We Study Billionaires - The Investor’s Podcast Network - TIP472: Inflation Masterclass continued W/ Cullen Roche

Starting point is 00:00:00 You're listening to TIP. In today's episode, I've joined by one of our most popular guests, Mr. Cullen Roach, for the ninth time. As you'll quickly learn, there is a very good reason why our audience always wants to learn more from Colin. He is as smart as they come. We'll continue where we left off on episode 370 with our inflation masterclass. We will learn why deflation is more likely than hyperinflation, what the two-year treasury is telling us, and whether we're entering a period of the Fed call. Colin has been spot on so far and today provides an updated outlook for inflation.

Starting point is 00:00:34 You definitely don't want to miss out on this one. Here we go. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected. Welcome to The Investors podcast. I'm your host, Dick Broderson, and I'm here with fan favorite Colin Roach. And whenever I say fan favorite, I mean it. This is the ninth time we had Colin on our show.

Starting point is 00:01:14 So, Colin, welcome back. It's great to be here. I love talking to you guys. So, Colin, we'll continue almost where we left off on episode 370 in our masterclass about inflation. Inflation is still the talk of the town, and today, it's no different. You're on record to have predicted the high inflation. And even though you also said that you've been surprised by the prehistory. persistence of COVID and the war in Ukraine like the rest of us. But you're now saying that inflation

Starting point is 00:01:43 will moderate in the coming years. Why? Well, you know, I think I've mentioned this and I mentioned this in the master class. I think that the big important takeaway from COVID versus the financial crisis, it's such a nice comparison because a lot of the policies were very similar. But the main thing that we did differently was we ran these big fiscal deficits. And so, So that basically means the government spent a lot more than it taxed. And so the government essentially printed a lot of treasury bonds to finance its spending during COVID. And so, you know, to put this into perspective, we did roughly $7 trillion of deficits over

Starting point is 00:02:23 the two-year period basically over COVID versus we ran about an $800 billion total deficit during the financial crisis. So we're talking about these programs were just monumentally different. and the size of the COVID response was so tremendous. And to me, that was always the big lesson from the financial crisis. I am sort of relatively well known for having been a sort of a disinflationist or deflation is coming out of the financial crisis. Because I basically, I understood that from studying Japan and their bouts with deflation and implementing quantitative easing, that when you look at it from an operational level, quantitative easing is essentially just an asset swap. The central bank comes in after the Treasury deficit spends, and then they exchange

Starting point is 00:03:13 types of assets essentially. So the private sector ends up with losing a treasury bond and gaining a reserve deposit. And you can, from a monetary perspective, you can have this big sort of boring debate about what is money and, you know, is a treasury bond money like? And in my view, a Treasury bond is essentially like a savings account. And so the private sector from QE, it gets a savings account and loses a checking account. So people don't feel wealthier, even though from a very technical sort of economic perspective, the government has printed money, you know, people would say, because people consider reserve deposits, obviously, to be more money-like than a treasury bond. And so in a traditional economic model, QE looks like it should be inflationary or even

Starting point is 00:04:03 hyperinflationary when they're, you know, they're doing trillions and trillions of dollars of it. But from a really, I think, basic household perspective, all the household did was exchange the composition of its assets. And so, you know, the Fed's response to COVID, or to COVID was very, very similar. They had this huge balance sheet ramp up. They cut rates. They did all the same sort of stuff that they did during the financial crisis. But the difference between the financial crisis and COVID was that the Treasury was the one that really ramped up their balance sheet and had this huge explosion. And so that's why I was much more worried about inflation coming out of COVID than I was with the financial crisis because of the Treasury's humongous response.

Starting point is 00:04:49 And so while I got the direction of inflation right, I think the tricky thing with all of this has obviously been the magnitude and the longer lasting effect of it. And I think a lot of that is just that, you know, I didn't think there'd be, God, I didn't think we'd still be talking about this thing at this point. Who could have predicted the Ukraine war, which Russia basically shuts down one of the largest commodity producing countries in the whole world. So there's been all these sort of weird impacts that have, I think, elongated the impact of inflation and made it a much trickier environment to navigate. But to me, that's the big lesson coming out of this, is the Treasury and fiscal policy is really, really important.

Starting point is 00:05:37 And that's really important to understand going forward because, you know, again, let's put this in perspective. In 2021, as of the end of June at this time last year, the Treasury had run a deficit of $1.7 trillion. These are huge, huge numbers again. Okay. So this is still, at this time last year, we're still in sort of the throes of really heavy-due, fiscal stimulus responding to COVID. So far this year, through June of this year, the Treasury has run a deficit of $137 billion. Okay. So we're almost running, I mean, in terms of the way the

Starting point is 00:06:20 U.S. government usually spends and runs a deficit, this is almost a surplus, which is very, very unusual. So there has been, on a relative basis, there has been a huge fiscal tightening. So people talk about the Fed and how the Fed has raised interest rates and, you know, a lot of that has caused this sort of like retrenchment in demand and tightening of the economy. And the thing that's lesser talked about is this huge decline in the relative size of the government's deficit. And that's, I think, you know, when you combine these two things, raising interest rates is a very, very powerful mechanism because it can, especially in a time like right now, it can cause a lot of turmoil in the housing market. We're starting to see that already. And if you adhere to the

Starting point is 00:07:05 theory that the U.S. economy basically is a housing economy, well, that's troublesome from a demand perspective. So high mortgage rates have snuffed out demand for mortgages, made it basically unaffordable for, you know, they've locked out another 40 million people with the rate increases from the last few months. So huge, huge number. So demand is coming way back. And that has this huge knock on effect through the whole economy because, you know, when you think about everything that goes into a house, you know, think about the demand for how furniture now goes down and refrigerators and appliances and all these other things that have a knock on effect through housing. But then when you combine that with the fiscal retrenchment, there's been a big, big government tightening.

