Afford Anything - Inflation, Explained

Episode Date: February 18, 2022

#365: Nearly every financial news story for the past several months has centered around inflation – but what, exactly, is inflation? What are its causes? What are its effects? How is it measured? What notable inflationary events have unfolded throughout history, and what can we learn from these? In this episode, we peel back the layers of the onion in order to deepen our understanding of the concept of inflation. We discuss hyperinflation, biflation, stagflation; we discuss the CPI, the PPI, and core inflation. We discuss the demand-pull inflation, cost-push inflation and the wage-price spiral. We resist the temptation to make predictions about the future, choosing instead to focus on refining our understanding of the present. Enjoy! For more information, visit the show notes at https://affordanything.com/episode365 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything. You just can't afford everything. Every choice that you make is a trade-off against something else. And that doesn't just apply to your money. That applies to your time, your focus, your energy, your attention to any limited resource that you need to manage. Saying yes to something implicitly means turning away all other opportunities. And that opens up to critical questions. First, what matters most?

not what does society say ought to matter most, but what is truly a priority, a value in your life? That's the first question. And the second question is how do you put that into action? How do you make decisions that reflect that which matters most? Answering these two questions is a lifetime practice. And that's what this podcast is here to explore and facilitate. My name is Paula Pant. I'm the host of the Afford Anything podcast.

and in today's episode, we're going to take a deep dive into understanding inflation. It's a hot topic. It's been on everyone's mind. It's the subject of news reports, headlines, cocktail party conversation. What is inflation? Today's episode will be an explainer episode to peel back the layers of the onion and understand what this concept truly is. First, a few disclaimers before we get started. Number one, we are not trying to predict the future. We are simply trying to make sense of the present. So this discussion about inflation is educational, not predictive.

And nothing I say is meant to be taken as a device, only as background for educational and entertainment purposes. Number two, I am not an econ professor, nor do I play one on TV. I trained as a journalist many years ago, and today I'm a finance podcaster, which is a polite way of saying, I'm a person with access to the internet. So take that for what it's worth. Now, with those two disclaimers out of the way, let's get started, and we're going to break this discussion into five parts. Part one, what is inflation? What's the cause of inflation? Part two, what are the effects of inflation, and how are different types of assets impacted?

Part 3, how is inflation measured? Part 4, historic examples. And part 5, the relationship between inflation and unemployment. All right, let's get started. Part 1. What is inflation and what causes it? There are some who define inflation as too much money chasing too few goods. That's a cute description, certainly a sticky one,

but it is a description that overly emphasizes the demand side of the causes of inflation. So rather than describe it as too much money chasing too few goods, the more technical description is that inflation is what takes place when the growth in money supply outpaces the growth in the economy. And this results in a decline in purchasing power for a given currency. In other words, goods and services cost more than they used to. So if the cause of inflation is that the growth in money supply outpaces the growth in the economy, economy, that presents an obvious follow-up question, which is, how does the money supply grow?

There are three common ways that it can happen. Number one, the money supply can grow from the printing and issuance of new money. Number two, the money supply can grow when a government decides to loan a new money into the banking system by purchasing government bonds. And number three, the money supply can grow if a government decides to legally devalue the current economy. Now, in addition to those three ways that the money supply can grow, printing money, loaning money, and legally devaluing the currency, the other element of inflation is not just the supply of money, but the velocity of money. So the supply of money is what we just discussed.

New money gets pumped into the system through one or a combination of the three mechanisms that we just described, but the velocity of money is the rate at which money changes hands, the speed of transaction. if a bunch of money is pumped into the system, but everyone hides it under their mattress, this doesn't create the same type of inflationary pressure as new money getting pumped into the system and then buyers and sellers exchanging that money for goods and services at high velocity. The supply of money is the attribute that a government can directly control. The velocity of money, however, can only indirectly be influenced through the mechanisms

that create or detract from consumer confidence and investor confidence. So how does that confidence, the willingness of consumers to spend, how does that contribute to inflation? In order to answer that question, we first must take a step back and ask ourselves, how exactly is it that both the money supply and the velocity of money have an impact in inflation? What is the mechanism through which that takes place? The answer to that question is that there are three common mechanisms. One, takes place when demand outpaces supply.

