-handling positions at restaurants have been replaced by table kiosks, phone apps, and touch-screen ordering. You may have also noticed that smart ATMs and online transacting are replacing bank tellers.As inflation intensifies, it may add to unemployment through automation and outsourcing, making “Maximum Employment” unattainable. Next StepsAs you will see in the remainder of my report, most of the leading and lagging indicators tell us that our economy is healthy and heading in the right direction.I previously stated, and reiterate here, that I believe 2021 and 2022 have the potential to be some of the best economic years ever achieved in our country—but this will come at a cost.So, with the clouds of inflation hanging overhead and a strong economy, here is what I recommend:Make sure you have a minimum of six months of cash on the side for financial emergencies. If your main source of income is susceptible to economic movements, you may want to increase that to twelve months.After taking your emergency fund into account, I recommend that you become more active in the placement of stagnant cash.I recommend you edit your financial plan to include 5-10 years of higher-than-usual inflation starting with this year. If you are one of my clients, I am already in the process of doing this for you.If you find your wages increasing due to inflation, I recommend speaking with your HR department and CPA to ascertain how it will impact your tax liability.If your current retirement plan or financial plan requires cash flow to pay for your retirement lifestyle, you may want to look into bond alternatives for the cash flow compenent—real estate and private lending are a couple of options.To avoid overleveraging yourself, I recommend you update your financial plan to include conditions in which you’re willing to use financing to make purchases and then discipline yourself to avoid the allures of cheap money. ConclusionEconomics is an imprecise field of study—each economist views economic data through their personal lens, which results in widely varying conclusions.Here is the state of the economy through my lens:I believe that we’re looking at significant prosperity that will be augmented by cheap money over the next 4-5 years.I believe that there will be many investment opportunities that will present themselves over the next 4-5 years and that you should beware of bubbles and investing euphoria.I believe that inflation is here for a while and that it will begin to taper as soon as manufacturing increases.I believe that several factors, such as COVID restrictions and a depressed labor market, are hampering the ability of manufacturers to increase the supply of goods.I believe that low-skilled labor will benefit from the economic push in the short term, but I think automation and outsourcing will replace them in the long term.I believe that retirees and those who are about to retire are facing an uphill battle over the next few years that will result in working longer than anticipated or reduced retirement expectations.I believe this is a good time to review your financial plan to ensure that you’ll be able to accomplish your financial goals with potentially higher inflation.I don’t like using debt as a tool, but I believe that there will be times over the next 4-5 years that will justify the use of debt.I believe there will be intermittent shortages of goods as manufacturers are playing catch up and COVID delays are still active.I believe that the government will have a hard time unwinding what it has done with Quantitative Easing, and this has the potential of being one of the largest economic issues of the future.That’s about it—I’m optimistic with a dose of caution. I hope you’re not freaking out. If so, please give me a call so that we can discuss what’s worrying you and see if there is a solution.Happy investing! Ü