Starting point is 00:07:50 So we had this big explosion in government spending and government stimulus in general. And now we're having a big, big give back. And if the government had continued to do these big programs in perpetuity, that would have worried me. I would actually, I hesitate to say anything like hyperinflation, but a much more prolonged a 1970 style rate of inflation where you had double digit inflation that lasted for basically 10 years, that's a much more plausible scenario under those circumstances. But right now, the opposite is happening. And so how fast will it come down? I think it's going to come down relatively slow.

Starting point is 00:08:32 But I think that we're now, I think disinflation, meaning a falling rate of positive inflation is going to become fairly well entrenched in the economy over the course of the next 18 to 24 months. On your wonderful blog, Prackcap.com, you said, and I've quote, there is no chance of hyperinflation. I would argue that the risk of deflation is substantially higher than. this point than the risk of hyperinflation, end quote. Could it please ask you to elaborate on that? Yeah, so I think, you know, kind of going back to that forward-looking, you know, expectation of a recent trend in the fiscal retrenchment and the Fed's big attempt to really snuff out inflation,

Starting point is 00:09:12 I think that the risk of deflation now becomes greater because I think that these are both very, very outlier events. So we're talking about, you know, pretty unusual things to begin with. But The risk of a sort of mini 2008 repeat where, let's say housing prices, I expect housing prices to fall 5 to 10% over the course of the next 18 months. That's kind of my base case. So housing is going to be relatively weak, I think, over the course of the next year at a minimum. There is a chance that I'm wrong about that, that the Fed response is much bigger than we expect, that they're much more aggressive and much more prolonged with it than we expect.

Starting point is 00:09:54 expect and that housing falls more than I expect. I mean, housing boomed so much during the pre-COVID period and then the COVID period that you could easily get a 20% retracement in house prices wouldn't surprise me at all if something like that happened. And that would have a very big negative impact on the economy. I think that if that happened, by the time, you know, that plays out, let's say it's 2024 and housing prices have fallen 20% from their peak. I think at that point, there's a very good chance that CPI readings and the Fed's preferred measure core PCE personal consumption expenditures is negative at that point. And that's just going to be a function of demand just falling off of a cliff and this, you know,

Starting point is 00:10:43 huge knock on effect from the negative housing market. So to me, that's a much, much more likely scenario than a hyperinflation, because in large part, because if you've read my research in past years, you know that hyperinflation generally occurs under very, very unusual, specific scenarios, usually scenarios such as very corrupt regimes, a government losing a war, a complete regime change in the government, these sort of really like seismic events that are very disruptive at a government level. And the government it usually responds to that by then printing huge amounts of money. And so, well, we've technically printed a lot of money in the last two, three years, you haven't had this big sort of disruptive,

Starting point is 00:11:32 you know, geopolitical event at a government level that I think has caused a complete collapse in the faith in the currency. And in fact, I would argue that if anything, what we've seen in the last sort of, especially the last 12 months is, if anything, we've seen increasing demand for the dollar in a relative sense. And so, you know, to me, it's very hard to envision, you know, yeah, if we were having this discussion and we were sitting in, you know, Nigeria or something, it would be a totally different discussion. But when you're talking about the world's reserve currency, you're still talking about on a relative basis, you know, and even if you believe all fiat currencies are trash, the U.S. dollar is the least trashy of the trashy currencies.

Starting point is 00:12:13 So it's very hard for me to envision a scenario where you get this huge, you know, collapse and demand for the currency in large part just because the U.S. economy's important role in the global economy and combine that with just the fact that you don't have the environment for this sort of seismic shift in faith in the currency. One of the major macro trends has been globalization, which have been inherently deflationary. For example, not pushing up wages in the U.S. that otherwise would have if American have not imported the same amount of goods from countries with cheap labor. Another is the major demographic trends.

Starting point is 00:12:55 Could you please explain how demographic trends can be inflationary or deflationary? Well, long-term trends in demographics around really the whole world are pretty alarmingly worrisome for economic growth. And it's one reason why, you know, it's interesting. We went through this, I think that the last sort of hundred years were really, they were sort of unusual. And you look at economic trends, the really long-term economic trends, one to two percent growth was pretty normal. That was kind of the status quo. And we had this really unusual period where, especially in a lot of the developed world, the populations boomed.

Starting point is 00:13:33 And so you had, you know, obviously like the baby boom and things like that, where at a very basic economic level, more people means more demand. It means more output, more things are going to be created. And so, you know, from a crude sort of economic level, you can argue that, you know, future economic growth is essentially, well, we can be more productive or we can produce more people, which will produce more demand, which will produce more stuff. And that's sort of a crude economic model, but it's generally in the long run. That's generally how economic growth works. And so seeing these declines and even slowdowns in demographics is worrisome just because it's foreshadowing of lower growth. And I think, you know, again, Japan has really been the

Starting point is 00:14:18 playbook for all of this stuff, whether you even look at like QE and fiscal policy or if you look at their demographic trends and, you know, what's been going on there and the very low rate of economic growth there. And I think that, that's already playing out across the entire developed economic system. And it's hard to see that changing, especially, you know, in the U.S., we're seeing this sort of reversal of some of the hyper-globalization trends where the U.S. is becoming a little bit more of a closed economy, a little more abrasive towards immigration, and some of the things that have really benefited the United States in terms of, you know, you can essentially argue that immigration is like stealing other people from another country

Starting point is 00:15:03 and benefiting in economic terms because you're, you've got this multiplier in terms of people. And that's especially true in the United States where we haven't just grown by having, you know, positive immigration trends. We've grown in large part because we've benefited from very high quality immigration. Our education system has attracted a lot of people that have built enormous valuable companies here and goods and services. So there's been an even bigger multiplier effect through that effect in the United States. And a lot of that's reversing now.

Starting point is 00:15:39 And so it's a little bit worrisome to see the decline in demographics because it's foreshadowing of lower growth. And so it's one of these big secular trends that I think in the long run makes it hard to foresee really, you know, even moderately, you know, high inflation, something like or a return to the 1970s. Because again, going back to the 70s, a lot of that was a population boom. People don't talk about how the 70s were still, you know, the back end of the, you know, the really the most, some of the most productive years of the baby boomers. So you had this huge demand boom at a time when you had supply shocks and things like that. And you're not going to have those trends going forward because we just don't have the population growth that we did back then.