The growth in money supply leads to consumer confidence. In other words, people have more money, so they want to spend it. But production capabilities can't match that demand. When that happens, when demand outpace supply, we wind up in a situation where we have too much money chasing too few goods, resulting in higher prices. However, that is only one of three mechanisms. The second mechanism takes place when manufacturers, suppliers, retailers, when they face higher production costs. This happens when there is some disruption that makes the cost of raw materials or the cost of

production rise, and that has a downstream effect on the retail costs of goods and services. So, for example, the cost of copper, the cost of lumber, the cost of steel, if there is some disruption, either to the acquisition of raw materials or to the processing, the transportation, the production capabilities or supply chain capabilities, if there are any upstream disruptions, then the producers in the middle face longer wait times and higher costs. And this gets passed down to the end consumer. That's the second mechanism. and then the third mechanism is what's known as the wage price spiral. This takes place when prices begin to rise, which means life gets more expensive,

as a result, workers demand higher wages to keep up with rising prices, businesses raise wages and raise salaries in order to meet that worker demand and in order to attract and retain talent, and businesses then have to raise the price of their own goods and services in order to pay their higher labor costs.

This creates a self-reinforcing spiral, known as the wage price spiral. So that's the third mechanism. Now, if much of what I've talked about sounds familiar, it's because this is the story that we have all lived over the last two years. On the demand side, when we went into shutdowns in 2020, services like concerts, massages, haircuts, those services were no longer available. And so consumers turned their demand away from services and towards goods. In addition, stimulus checks and enhanced unemployment benefits grew the money supply and kept consumer confidence strong further fueling this demand for goods. But the production capabilities and the supply chain capabilities for producers to produce those

goods could not meet this added demand. In addition to that, in many sectors, in order for producers to be able to increase their production capacity, they either need to make very large capital expenditure investments that require a long lead time, as is the case with lumber, lumber milling, or producers didn't have the confidence that this demand would persist after the shutdowns ended. And so for certain items, producers felt it too risky to invest in enhanced CAPEX if that means that they might end up in a situation two years in the future where they are overproducing once this temporary boost in demand subsides. Now on top of all of that, we've talked about the wage price spiral, but fueling that wage price spiral was a labor shortage as more people opted out of the workforce,

either because they need to homeschool their children, they need to care for an ill or elderly family member, or they received enough in various forms of non-wage payment that they could afford to opt out of the workforce. And so the labor shortage amplified the wage price spiral. And so you can see what's happened in the last two years is that when we talk about these three mechanisms that fuel inflation, one being demand outpaces supply, two being higher production costs, and three being the wage price spiral, there have been other inflationary periods where one or two of those factors have driven inflation. But in the last two years, we have experienced pronounced effects in all three. And so this wraps up part one of the five key parts of this episode,

part one being where we address the question, what is inflation and what causes it? And to recap the highlights. Inflation is an increase in the cost of goods and services and a decrease in the purchasing power of a given currency, and it happens when the growth in money supply outpaces the growth in the economy. The money supply grows through the printing and issuance of new money, through the loaning of new money into the system, and through legally devaluing the currency. The money supply, however, is just one of two factors that influence inflation, the other being the velocity of money. So the supply of money and the velocity. of money, both play a role, and they play a role through three mechanisms.

Demand outpaces supply, higher production costs, and the wage price spiral. So that's the recap of part one. All right, let's move to part two. What are the effects of inflation? Part one, we discussed cause, part two, we're discussing effect. And let's start with the good news. Some degree of inflation is desirable. inflation spurs investment because investors look to various assets like equities, commodities,

real estate in order to beat inflation. Inflation also spurs spending because the knowledge that cash tomorrow will be worth less than cash today is a motivator to spend now. So it's healthy for a society to have a small, controlled degree of inflation. Oftentimes in developed economies like the United States, United States, a target inflation rate of around 2% is considered just the right dose in more rapidly developing economies. That inflation rate can notch up a bit higher. India has set its target inflation rate at 4% with a plus minus 2% on either end, so they've set a target range of between

2 to 6%. So different nations set different inflation targets because inflation does produce some healthy benefits into the system, but even in the best of times, inflation needs to be managed carefully. And every time a government introduces new money into a financial system, the first order effect is felt based on how, where, and when that new money is issued. And this leads to a discussion around something called the cantalon effect. Quick pronunciation note, some people call it the cantillan effect, others pronounce it the cantalon effect. I'll be calling it Cantalon, it was named for an economist who lived in the 18th century named Richard Cantalon. He observed that when new money enters into a system, when the money supply grows, it does not

have an immediate universal effect on all prices in all industries impacting all people. Instead, it has a localized effect, and the closer you are to that injection of liquidity, the faster you will feel that effect. So the cantalon effect states that prices and inflation will rise at different rates for different market sectors, which is a concept known as relative inflation. Now, what this means is that those who are closest to the source of that money, the source of the new liquidity that's entering the system,

