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Inflation v. Money Supply - An Epic Battle!

Inflation v. Money Supply - An Epic Battle!

May 07, 2022

What was described a little over a year ago as “temporary” is now firmly entrenched in our everyday lives – inflation. The last time inflation has reached this level of relevancy was over 40 years ago, which means that most Americans have not experienced the practical effects. And even if you did go through the inflationary years of the late 1970s and early 1980s, it would be difficult to meaningfully recall how it impacted our lives.

TOP 5 Inflation Years (in the last 50 years)

 Okay, I know what you’re thinking. Isn’t the above data a little old? Yes, it is. Anybody under the age of 55 was, at most, just entering high school and listening to Bee Gees during the late 1970s. But seriously, if you consider that the annualized inflation rate between 1982 and 2000 was 3.3%, and the annualized rate from 2001 to 2020 is 2.0%, there is not much practical recent evidence to compare. But consider that in 1978,15% of Americans were over age 60. Today the percentage of Americans over age 60 is 22%. It is estimated that by 2035, 27% of Americans will be over the age of 60 (Est 97 million individuals). More and more retiree budgets are sensitive to inflationary pressures than they were over 40 years ago.  

 Despite the negative GDP growth in the first quarter (-1.4%), the economy is still benefiting from the high levels of cash accumulated during the pandemic (see my2/22/22 blog “Is our Money Supply Really That High?”). In fact, one of the reasons GDP was negative for the first quarter is because American consumers and businesses were spending massive amounts on imports from foreign countries. The excess of imports over exports is actually a negative component in the calculation of GDP. The unemployment rate is at its lowest level in almost 50 years. Factory output is close to full capacity, but there are not enough employees to handle the high demand.

 On the other hand, we have rising prices that do not appear to be slowing down as supply chains are not functioning at pre-pandemic levels yet, and the Russia-Ukraine conflict and mandated closures of the Chinese export market are creating greater supply obstacles. “Purchasing power loss” will be a term heard frequently from the financial industry and financial press to describe the financial impact of an item that costs $10 today, for example, but may cost at least $11 next year.

 If your income doesn’t increase by at least the same percentage as your living expenses, then your ability to purchase the same items in the future is undermined. And if the deficiency each year grows larger or continues, the long-term impact can be financially devastating.


Fed’s Solution

The Federal Reserve has two weapons in its monetary policy arsenal that has been seldom used in the past twenty years:

  1. Raise interest rates: By charging member banks higher rates and they, in turn, raise their lending rates to businesses and individuals. The downside to raising rates is that the intended result of lowering the money supply (which lowers demand and prices) by raising rates can put the brakes on a growing economy. It would be safe to say we are still in the expansion or peak stages of the economic cycle. The next phase of the traditional business cycle is a recession, but our employment, production, and strong dollar show no signs of reaching that next phase just yet.

  2. The Fed is currently holding approximately 9 trillion dollars in bonds that governments, banks, and large companies had previously borrowed from the Fed. Beginning June 1, the Fed has announced that they will begin retiring (get paid back) approximately $95 billion a month. This action has the hopeful effect of reducing the money supply and lowering demand and lowering prices (please see my blog "The Fed - Between a Rock and a Hard Place").

 The math is straightforward – if your expenses are rising faster than your income, either you increase income, lower expenses, or dip into retirement savings.

Increasing Income

If you are still employed and receiving W-2 wages, hopefully, you are receiving wage increases in line with inflation. Once you retire, the income sources may or may not increase with inflation (or cost of living) adjustments. Social security payments are upwardly adjusted for increases in the Consumer Price Index, which is a national measurement, not local, of prices throughout the country. Some pensions contain inflation adjustments, but most do not. Increasing investment income generally means accepting higher risk, not something that you thought you would need to be doing at this time in your life. Rental income increases, when possible, can provide inflation protection. Annuities can provide income but there are many variables in annuity contracts (including inflation adjustments) and I would recommend careful analysis before considering one.

Lowering Expenses

Another way of expressing the act of lowering expenses is the unappealing phrase “lowering your standard of living.” It may be unnoticeable for a short time as adjustments to discretionary items take place in the short term, but persistent purchasing power loss will eventually create more permanent adjustments for certain essential items. Identifying and quantifying financial goals becomes necessary as the more important goals may not be impacted by increasing prices but some lesser important goals may not be a viable goal any longer. Anyone who has set financial goals for themselves could use help with financial decisions. A plan can help investors identify their goals and calculate the probabilities of achieving those goals based on their financial circumstances including income, assets, spending, savings, taxes, views on risk, and asset allocation.

Dip into Savings or Retirement Accounts

The deficit that may exist when comparing your income and living expenses is usually fulfilled with distributions from retirement savings. A common principle that seemed to make a lot of sense in the last 40 years was that each investor should attempt to keep up with inflation, which has been between 2% and 3%. Considering the overall U.S. Stock market has earned an annualized return over 11.5% the past 40 years, keeping up with and exceeding inflation was not difficult. However, today investors are asking themselves:
 To keep up with a possible inflation rate of 6% to 10% over the near to intermediate term, do I increase my exposure to stocks and higher-yielding asset classes? But when most indicators point to a probable economic downturn happening once the higher interest rates take full economic effect, is that such a good idea? After all, the shorter your time horizons become, the less risk tolerant you should typically become. As a financial advisor, I view this dilemma as a central planning issue for a large segment of our population for many years to come.


As for the ideal investment strategy during inflationary periods, I would only direct your attention to the below chart to suggest a solution. Simply stated, the capital markets have risen over time through all types of economic cycles, political upheavals, global catastrophes, interest rate increases, wars, and inflation. The growth also reinforces the commonsense investment principle of risk and return – for example, smaller company investments are generally riskier than larger company investments and have accordingly compensated the investor for the higher risk tolerance.



In US dollars.

US Small Cap is the CRSP 6–10 Index. US Large Cap is the S&P 500 Index. US Long-Term Government Bonds is the IA SBBI US LT Govt TR USD. US Treasury Bills is the IA SBBI US 30 Day TBill TR USD. US Inflation is measured as changes in the US Consumer Price Index. CRSP data is provided by the Center for Research in Security Prices, University of Chicago. S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. US Long-term government bonds and Treasury bills data provided by Ibbotson Associates via Morningstar Direct. US Consumer Price Index data is provided by the US Department of Labor Bureau of Labor Statistics.

Past performance is no guarantee of future results. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.

  Of course, there are investments available that can address the inflation and interest rate situation (please see my blog "Inflation - Should You Finally be Concerned?). Each investment strategy is unique to each client and the many variables at work should be addressed before recommending particular investment strategies. Please review my website for more information about our services and feel free to contact us if you have a question or would like to schedule a no-charge consultation.