Starting point is 00:16:25 So, yeah, it's worrisome. But when you combine that with things like, you know, technology growth and, you know, the coming fiscal retrenchment and things like that, it's hard for me to imagine that some of those big secular headwinds won't be things that are kind of anchoring inflation to some degree. So let's dive deeper into inflation. Could you please explain the concept of velocity of money and whether that's an important concept to understand inflation? This is a tricky one. So in the traditional old monetarist methodologies, you would argue that, something like mv equals p y which is basically that money times velocity equals price times growth

Starting point is 00:17:11 basically and that's it's a crude sort of model and i'll explain why it's because the you can back out velocity based on what your definition of money is so when you when you look at the front end of that equation m times v well the tricky part about that is you have to define m Okay. So if you assume that M, for instance, is bank reserves, well, when you run your model based on that and you look at mv equals PY, well, what does that mean for inflation and economic growth? Well, you assume that it means that demand will increase. Okay. So quantitative easing technically is an increase in M. Okay. Under a traditional sort of monetarous model, well, that should increase. in the long run, assuming that you don't get a big surge in V. But when you reverse that, you go through the math on it. Well, if P doesn't increase, then V has to have declined. Okay.

Starting point is 00:18:22 So you can kind of back into this model where when you look at, you know, this has been a common excuse for why QE didn't cause inflation. People will argue, well, V just went down. Well, of course, V went down because P didn't go up. But the problem with that is that when you look at quantitative easing, well, the problem there is that your definition of M was wrong the whole time, you know, or at least your definition of M was, I think, very, very loose to a point where because you didn't understand the difference between treasury bonds and reserves, well, you know, like I said before, quantitative

Starting point is 00:18:59 of easing was just this asset swap. And so technically we increased the quantity of M. But if you included treasury bonds in the definition of M, well, from a private sector perspective, all that happened was the amount of M was swapped. You know, the Fed created more reserve M and eliminated from the private sector treasury bond M. And so there was this clean asset swap. And so the velocity of money went down in part because you could argue that was quantitative easing, for instance, coming out of the financial crisis, was it deflationary? Basically, what the government did was they reduced the value of the M that they created because they reduced the amount of interest they were paying. And that's what quantitative easing does. And so there's this interesting sort of theoretical

Starting point is 00:19:53 debate about, you know, was quantitative easing inflationary or was it deflationary? And I'm not really sure. I mean, there's all sorts of knock-on effects from quantitative easing and interest rate impacts and things like that. And I don't have like a strong definitive view. But I suspect that quantitative easing is far less powerful than people generally suspect. And so, you know, getting back to the question with the velocity of money, it's this very tricky thing to really articulate because you have to have an accurate definition of M. And I prefer to use. I don't think you can use a black and white definition of what M is. I think that in my view, money is something that exists really on a scale. I argue that stocks have a certain degree of

Starting point is 00:20:42 moneyness. And this concept of moneyness is important because treasury bonds, while they may not be strictly money, they have a certain degree of moneyness. And so, you know, when you think of things in this sort of scale rather than a black and white model, the world gets a love. more difficult to put into sort of this strict mathematical model like the velocity of money likes to sort of define. And so to me, I don't find money velocity to be a very useful metric just because I don't think you can strictly define what M is in this sort of mathematical sort of sets. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine spending three days in Oslo at the height of

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Starting point is 00:25:21 Go to Shopify.com slash WSB. That's Shopify.com slash WSB. All right. Back to the show. Colin, every week, the economist publishes economic and financial indicators for the 43 biggest economies in the world. And there are only three countries

Starting point is 00:25:43 that have a positive budget balance, Denmark, Norway, and Saudi Arabia. If you don't know what the budget balance is, It's the balance between total public expenditures and revenue in a specific year. So if you look at the US minus 5.9% of GDP, Euro area minus 4.4%. Communist China, that's minus 6.2. So it's across the board. Does spending more money than you bring in create inflation?

Starting point is 00:26:12 That to me is one of the big lessons of COVID, is that when governments run big, big deficits, you have the risk of rising demand. and especially when you don't produce the, you know, the aggregate supply to meet that aggregate demand, you get a price increase. And so, yeah, that's one of the important lessons coming out of COVID. I think, you know, this gets into a really sort of interesting theoretical debate of, you know, in the long run, it makes sense that balance sheets, I mean, in a Fiat monetary system, balance sheets basically need to always expand.

Starting point is 00:26:47 My deficit is somebody else's surplus. Somebody, in order for you to be able to save, you essentially have to rely on somebody else running a deficit to be able to create the financial assets to allow you to be able to save. And that can come from, it could come from the government. It could come from me. It could come from the corporate sector. It could come from the rest of the world sector.

Starting point is 00:27:09 So, you know, this balance sheet expansion doesn't have to come from the government, but it has to come from somebody in the long room. And that's, I think, an important thing to understand about how any, I mean, any credit-based system, you can get into this really interesting theoretical debate, though, about whether or not does that deficit have to come from the government sector? You know, and I don't know, honestly. I tend to, I mean, gosh, I wrote a book called The Pragmatic Capitalist. So like I I'm obviously, you know, amenable to capitalism more so than socialism. But and I'm pretty skeptical of the idea that the government can do things as well as the private sector in general. I think that when it comes to government spending, I think that the government generally should do things that the private sector simply cannot or will not do.