will enjoy a higher quality of life, and will have the opportunity to generate the largest amount of wealth as a result of their proximity to this liquidity that's entering the system. Stated simply, when new money enters a system, the people or companies who can get their hands on it first can take advantage of this new money and make investments and allow this money to compound and grow and they can do that before this injection of new money into the financial system

has time to spread across the entire system. system. In other words, they can make investments before inflation becomes obvious everywhere. And that's why decisions around how, where, and when new money enters the system is so critically important. Think back to the beginning of the pandemic when individuals and households were receiving stimulus checks. Remember that first stimulus check? It was a huge input of new money into the system, and when those stimulus checks came out, a lot of individual investors opened up accounts on Robin Hood and started investing their stimmies, the cultural phenomenon of meme stocks and stonks, the Reddit run-up of GameStop and AMC theaters, all of that happened

when new money entered into the financial system, but inflation hadn't kicked in yet. And so those who received that new money were able to invest it or use it to speculate. Now, oftentimes banks or financial institutions are the recipients of the new money supply, because as we discussed earlier, one way that the money supply grows is by loaning new money into the banking system by purchasing bonds. Once the banking system has money, they're able to lend it out, both to businesses, such as businesses looking for loans and to consumers, such as retail homebuyers. And the people and companies who were able to get those loans are poised to benefit significantly as inflation

picks up because inflation is good for borrowers, particularly good for borrowers with fixed rate loans. Because when you borrow money and you have a fixed interest rate and that rate is less than the rate of inflation, then over time you repay that. loan with cheaper and cheaper dollars. So inflation is great for borrowers. This is a wonderful time to have a fixed rate mortgage, or a few of them if you're a rental property investor. But it's bad for savers because savings are eroded. Inflation is good for exporters because exporters can produce something while paying the production costs associated with a weaker U.S. dollar. They can then sell that item overseas and collect.

payment in a stronger currency, and they can benefit from that enhanced spread. So inflation is good for exporters, but it's bad for importers because a weaker U.S. dollar means that foreign-made goods are more expensive. Stated another way, in the U.S., every dollar becomes less valuable. And so what does that mean for assets? How are different types of assets impacted? Well, tangible assets that are valued in currency, like real estate, gold, commodities, these are inflation hedges. And particularly if you have a tangible asset like real estate and a fixed rate loan

as a borrower who has borrowed money in order to acquire that tangible asset, you now have a fantastic setup in an inflationary environment. Not only do you own a tangible asset, you also are a borrower in a period of high inflation. So it's a double win. Now, in contrast,

to tangible assets, paper assets, assets that are denominated in currency, like cash or bonds, these types of assets are eroded by inflation. So in an inflationary environment, tangible assets good, paper assets bad. Borrowing money good, saving money, I don't want to say bad, saving money is a value that I espouse, but yeah, inflation is bad for savers. Broadly speaking, stocks and real estate have historically been great hedges against inflation. But not all stocks are created equal. Growth stocks in particular are negatively affected. Now, what do I mean when I say growth stocks?

Let's pause. Let's take a step back. We'll zoom out. Stocks, equities, generally are classified based on size, style, and location. So when I say size, I'm talking large cap, midcap, small cap. When I say location, I'm talking U.S., international, emerging markets, frontier markets. And when I say style, I'm talking about growth stocks, value stocks, or a blend. Those are three common classifications for equities.

Now let's take a close-up look at the style classification. Growth stocks are stocks that seem to be very promising for the future. So they may not necessarily be turning a profit right now. their numbers today might not look that great, but their future prospects seem optimistic enough that investors are willing to make a bet that these stocks, these growth stocks, will outperform the market over time.

This is in contrast to the alternate style, value stocks, which are stocks that typically tend to be performing well today, but that investors decide, are trading at a cost that is less than what they're actually worth. In other words, with value stocks, investors believe that the market has undervalued the worth of a given company. The market has underpriced that company.

And so value stocks are sought after based on their current performance and their current price relative to their current performance. By contrast, growth stocks are sought after based. based on the expectation of their future performance. And this is where inflation starts to fiddle with those numbers. Because when dollars become less valuable, the present value of those future dollars is also reduced. And as a result, growth stocks tend to take a hit in an inflationary environment.

Now, tech stocks tend to represent a lot of growth stocks, and the tech sector also represents the biggest stock. talk large cap, the biggest stocks in the index. So among the 10 biggest stocks in the S&P 500, we find Apple, Microsoft, Amazon, Facebook, Google, Tesla, and Nvidia, all of which are tech stocks, all of which are among the 10 biggest stocks in the overall S&P 500. Now, just because their tech stocks doesn't mean they're necessarily considered growth stocks. That's disclaimer number one that I want to make. disclaimer number two that I want to make is that sometimes a growth investor and a value investor might both buy the same stock for different reasons.