Starting point is 00:28:06 So, for instance, like operating a military is the perfect thing for a government to be doing because the private sector doesn't want to do that, can't make money from doing it. You know, it's pretty hard to make money when you rely on killing your workforce and blowing things up. You know, that's not a very profitable business endeavor. So, you know, things like that that have a sort of a negative net present value, those are perfect things for the government to do. And socially, we benefit from those things because obviously,

Starting point is 00:28:36 you're like if you have to go to war, that's something that needs to be done. And it doesn't, you kind of accept the reality that like, oh, during wartime, like maybe, you know, making money isn't the most important thing in the long run. And so that's all well and good. But you get into this debate about, you know, should the government then try to do things that have a positive net present value? Like that's essentially the role of the private sector is that all of us in the private sector, we're trying to add value and run operations that are essentially adding, you know, present value to people in the future. And we do that by trying to run, you know, businesses or or at a household level trying to generate a net income, basically. And so the things that

Starting point is 00:29:20 we do, they have to add value to other people, whereas the government in a lot of ways, the government can just do things that are socially good to some degree that, you know, maybe they don't have a positive net present value at the aggregate level. You know, maybe they're more charitable in terms of the way that they're being done. And so, you know, you get into this big debate of whether or not operating an economy to just run profits is in the best interest in the long run versus, you know, should we do things that are more charitable in nature that sort of, you know, take care of the social well-being of the country.

Starting point is 00:29:57 And I think, you know, for the most part, I think that the developed, world and the United States has done a pretty good job managing that balance of of government spending versus having a big mainly, you know, capitalist sort of private sector run economy with a pretty large government sector attached to it. But a government sector that for the most part does a lot of funding of financing and things in the private sector, but for the most part doesn't do, you know, a lot of sort of crazy large negative net present value projects like you see in places like, for instance, I'd argue that a lot of the, you know, I mean, Latin America is like the perfect example of how not to run a, you know, this balance of private sector versus public sector.

Starting point is 00:30:45 And the United States, for the most part, has done a pretty good job. You could argue that the last few years were really tricky in terms of navigating COVID and that we did a lot more than we should have, obviously in retrospect. But for the most part, you know, it's a tricky debate. I tend to lean toward the, you know, the view that the government should sort of sit back and do these negative net present value projects. Put out fires, run the military, and then, you know, manage the court system and kind of back off. Running a budget balance that's a negative budget balance in the long run is not necessarily bad.

Starting point is 00:31:22 And I think running at least a, you know, having a guise a guise of. government that runs a negative budget balance to some degree, even while it might be inflationary, it could still be perfectly consistent with generating social good in the long run. So I hesitate to say that running deficits is inherently bad, even though obviously we know now from COVID, for instance, running really, really large negative deficits is it can have a hugely inflationary impact. And so it's this balancing act where in the long. long run, I think, you know, you want a government that's regulating the economy and to some degree. And you want a government that is, you know, operating a military and doing these

Starting point is 00:32:06 things that the private sector doesn't want to do. But nobody really knows the exact right balance. Yeah. I think you bring up just a good point because it's also so value driven. Like, what is it that you want? And based on what you want and what your values are, you can come up with, this is how much the government should be included or not be included or should you even run a deficit in the first place. It's so subjective. It's so subjective. You get into this debate about living standards. And like, you know, it's one thing that I've always said and written about a lot on my website, you know, that living standards in the United States have boomed in the last, you know, 100 years. You could argue that people today live better than at any point in human history.

Starting point is 00:32:49 And which is weird to think about when you look at things like, if you look at metrics like government in debt or the value of the U.S. dollar. You see this all the time. I talk about it a lot. The value of the U.S. dollar technically has declined in purchasing power terms by 95% over the course of the last hundred years. But living standards have boomed. And so it's this weird, very subjective debate where, yeah, at a basic sort of economic level, you have a decline in purchasing power, but living standards have actually increased substantially. And so, and that's in large part because we've produced a huge amount of real goods and services that have made life just better in general. But it's all so highly subjective. And different countries obviously

Starting point is 00:33:33 value different stuff. And, you know, Europeans value very different things than Americans do. And so, yeah, it's, you know, people like different stuff. And it becomes this very subjective argumentative debate about, you know, value judgments. It was a lot more political charged, I guess, what I said before with my previous questions that I recently intended, but let me take you from the frying pan into the fire. The next question here is tricky, because many of the listeners are already thinking about retirement, and inflation is really hard to pin down. Whenever you can consider your portfolio and your financial needs when you retire, you're looking at hopefully decades to come.

Starting point is 00:34:14 How do you include your inflation expectations in your asset allocation for retirees who have to live off the portfolios? This is a hard question. I've advocated increasingly, you know, in recent years, I've become a big, big advocate of all-weather portfolios. And I've always loved that concept of sort of having an allocation that protects you no matter what the scenario is, whether it's, you know, the classic for people who aren't familiar, the classic sort of all-weather portfolio was Harry Brown's four quadrant all-weather, which basically was, It was deflation, inflation, recession, and expansion. And basically his sort of really simple model for that was that you wanted to own gold for inflation, you wanted to own stocks for growth, you wanted to own treasury bonds for deflation, and you wanted to own cash for risk recessions. And so you had this very simple 25% four quadrant breakdown of the portfolio that the theory

Starting point is 00:35:19 was that this would protect you from all environments. And I've always been, the thing that has always sort of, I think made me reluctant about adopting that sort of a model, really embracing it aggressively, is the holding of 25% gold and 25% cash, just always from a basic portfolio theory perspective, struck me as, that's too much, too much in both. And, you know, who knows what's going to happen with, you know, if for some reason, like, the demand for gold was reprimed. replaced by the demand for Bitcoin, let's say, for instance, in the next hundred years, well,

Starting point is 00:35:55 your inflation component there might not do anything. And so we've kind of seen that in the last few years, for instance. Gold hasn't done as well considering the inflation that people might have expected. And actually a broader basket of just commodities has done much, much better. And so, you know, for me, from a financial planning perspective, I think you have to take inflation and the asymmetric risk of it into consideration. And for most people, I always say the stock market in the long run is a is a pretty good inflation hedge in large part because corporations, they basically earn a profit by buying things at whatever the rate of inflation is and then trying to mark them up. And so in the long run, something like the S&P 500 tends to be

Starting point is 00:36:42 a pretty good inflation hedge. You see years like 2022 though, where, you know, You can go through periods where the stock market goes down. And in real terms, the stock market is down what, you know, 25, 30 percent this year. And so you can get periods where the stock market volatility doesn't protect you in the short term. And that's where a lot of this gets tricky. And for most people, I always tend to, from a sort of financial planning perspective, I think you have to look at this holistically. So for instance, like, do you own a home?

Starting point is 00:37:14 I mean, I think housing in the long run tends to be, or really owning real stuff, tends to be a pretty good inflation hedge in the long run. I mean, real goods and services tend to be, and you could argue that stocks are to some degree just to, you know, real assets. Real assets in the long run are always good inflation hedges. But you can have these acute periods like this year or the last, you know, sort of 12 months where things. Things like commodities are much better inflation hedges. And for me, it's interesting timing bringing this up because I'm about to publish a new paper. It's the first paper I've written in years.

Starting point is 00:37:56 It's called all duration investing. And my perspective on this basically is I'm trying to apply a concept that is similar to all weather, but I'm doing it in very specific time horizons. And so what I've done is I've actually calculated the duration of all asset classes across the board. I've calculated the duration of commodities, of equities. And what I mean by that is I'm using essentially a model where I'm assuming a point of indifference. And so to me, the point of indifference for an investor, when you think of fixed income, you know, the traditional metric of duration is how indifferent is an investor in fixed income or bonds to losses, basically? So what will an

Starting point is 00:38:42 increase in interest rates caused in terms of principal losses. And when you think of that as like a point of indifference, well, in the long run, a fixed income investor becomes indifferent to losses at some point because they're earning a higher interest rate. And at some point in the future, the highest, the higher interest rate pays off. You can do this across all instruments where you look at, for instance, if the stock market were to fall by 50%, well, future expected returns should increase typically in the long run. When asset prices decline, typically the value of that asset becomes actually, you know, it's kind of, you know, counterintuitive. But when the asset prices fall, typically the future expected return of that asset should increase at some point in the future,

Starting point is 00:39:26 you become indifferent to the loss in that asset class. And so in my model, for instance, and a stock market investor is indifferent to losses on average over about an 18 year period. And so what I've done is calculated these durations for all asset classes and then plug this into a model across time. And to me, that's the key aspect of good financial planning is that you want to look at things in certain buckets essentially, where, for instance, you've got, you need some cash in the short run to manage your, say, whether it's emergency funds or your monthly liabilities. But that's the way the financial system works is that the financial system is structured, and our financial lives are structured across these very specific time horizons. And so you want buckets for short time horizons and medium time horizons. And let's say, you know, maybe you want to put a down payment on a home in the next five years,

Starting point is 00:40:25 but you're not really sure where. Well, that money shouldn't be allocated to the stock market because the stock market in my model is this 18 year instrument. So if you need that money in the next five years, for instance, well, the stock market's not a good place to put that. It needs to go into an instrument that has an appropriate duration relative to that. And so something like cash or even an aggregate bond fund would fit that model inside of a five-year time frame. And commodities and inflation hedges, the way that I calculated this, it's interesting, they're basically like 30 plus year instruments. but they have a highly short-term asymmetric payoff.

Starting point is 00:41:07 So what I mean by that is that gold and commodities, they almost operate, I shouldn't say almost, they do. They operate like inflation insurance in a portfolio. So, for instance, what is insurance in a financial planning aspect of a portfolio? Well, if you buy a 20-year-term life insurance policy, you've bought a long-duration asset that has a highly asymmetric short-term payoff. So if I buy a term life insurance policy that has a 20-year term, and let's say I croak in two years, well, that instrument, although it had a 20-year duration, that instrument had a huge, real positive asymmetric payoff in a two-year period. So you can think of, I like to think of commodities and gold and inflation hedges in much the same way where they have the potential to provide you with this almost like insurance-like policy.

Starting point is 00:42:02 payoff in a short time horizon, even though they're really long-term instruments. And so if you think of this stuff sort of on a bell curve, I think it's useful to think of like building out your asset allocation in terms of like across these durations where the stock and bond market make up the core sort of central aspect of the bell curve. And then on the edges, you have things that have these sort of important real and nominal asymmetric payoffs where cash, for instance, it's going to lose in real terms every single year, but it provides you with absolute nominal certainty. And so on this left tail of the bell curve, you've got this absolute certainty in nominal terms. And on the right tail of the curve, you've got insurance type instruments. So gold, commodities,

Starting point is 00:42:50 you could throw Bitcoin into there, things like that. Life insurance fits into that for sure. Things that have this sort of, you know, really, they're long duration instruments that have a potentially large asymmetric payoff. And you can, you know, depending on how, you know, personalized you need this all to be, you know, me personally, I tend to, you know, you got to start with the stock bond core. And then you can build out all of your, you know, sort of tangential instruments on the side.

Starting point is 00:43:18 But I think in the long run, you know, this fits into sort of an all-weather approach in the sense that you can build out this model and this asset allocation approach where you're taking sort of a what I call this all duration approach where you own things like commodities and gold, but they're there in a very specific allocation where, you know, let's say it's like 15% of your portfolio in total, where it's a relatively small portion, but it provides you with asymmetric certainty in environments like the one we're going through. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up,

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Starting point is 00:46:50 return since inception is 7.8%. Past performance does not guarantee future results, current distribution rate as of 1231, 2025. Carefully consider the investment material before investing, including objectives, risks, charges, and expenses. This and other information can be found in the income fund fund's prospectus at fundrise.com slash income. This is a paid advertisement. All right, back to the show. Yeah, it's such a tricky topic. I mean, you're trying to forecast something for decades, and you're doing that with instruments or assets

Starting point is 00:47:26 that you don't know what's going to yield. And we depend on it. That's what makes it even more scary. Colin, in December 1989, the parliament in New Zealand decided on a 2% inflation target for the central bank. And this is perhaps more significant than it sounds like to our listeners, because this was the first formal target to be adopted

Starting point is 00:47:47 by a central bank. And since then, many have adopted a similar 2% target, including the Fed and the ECB. And you can also argue that the low the inflation target, the more unemployment the Fed would have to create to get there. Now, let's get to the perhaps more controversial part of it. Remember that the Fed has this dual mandate of price stability and maximum employment, which seem to be counterintuitive. Of course, no one likes unemployment. And since there is a perceived little difference between a two and a three percent inflation,

Starting point is 00:48:20 should the central bank then increase the target? What is the right amount of inflation in the economy and should the government even have a positive inflation target? You know, it's interesting. I think when you look back through history, I think part of the reason that they arrived at this sort of 2% target is because 2%, this sort of low rate of inflation, 1, 2%, something like that, it's still consistent with rising living standards and historical data.