Philip Fisher is one of the most acclaimed American investors of the 20th century. He is sometimes referred to as the father of growth investing, and ironically, his son is a value investor. And he wrote about times when both he and his son would purchase exactly the same stock, But Philip Fisher would come to that decision through a decision-making framework that prioritized growth stocks, and his son would come to that same decision through a decision-making framework that prioritized value investing. So that's the second disclaimer that I want to throw out there. Not all tech stocks are growth stocks, and some growth stocks are also really good value stock picks.

With that said, it is also the case that there's a lot of over. overlap between growth stocks and tech stocks, and it is also the case that the broad market is heavily represented by large-cap tech stocks. And so some of the volatility, the swings that we're seeing in the market right now and the declines that some major companies have faced in the past few weeks, much of that reflects investors repricing these stocks and reassessing what they're willing to pay for the prospect of future returns in light of the high inflationary environment that we're currently in. So, stocks and real estate historically are great hedges against inflation, but not all stocks are created equal. And they're...

will be in the short term volatility in the markets as investors reassess what they believe companies are worth in light of inflation expectations. And by the way, I don't mean to constantly be banging the pro real estate drum, but if you've spent the last couple of years sitting on the sidelines considering possibly investing in real estate, the draw of locking in a fixed straight mortgage, and buying a tangible asset that historically is a low volatility inflation hedge, that tangible asset, of course, being real estate, that draw, the inflation protection that real estate can provide is particularly appealing at this point in time. We know that inflation is not transitory, it's here to stay, and the current economic

environment really highlights the usefulness of holding a tangible asset like real estate that provides a stable long-term inflation hedge. If you want to learn more about real estate, go to afford anything.com slash VIP list. That's afford anything.com slash VIP list. We'll email you a ton of information about real estate. It's totally free. Lots of valuable information contained there around how to approach this asset class. Affordanything.com slash VIP list. So let's recap what we've talked about.

In part one, we defined what is inflation. We discussed the causes of inflation, and we related this to everything that's transpired in the last two years. In part two, we discussed the effects of inflation. We talked about how some degree of inflation is desirable, a target of around 2% for a developed nation like the U.S., And that even in the best of times, inflation needs to be managed carefully because anytime you inject liquidity into a financial system, the effect is not felt equally. We discussed the cantillin effect, which describes the concept of relative inflation, which means there's a disproportionate rise in prices among different goods in an economy

that takes place at different times, and the close. closer a person or entity is to the source of that liquidity, the faster they're likely to be to access that money and therefore generate wealth. So the cantillin effect describes how the new money supply has localized effects. We talked about how inflation is bad for some people and good for others. For example, it's bad for savers and good for borrowers. Bad for importers, good for exporters. We talked about the difference between tangible assets versus paper assets, and we described growth versus value stocks. Right now, we're going to take a break for a word from our sponsors, and when we come back, we're going to kick off part three of this five-part deep dive

into understanding inflation at a conceptual level. So when we return, we're going to talk about how inflation is measured. That's part three. Part four, we're going to discuss historic examples of inflation. And in part five, we're going to discuss the relationship between inflation and unemployment. Stick around. The holidays are right around the corner, and if you're hosting, you're going to need to get prepared. Maybe you need bedding, sheets, linens. Maybe you need servware and cookware. And of course, holiday decor, all the stuff to make your home a great place to host during the holidays. You can get up to 70% off during Wayfair's Black Friday sale. Wayfair has Can't Miss Black Friday deals all month long.

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Big Bank Muscle, FinTech Hustle. That's your commercial payments. a fifth, third better. We're back. We're back with part three of this inflation explainer episode. And in part three, we're going to talk about how inflation is measured. Remember, as we discussed in part two, inflation doesn't happen universally across all sectors of the economy at the same time.

And so, in order to measure inflation, we have to track a diversified basket of goods and services. There are two such baskets that are used. in the U.S. One is the CPI, the other is the PPI. The CPI, the consumer price index, is a weighted basket of consumer needs. So it represents things like transportation, food, medical care, the types of necessities and consumer staples that individuals and households have to buy, which is another way

of saying the CPI measures or at least attempts to measure cost of living. So when the CPI is calculated, retail prices are tracked, meaning they're not looking at production costs, they're not looking at wholesale costs, they're looking purely at what you or I would pay for an item on the open market. And then those changes in price are weighted in proportion to the significance of that good or service when it comes to household spending. So all these retail prices are being tracked in accordance with their relative weight within this basket. But here's the thing. Sometimes there are items in this basket that change in price for reasons that don't have anything to do with inflation. And sometimes those items constitute such a big chunk of household spending that including those items in there can really throw the numbers off.