Starting point is 00:48:56 And so, you know, from a basic financial system perspective, like I was saying before, you're always going to have, you need balance sheet expansion. You need somebody, somebody has to be borrowing and creating financial assets in order for the rest of us, to save. And it's just a natural byproduct of, you know, population growth and increased productivity is that you're going to have more borrowing, more people. Money isn't always equally distributed. And so, you know, when somebody wants to buy a new home, you know, they may not be able to find existing money. They may not have the, you know, the money in their pocket right now to be able to buy that home and build it. And so, you know, some level of borrowing is, is totally natural

Starting point is 00:49:35 in a credit-based monetary system. The question is, does that create? growth have to coincide with inflation. And I think that's a much, much trickier discussion. I think that if you had an economic system where the private sector was the only borrower, where all money creation essentially was valued based on how productive it ultimately was, I think you would experience lower rates of inflation than we've seen. The interesting thing with having a system like that where when you have a, if you had a purely private based financial system, well, you'd probably have higher degrees of things like inequality, which then creates an argument for more government, which you get more government, then you get more inflation. You get more

Starting point is 00:50:29 of that negative net present value spending potentially to try to equalize things. And so it gets, you get into this messy debate about what is the right size of government, really? And to me, I mean, personally, I don't think there's, there's not like a need in a, in a monetary system to have a positive rate of inflation. To me, it's just the positive rate of inflation is to a large degree. It's a byproduct of having a primarily capitalist-based system that is predominantly private sector run that also happens to have a fairly large government attached to it. And I think you can make an argument that one to two percent inflation per year is sort of, it's the cost of having things like a public sector run court system and regulatory systems.

Starting point is 00:51:20 And these things aren't free. And so to the extent that we borrow or that they just don't have a net present value sense, they don't have a positive net present value in terms of like a profit sense, these things can result in in some marginal inflation, I think, that, you know, is that necessarily bad in the long run? Well, history would tell us that, you know, averaging one to two percent inflation is not necessarily consistent with declining living standards. So I don't know. I don't know the right answer. I would like to think that you don't need to have inflation in a monetary system, but I think that, you know, it's hard managing, you know, that right balance of public

Starting point is 00:52:07 sector versus private sector. And obviously, you know, you don't want really high inflation, but there's, there doesn't seem to be an inconsistency between a low level of inflation and, rising living standards in the long run. So, you know, maybe, you know, maybe having a court system and a military and things like that, maybe those are just the, you know, the inflationary cost of having a government in the long run. You can get into the debate about how much bigger the government should be than that. And I think that's a useful debate to have. But in general, I guess my answer is I don't really know. I don't know what exactly is the right rate of inflation. But we certainly know that anything over 2% or so seems to be problematic. At a minimum,

Starting point is 00:52:53 it's consistent with social upheaval and bigger societal problems that, that, do cause meaningful declines in living standards. So I think we can all agree that nobody wants a high level of inflation, but whether or not we want zero percent inflation or one or two percent, I think is a much more reasonable debate. You know, as much as we could say today, well, we should probably have, say, three percent because then we don't need to bring in as much unemployment. Everyone lacks high employment.

Starting point is 00:53:26 Well, it's a slippery slope. You know, we also have seen that before if we tend to think that inflation is coming and like it becomes self-reinforcing. Does that mean that in the next crisis, we will say it's okay with a 4% or 5% and then what happens in the next crisis, you know, following that? So it's really tricky and it's as much as the 2% is arbitrary and the Fed is on record saying that it's arbitrary, it's definitely on purpose that it's in that level and it's positive and It's not deflation.

Starting point is 00:53:57 MNT has been really popular in the last few years in terms of like the social discussion. And like what their big policy discussion is that the government should run a job guarantee. And I've always been sort of skeptical of this idea because the basic thinking there is that you can give everybody a job. So the government guarantees everybody a job and they argue that there would be price stability. And so that's where you get into this very, you know, theoretical debate about is it even possible. to have a society where everybody has a job, everybody's guaranteed a job, and you have low inflation. I don't know. I'd like to think that that is certainly possible. It would be great if everybody was employed and doing something productive and happy. Oh, and we also just happen to have

Starting point is 00:54:44 low rates of inflation. I'm pretty skeptical of whether or not that's possible. It's certainly never been done. But you can also have the opposite where you have societies and economic periods where unemployment is super high. And obviously the tradeoff for that is that sometimes the rate of inflation is really low as a byproduct of that because demand is so low. The Fed does not have an enviable job trying to manage a dual mandate of inflation and unemployment. Carter, let's continue with this thought experiment. Let's say that we would go into a prolonged period of not only disinflation, but for example, two decades of deflation. And I just wanted to clarify disinflation is a lower but still positive inflation rate,

Starting point is 00:55:30 whereas deflation is a negative inflation rate. So how would consumers and investors need to adjust to this prolonged deflationary period? Man, one of the most interesting charts I've ever seen is Japanese real estate in the last 20 to 30 years. I mean, we're so used to in developed world, real estate prices just always going up pretty much. You know, that was a part of what everyone kind of knows. Like, that was part of what caused the financial crisis to be so bad was that in the economic models, you know, all these investment banks assume that real estate prices just either wouldn't go down or wouldn't go down very much. And so when real estate prices went down 20, 30 percent, you know, that obviously, that caused it through a wrench and everything.