Specifically, I'm talking about food and fuel. Sometimes food prices go up because there was a hurricane, or there's some sort of e-coli outbreak. Or, as happened recently, a safety inspector got a credible death threat, and now we have a shortage of avocados coming in from Mexico, which is causing the price of guacamole to go up. these types of events, particularly natural disasters, weather events, these can temporarily impact the price of food or the price of certain types of food, but it doesn't reflect anything related to inflation. And similarly, the cost of fuel, oil and gas, that can be impacted by a whole bunch of factors, including political factors, that don't necessarily reflect inflation. So both those sectors, food and fuel, are pretty volatile. If those two sectors move, that can have an

outsized impact on CPI, even though it doesn't actually reflect inflationary pressures. And so, there's a measure, a different measure, referred to as core inflation. And core inflation is the measure of CPI minus food and fuel. Core inflation looks at price changes across that same diversified basket of services, goods and services, except for food and energy in order to mitigate the impact of these volatile sectors. Is it a better way to measure inflation? That's a subject of debate, but certainly it provides another data point that can round out the picture. And another data point that can round out the picture is what's known as the PPI, the producer price index. And this measures the average weighted price changes that sellers receive

for intermediate goods. To state it simply, the CPI is looking at inflation from the perspective of retail buyers, you and me. The PPI is looking at inflation from the perspective of sellers and producers. If you go to the Bureau of Labor Statistics website,

you'll see that the PPI publishes more than 3,700 commodity price indexes for goods and 800 for seasonally adjusted services. So they're tracking a lot of the price changes that are happening upstream, and that offers another layer of insight that can round out the way that we monitor and measure inflation. Now, we don't hear about PPI as much. On the news, typically, we'll hear some headline related to the CPI. And often the discussion is really around two things. Number one, how much has it gone up?

But number two, how fast is it continuing to go up? Have we hit an apex after which the rate of increase will slow? Or are we a boulder rolling down a hill with lots of momentum? And no sign of stopping. Anytime you're monitoring any metric or any change, you're looking not just at the month-over-month numbers, but also at the increase or decrease within those numbers over time. And again, this episode is not here to predict the future.

This episode is here to have a stronger understanding of the present. And so to that end, bear in mind that whenever you see a headline about CPI, look not just at the most recent reported change, but also at how that change compares contextually to the rate at which it's been changing. And that wraps up part three. our discussion on how inflation is measured. Leading us to part four, let's talk about some historic examples. How has inflation played out in the past?

We'll start in the 1920s with the German Weimar Republic. Germany financed World War I by borrowing heavily and printing huge amounts of unbacked currency, fiat currency. And the reason I'm taking the time to note that it was unbacked was because prior to World War I, Germany's currency was backed by gold. Germany got rid of this gold standard in 1914, and at the time, the German mark, the French franc, the Italian lira, and the British shilling,

all had roughly equal value and roughly comparable dollar exchange rates, U.S. dollar exchange rates. So that was a situation in 1914, but then from 1914 to 19191919, prices of everything in Germany doubled, as Germany both borrowed a lot of money and printed a lot of money

to be able to pay for the war. World War I ended in 1918 and under the Treaty of Versailles, it was required to make reparations payments in gold-backed marks. This created a degree of financial stress, and remember how we mentioned that prices doubled between 1914 and 1919?

Well, they doubled again between 1990, and 1922. And so by 1922, many citizens were starting to get rid of their paper assets, get rid of their currency, and convert it into tangible assets. Pianos, diamonds, pieces of art, real estate, people began piling into tangible goods because prices had doubled twice in the last eight years. But despite this, people were more worried about unemployment than they were about inflation. the chief objective was to keep the population working, and Germany saw that given the devaluation of the mark, they were well poised to be able to export many of their goods.

So they just kept printing money. They kept printing money in order to facilitate exports and keep the population employed. And what happened next was it spiraled out of control. In 1914, one U.S. dollar was worth about four or five German marks. By November 1923, one U.S. dollar was equal to one trillion marks. So at that point, the currency straight up lost all meaning. And ordinary citizens were bartering goods with one another.