Starting point is 00:56:14 And in Japan, though, real estate. prices have been going down for 20, 30 years, which is sort of unfathomable in the United States. But it's something that, you know, that sort of a scenario, I mean, it keeps me up at night, to be honest, because you, again, the real estate market is such an impactful instrument in the entire U.S. economy. You'd have very, very low rates of growth. I mean, in that sort of a scenario, if that's something that you, you'd have. expected or if you thought it was a risk, you'd want to own counterintuitively, you'd

Starting point is 00:56:54 want to own a ton of bonds. So bonds in Japan were the thing that hedge people from, you know, people talk about how the Japanese equity market has been down over this, you know, this sort of, you know, lost decade or whatever. Well, the thing that people don't always point out is that if you owned a 6040 portfolio denominated in yen, where you own the, the Niki, for instance, and Japanese government bonds, well, you actually did okay because the government bonds performed so well that your relative performance was okay. So diversification actually worked out okay in Japan

Starting point is 00:57:30 because of the bond component. But the same sort of scenario would play out in the United States where, you know, people are worried about inflation now and they're worried that, oh, bonds are dead. But if you got prolonged, entrenched deflation, the bonds are the things that would perform really well in that in terms of an asset allocation. So, you know, again, kind of going back to that sort of all duration or all weather sort of perspective, it's why I always advocate, I always tell people, you know, you always need to hold some cash and short-term bonds and even some intermediate potentially long-term bonds. Treasury bonds are, you know, they're sort of that deflation insurance like product, super long duration instrument.

Starting point is 00:58:11 But yeah, in terms of like an economic outcome, it's hard for me to imagine that wouldn't be sort of a disastrous scenario, that it wouldn't be coinciding with something much more negative in terms of what's occurring, just because in order to get this sort of 20-year period of entrenched in deflation, you'd have to have not just negative, probably demographic growth. You'd have to have declines in productivity and really, you know, almost like 0% GDP probably for decades, which would not be, obviously would not be. be great. So is that going to happen? Personally, I think that's a low, a low probability, just because the demographic trends, even as bad as they are in the United States and a lot of

Starting point is 00:58:58 some of the developed world, they're not necessarily going to be negative. I think productivity will continue to be relatively strong. And it's hard for me. The United States is still such a real estate based economy that when you look at it in the long run, I mean, God, looking at it from like a supply perspective, like one of the problems in housing is there's a huge shortage of housing. And so in the long run, is there, are we going to stop building homes in the United States, you know, using a sort of crude housing is the economy sort of model? It's hard for me to imagine that even with the ebbs and flows in the long run, there is a lot of building to be done in the United States in terms of building out the, you know, the real estate market.

Starting point is 00:59:41 Well said. Now, Colin, let's transition into the next topic of today, which is the concept of the Fed put, which dates back to the era of Anna Greenspan, former share of the Fed. Starting with the stock crash of 1987, the Fed cut rates whenever share prices plunged. If you're an investor, it resembles the benefit of the put option where your downside is getting cut. Some argue that we're now hitting for a time with the Fed call, which is exactly the opposite, meaning capping the investors upside. We know from studies of the wealth effect

Starting point is 01:00:13 that the wealthier people feel they are from their stock holdings, the more the spend. One started from Howard University shows three cents of increased spending of each dollar of increased stock wealth plus increased employment and wages. All of this adds to inflation,

Starting point is 01:00:27 which currently seems to counter the main objective of the Fed. So with all of that being said, do you think, Colin, they were heading into a period of the Fed call? There's a lot of different transactions. mission mechanisms for monetary policy. And to me, interest rates are a very powerful policy lever. I do not think, people tend to think, you know, when people talk about, you know, like the Fed put,

Starting point is 01:00:53 they often talk about quantitative easing and like the balance sheet expansion. And I just, I don't think quantitative easing is as powerful as a lot of other people tend to think. And I think that, you know, drawing these correlations between like the Fed's balance sheet and the The stock market to me is just sort of silly. Like the Bank of Japan increased their balance sheet for decades and the, you know, the NICA, you know, had a marginal correlation to these changes. So, you know, there's scenarios where the, or the ECB also like, you know, the European stock markets performed on a relative basis horribly compared to the US stock market and the

Starting point is 01:01:32 ECB was ramping up their balance sheet. So what was the, you know, it seems like there's very mixed evidence on whether or not the balance sheet expansion really is that the Fed put? To me, the Fed put and the, or what we're seeing now, sort of the Fed call is really the interest rate impact in the way that the Fed can very precisely, or I shouldn't say precisely, I should say the Fed can very, you know, almost like using a hammer can sort of bludgeon the economy with interest rate changes. And that's, You know, that's a lot of what we've seen in the last six months is this repricing of assets because interest rates have changed so dramatically.

Starting point is 01:02:16 And that's a very, very blunt instrument. But it's a very, very impactful instrument, especially when it's when it's used in a very aggressive way, which is what the Fed's been doing. And so, yeah, they've made it very clear. I think that they've, have they overreached, I think at this point? That's the bigger question. I think that's the question that the stock market and the broader economy is now grappling with is, has the Fed implemented this call in a short-term period where

Starting point is 01:02:45 they've raised rates so fast that they've sort of bludgeoned the real estate market, basically? Have they snuffed out demand for real estate to an extent that, yeah, it'll fix inflation because it's going to fix the demand side of everything. But have they overreached? Are they now going to find themselves going into 2023? having to backtrack a little bit because, you know, the, they cause some unemployment. And that's where you get into that, you know, that dual mandate balance and what a, you know, tricky balancing act it is. Because now, you know, it's crazy. The Fed forecast or Fed funds futures,