They were that into tangible assets. That by 1923, people were trading a handker, for some carrots or a shirt for some shoes. People were also, especially pre-1923 when it really went to arrive, back in 1921, before it spiraled out of control, people were also aggressively investing in foreign currencies, trading German marks for a litany of currencies from many other nations. As a side note, I will make the connection that cryptocurrencies, which are non-fiat currencies grew in popularity during the pandemic. And as I've said many times before on this podcast, when we talk about quote unquote investing in crypto, what we're really talking about

is a form of currency exchange in which you exchange one medium of exchange, the U.S. dollar, for a different medium of exchange, such as Bitcoin or Ethereum or Stellar Lumens. Now, I'm not stating that the U.S. is going to be the Weimar Republic. Like absolutely not. But I do think there's a notable parallel that when a population anticipates inflation, one of the things that ordinary individuals do is they start converting their money into other forms of currency. And it happens that we currently live in an age where currency can be digital and programming language can be written such that the issuance of new supply of that digital currency into circulation is governed.

by an algorithm rather than by politicians. Again, I am not comparing the U.S. to the Weimar Republic in any way whatsoever. Please don't think I'm doing that. And what I'm largely speaking to is the reframing of cryptocurrency, not as an investment, but as an alternate currency. At any rate, this is a history lesson, so we won't go down the crypto rabbit hole. But that is the cautionary tale of the Weimar Republic, and it's a tale of how much hyperinflation. And while it's easy to say, well, that was the 1920s that happened in

literally a century ago. And that was a very different time. There was a war in Europe. There was a different pandemic, the Spanish flu pandemic of 1918. And that was a much deadlier pandemic. One third of the world's population ended up infected by the virus and about 50 million people worldwide died in that pandemic. So they were dealing with a lot back then. Nothing that we could ever relate to. So why spend all this time talking about something that happened a century ago? Why live in the past? And if that's what you're thinking, all right, fair enough. Let's talk about Zimbabwe.

Zimbabwe was the first nation to experience hyperinflation in the 21st century. In 2007, as the rest of the world was undergoing the Great Recession, Zimbabwe's inflation rate topped 50% per month. And it got worse from there. By November 2008, prices were doubling on average every 24 hours. But I don't want to sound alarmist or I don't want to sound as though I'm telling you about these historic examples in order to create an alarmist narrative. Because the reality is nothing like that has ever happened in the United States. In 2007, 2008, when Zimbabwe was experiencing hyperinflation, we in the U.S. were experiencing what's known as biflation.

biflation is an example of the cantillin effect, and it happens when there's strong demand for certain types of assets and weak demand for others, causing prices in one sector of the economy to rise and prices in other sectors to fall, which means that we simultaneously experience both inflation and deflation at the same time. That's biflation. That's what happened in the U.S. during the Great Recession of 2007-2008. Given the severity of the 2008 recession and given the amount of money that was pumped into the economy

in order to get us out of that recession, it is truly uplifting and very fortuitous that inflation fears that some of us held during that time did not come to pass. We ended that recession and launched into a decade of prosperity with a low-inflation

an 11-year bull run and an unprecedented flourishing of digital innovation that took place over the last decade. And so fortunately, our most recent example of inflation, or specifically biflation, fortunately is not a cautionary tale. It did not spiral out of control. In fact, the worst that the U.S. has experienced was a two-decade period from the mid-1960s to the mid-1980s. known as the Great Inflation. So let's close out this history lesson by taking a look at what happened during the Great Inflation and seeing if there are any lessons or parallels that we can draw

from that much more recent example in U.S. history. And this topic dovetails perfectly with part five of this five-part inflation explainer, the link between inflation and unemployment. So here's what happened. During the Great Depression of the 1930s, the U.S. saw record high unemployment. It was incredibly painful,

and no one wanted to repeat that. So after World War II, Congress decided to focus on creating policies that would, in theory, keep unemployment low. And as part of that, they passed a law called the Employment Act of 1946. This law declared that the government has the responsibility, quote, to promote maximum employment. This became the basis of what's known as the dual mandate for the Federal Reserve.

And that dual mandate, which continues to this day, is that the Fed is supposed to be attentive to both inflation and employment. Now, this is the first time we're mentioning the Federal Reserve this deep into an episode about inflation, and that's by design. I wanted to create an explainer that avoids jargon. So I've steered clear of talking about quantitative easing and tapering, the words that you commonly hear in news reports, but that no one or few people necessarily understand. In my view, this explainer episode can be much more educational if we take a step back from the jargon and talk about the concepts and the context,

theory and history. But since our life, look at the inflationary era of the 1960s through the 1980s necessarily involves discussion about the Fed or take a brief moment to establish who they are and why they exist. The Federal Reserve consists of eight people, seven governors and one chair. As I mentioned, they have a dual mandate to keep inflation low and employment optimal. They control the monetary supply, and they do so in two main ways. One, by targeting short-term interest rates, which gets the most headlines, and two, by buying assets, like commercial bonds. Because when the Fed buys assets, it creates added demand,

and that increases the money supply. So when you hear people talk about how the Fed's balance sheet has grown, they're talking about the fact that the Fed has really stocked up on a lot of bonds lately. So, back to the 1940s. The Employment Act was passed in 1946, but two years before that, in 1944, in the aftermath of World War II, a total of 44 nations all met in Bretton Woods, New Hampshire, and hammered out an agreement that did two things. Number one, it created a fixed exchange rate between various world currencies and the U.S. dollar, and number two, it linked the U.S. dollar to gold. And so the U.S. dollar became the world's reserve currency. But over the next 25 years, from the mid-1940s through 1971, the flaws in this system became increasingly obvious.

The major flaw being that as global trade grew, so did the demand for U.S. dollars. and eventually the supply of dollars needed in order to meet the demand for dollars exceeded anything that could be backed by U.S. gold supplies. And that meant that the U.S. could not convert its dollars to gold at the current existing price of gold. As inflation in the U.S. picked up during the 1960s, that shortfall became even more pronounced. And so finally, in 1971, the U.S. halted the exchange of dollars for gold by foreign central banks, and in doing so, cut the last link between the U.S. dollar and gold backing. And that meant that every major currency on

earth, including the U.S. dollar, which was the world's reserve currency, was unanchored to any type of commodity reserve. We went entirely to a Fiat system, a paper money standard, And that continues to be the case today. I should state for clarity that the U.S. was largely off the gold standard well before 1971. And so the severing in 1971, that was letting go of the very last link. But in practice, we'd been unanchored or only loosely anchored for decades. So at the same time this was happening, the U.S. was grappling with how. to combat unemployment. In 1964, inflation was at 1%, unemployment was at 5%. And although both

numbers began to drift upwards throughout the mid to late 1960s, the general sentiment was that unemployment was a greater threat than inflation. One decision-making construct that guided the way that people thought about how to deal with this problem, came from a concept known as the Phillips Curve. The Phillips Curve is named after an economist named Albin William Phillips. And by the way, before I explain what the Phillips Curve is, quick tangent, this guy had a super interesting life. So he was born in New Zealand, dad was a dairy farmer,

mom was a schoolteacher, he dropped out of school and moved to Australia where he became a crocodile hunter. I kid you not. Dude was the original Australian crocodile hunter. Then, in 1937, he goes to China, but then China gets invaded by Japan, so he escapes to Russia, travels the Trans-Siberian Railway,

makes it to the UK, then World War II breaks out, so he joins the Royal Air Force, get sent to Singapore, Singapore falls, he becomes a prisoner of war in Indonesia, spends three and a half years as a POW, and then when the war ends,

he goes to London and comes up with this idea called the Phillips Curve, which guided U.S. economic policy for decades. So anyway, A.W. Phillips, fascinating dude, but the Phillips curve, which was his major contribution to the field of economics, states that there's a negative statistical correlation, an inverse correlation between unemployment and inflation. You can cause unemployment to go lower if you push inflation a little bit higher, and the Phillips curve sees this as a stable relationship. And so based on this model, policymakers in the 1960s and 70s thought that they could embrace a little bit of a trade-off. Remember in 1964, the inflation rate was 1%. It wasn't seen as a threat. So the notion that was embraced at the time was to embrace

a little extra inflation for the sake of giving more people jobs. The problem is, this didn't work out so well. By 1974, inflation was over 12%, and unemployment was over 7%. So the U.S. was in a period of what's known as stagflation, where both inflation and unemployment were rising in parallel. And so the Phillips curve model proved to be unstable. It worked until it didn't, and when it didn't, it fell apart in a way that made things worse. To combat this, during the 1970s, the Fed decided to embrace what's known as stop-go policy,

where they alternated between fighting unemployment and fighting inflation. And so during the go periods, the Fed would lower interest rates with the hope of pumping more money into the economy, so that more people would get jobs. And then, during the stop periods, they would raise interest rates, and it became like interval training at the gym. They would pull one lever, then they would pull the other.

Go, stop, go, stop. And that didn't work either. The other thing they tried during the 1970s were price controls, wage and price controls, between 1971 to 1974. The idea was that if the government could mandate price controls, that might control inflation without creating unemployment. But in reality, it only temporarily slowed the rise in prices while simultaneously creating huge shortages.