Starting point is 01:03:26 they actually forecast falling rates in 2023. So the Fed has sort of, you know, put themselves in this position where, yeah, they've raised rates very aggressively. It looks like they're going to get, hopefully they're going to get inflation under control, but are they going to do so by driving the economy into sort of this prolonged or deep state of either negative or zero growth where you get a jump in the unemployment rate that causes them to then have to implement, you know, the Fed put again to cause a reversal in a lot of these trends. Personally, I don't think the Fed can afford to to continue to implement this so-called Fed call in the long run in an aggressive sense that, you know, they won't continue to raise rates really aggressively because I think they'll cost

Starting point is 01:04:16 too much damage to the housing market. So, you know, kind of going back to the beginning of our discussion, that risk of deflation to me is higher than the risk of inflation or prolonged high inflation going forward in large part because of the Fed's policy response. I think they overreached a little bit. The mortgage market has started to adjust some already. We've seen interest rates retrench a little bit in the last month. And I'd be shocked if they continue to really put the pedal to the metal because I think there's a really meaningful risk now that the housing market is slowing and that it's slowing at an uncomfortable pace that could result in, you know, we're having this big debate in the United States over whether there's a recession and it's kind of a silly

Starting point is 01:04:59 debate whether two quarters of negative growth, I wouldn't be shocked if we've had, if we end up having four quarters of either low or negative growth in a row. Is that going to be technically a recession? I don't know, but it's not good. In a big, big bind here, I don't think they can afford to implement a long-term Fed call because I don't think they can, I think doing so would result in pulverizing the real estate market in essence that would force them to re-implement the Fed put basically. So let's talk about the rates. We often hear in the business news that the market has priced in the high of 50, 75, 100 basis

Starting point is 01:05:36 points or whatever it might be. Where can we find that information or, you know, that website that says, this is what the market has priced in. And what does that number imply for investors? The best place to always look at the two-year, the two-year treasury, that is reflective of the future expectations of the future expectations. of Fed policy in essence. So for instance, the two-year peaked at like 3.4%, you know, what was it, a month or two ago,

Starting point is 01:06:05 we're at 2.9 right now. The Fed funds rate is only what? It's 2.3 or so. The effective Fed funds rate is 2.3 right now. So even though they've made it very clear they're going to raise rates to probably at least 3%, the two-year treasury is priced that in. And it was more aggressively priced even just a month or two ago. So that's usually the place to look is the short end of the treasury curve usually front

Starting point is 01:06:35 run to the Fed. And they try to get ahead of where the Fed is going to be. And so you can't just look at, like a lot of people, I see this on Twitter all the time where people are like, oh, the rate of inflation is 8%, and the Fed is only at 1%. And it's like, well, wait a minute, even a year. year ago, the two-year treasury bill priced in way more than 1% Fed funds rates. And this is part of how Fed policy theoretically works. Well, not theoretically. This is how it really works, is that they tell you, they tell the market where rates are going to go. And they're trying to, you know, it's called

Starting point is 01:07:10 open mouth policy, basically. They're communicating to the market, hey, we're going to do this. And, you know, there's a lot of theory about how powerful this is, but it certainly, you see it reverberate through the actual bond markets where the two-year treasury will respond to these comments in a sort of hyperactive manner where bond traders do reprice what the Fed does. And I always like to use the analogy of the Fed curve and the interest rate structure is a lot like a man walking a dog. And if you think of the, let's say the two-year treasury is the dog, well, the Fed's holding the leash, but the Fed basically, when they say they're going to raise.

Starting point is 01:07:53 interest rates to like 3%, well, what they're really doing is they're letting the leash out a little bit. So they're letting the dog run out. The dog gets ahead. The dog front runs where the Fed is going to be in the future. And so even though the man might be holding this tight leash where, you know, he's only allowing what looks like a 2% interest rate increase, the dog is already out there at 3%. And that's what you see in the two year. And so that's the, that's the best place to look when you're looking for, you know, what are the market expectations? And it's weirdly, it's actually one of the worrisome things right now is that the two year is high relative to the 10 year. And so, you know, people talk about this yield curve and the yield curve inversion.

Starting point is 01:08:33 What the yield curve is basically saying right now is that the 10 year expectation of rates is lower than the two year expectation of rates, which is consistent with what we were just talking about how, you know, the risk of this policy mistake is being priced in. that the Fed, yeah, in the short term, they're going to go to 3%, but in the long run, are they going to end up having to retrace back to, you know, two and a half or 2%? And that's what the market is grappling with right now. Colin, as always, it's been fantastic speak with you about inflation, this second part here or inflation master class. Is there anything where you feel like we skipped over it, anything you wanted to add to the conversation?

Starting point is 01:09:16 No, I feel like I talked so much. I talk too much. People are probably like, shut up. I'm sure people are not like that at all, Colin. It has been absolutely amazing. As always, speak with you. I already look forward to the 10th time that we're going to bring you on. Colin, where can the audience learn more about you, anything that you're up to? My main website is pragmatic capitalism.

Starting point is 01:09:39 I started on a YouTube channel recently called Three Minute Money. If people want, they're sort of short, concise, educational, mostly videos on money in finance and keep an eye out for my new paper, the all duration paper. I think it's pretty cool. It's one of the first like things I'm kind of excited about having written in a really long time. I haven't published a paper in, I don't know, five years. Not that that's something I try to do often or am proud about necessarily, but it's, I think it's a cool sort of counterintuitive look at building out asset allocation models and a new framework for thinking about things across a very time-specific perspective of asset allocation.

Starting point is 01:10:19 It's very financial planning consistent. So I think it's cool. I think that people will like it and keep an eye out for it. I'll publish it probably on SSRN and hopefully some journals and certainly on PradCAP. Colin, as always, it's been a pleasure. Thank you so much for making time for the investors' podcast. It's always great to talk to you guys.

Starting point is 01:10:40 Thank you for listening to TIP. Make sure to subscribe to Millennial Investors. by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision consult a professional, this show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - TIP472: Inflation Masterclass continued W/ Cullen Roche

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