So by the end of the 1970s, the U.S. had a lot of experience with ideas that didn't work. And the effect showed, because by the summer of 1980, inflation was near 14.5%. percent, and unemployment was still over 7.5%. So, how did this ultimately all get resolved? Well, in August 1979, the Fed appointed a new chair by the name of Paul Volker. Now, at the time that he was appointed chairman of the Fed, inflation was at 11%. This is summer 1979. Remember, one year later, summer 1980, inflation grew to 14.5%.

so he did not have a good first year on the job. But he set in motion and was ultimately able to execute a much more aggressive inflation combating strategy. He created incredibly tight controls around the money supply. And part of the fallout from that was that the U.S. entered a severe recession. The recession of 1981 to 1982 was at the time the most severe recession that the U.S. experienced since the Great Depression. That, of course, is a dubious honor that has been supplanted by the Great Recession of 2008, but it was certainly a terrible recession for its time. Unemployment peaked at 11 percent at the end of 1982, but at that same time, inflation at the end of

1982 had fallen all the way down to 5%. And through a commitment to a tight money supply, the U.S. managed to keep inflation in the single digits from that point forward. Thus bringing an end to the nearly two-decade era from the mid-1960s to the early to mid-1980s, known as the Great Inflation. And with that recapping of history, we tie up part of the mid-1960s, we tie up part of the mid-1960s, known as the great inflation. And with that recapping of history, we tie up part five of this five-part inflation explainer, which highlights the relationship between inflation and unemployment.

So let's quickly recap everything we've just covered. We started in part one by defining inflation, which is when the value of a currency goes down, a decrease in the purchasing power of a given currency and an increase in the cost of goods and services, and it often happens when the growth in money supply outpaces growth in the economy. We talked about various causes of inflation, including demand side causes, which happens when demand exceeds supply, too much money chasing too few goods. We talked about supply side causes when there's a disruption that makes the cost of raw materials go up, or that makes the cost of production go up or that messes with the supply chain. That's another mechanism that contributes to

inflation. And then we also talked about the wage price spiral. So we discussed those three mechanisms that can all fuel inflation. We talked about the supply of money and the velocity of money. And we shared multiple ways that the supply of money can grow, including the printing and issuance of new money and bond buying. All of that was in part one. Part two. We talked about the effects of inflation, the cantillan effect, and the tendency for individuals to move towards holding tangible assets like gold or real estate, or to convert their currency into other forms of currency. We talked about how inflation is good for borrowers who have fixed rate loans, but bad

for savers who have cash in the bank, and how inflation is good for exporters, bad for importers. That was part two. Part three. We talked about how inflation is measured. The CPI, the PPI, and a measure referred to as core inflation, which is the CPI minus food and energy. Part four, we talked about historic examples. The Weimar Republic in the 1920s and Zimbabwe in 2007, both as cautionary tales of hyperinflation,

the Great Recession in the U.S. in 2007 as an example of biflation. And then we transitioned from part four into part five by looking at the U.S. from the mid-1960s to the mid-1980s, which gives us an example of stagflation. And in telling that story, in part five, we discussed the Phillips curve and the relationship between inflation and unemployment. So where does that leave us? As I said at the beginning of this episode, the intention of this podcast episode is not to make predictions about the future,

nor is it to give advice, which necessarily presupposes some level of prediction about the future. Instead, the purpose is to have a deeper understanding of the present and the past, concept and context, and to explore the idea of inflated, in a way that's jargon-free, in a way that's non-reactive. We're not asking what should I do, how do I react or respond to momentary stimuli, and in a way that is not overly concerned with the noise of the latest headlines.

The mistake that many people make when approaching the topic of inflation is that they get caught up in news of the latest interest rate hike, or worse, speculation about interest rate hikes that may or may not transpire in the future, they get overly caught up in the movement of a handful of basis points, and then they become reactive. And they begin questioning if they should disrupt or accelerate or reduce their entire financial and investing strategy based on fears of... Oh, I'm worried that interest rates might rise more in the future.

Therefore, I should accelerate buying a home right now even if I'm not ready for it. That's an example of this done wrong. Likewise, oh, I am saving up for a major goal. I'm saving up for a down payment or to send myself back to grad school or heck for a trip around the world for whatever it is. but this means I have a lot of cash on hand, and I don't want to keep that cash in a savings account. So is it okay, because I'm hearing all these headlines about inflation, is it okay if I, just for a moment, treat the stock market like a high-yield savings account and throw my cash in there despite the fact that I know I'm going to need it in a short time frame?

That's a question that I hear constantly these days. And that question naturally emerges from our exposure to the day-to-day minutia around the latest tapering announcement, the latest interest rate hike, the latest CPI report. And so my hope is that this episode allowed you to take a moment to be seen. still, to zoom out, and to look at the concept of inflation, concept and context through a wide-angle lens, which allows us to develop a tree trunk of knowledge rather than simply looking at the branches. So that is my hope for you in this inflation episode.