Does the Minimum Wage Cause Inflation or Unemployment

Does minimum wage cause job loss, inflation? Income inequality is an issue important to everyone. The benefits of increasing the minimum wage are greater than first thought. #minimumwage #incomeinequality #fairwage #workingwageEconomic growth is pushing towards 10 years as of this writing. The 2008-09 recession was deep and slow in recovery. Fewer jobs at lower wages coupled with the long time frame unemployed people had to wait to even get a job at any wage caused tempers to flare. The minimum wage was raised in 2007, 2008 and 2009 to the current federal rate we have today.

Jobs available as the recession eased were not of the same quality as jobs lost. More workers were among the working poor, earning minimum wage or close to it. Eventually a vocal crowd demanded a $15 an hour minimum wage. It all sounded good. And fair to workers making less. Business owners also made powerful points. In the end nothing of consequence came of the movement. The expanding economy lifted wages, nullifying the demands of the activists. Better jobs with higher wages started appearing, too. People used to a higher income had greater opportunity to explore a pay increase at a new employer if their current employer refused..

The issues never went away; they’re just hibernating until the next opportune moment. Many myths cropped up during the debate. Does a modestly higher minimum wage cost jobs? Does it increase automation, eliminating the job completely? Do worker deserve a fair wage? A higher wage than $10 or so?

I did some research to see if the minimum wage causes inflation, another of the complaints against increasing the minimum wage. Of course, most people agree workers should be paid fairly. We all want to earn more for our efforts. Even business owners understand employees need a living wage.

We will explore some of these myths and how they affect your personal finance decisions. As with most issues, the answers aren’t as clear as activists claim; businesses, either. The debate gets steeped in politics when economic matters are considered. This article will explain the truth behind the myths and what government and you can do about it.

First we address the myths.

Myth #1: The Minimum Wage would be $22.50 an Hour if it kept Up With Inflation

At first I accepted this claim at face value. After thinking about it for a while I began to doubt the claim. Protesters claimed the minimum wage would be somewhere in the neighborhood of $22.50 an hour if the minimum wage had kept up with inflation from a certain date. Extraordinary claims require extraordinary proof! Fortunately we have actual data to determine if the minimum wage now is lower than in the past, adjusting for inflation.

I will do the heavy lifting for you. I’ve included links if you wish to dig deeper into how the minimum wage has fared against inflation. We will test this claim by looking back to 2009, 1990 (a date protesters sometimes used in their claim), 1978 (another date used by protesters) and all the way back to the beginning on October 24th, 1938 when the first federal minimum wage was instituted in the U.S.

Disclaimer: Several states have their own higher minimum wage. We are discussing the federal minimum wage only. Minimum wage data was used from the U.S Department of Labor and the Consumer Price Index-U (all urban areas) was used in calculating the inflation adjusted minimum wage.  We will not address salaried workers, restaurant workers or individuals under age 20 first starting a job, all of which have a different minimum wage.

Has the minimum wage kept up with inflation? The answer might surprise you. And if the minimum wage is increased at the right time is sparks economic growth while crushing deflation. An honest day's pay for an honest day's work. #work #wages #minimumwageAdjusted Minimum Wage from 2009: The current federal minimum wage is $7.25 an hour. There are other rates based on age and occupation. To keep this post brief I will focus on 1938 Act until 1978 where I use the all nonexempt workers rate.

The federal minimum wage was last increased, effective July 24th, 2009. The CPI index stood at 215.351 in July of 2009. The latest reading for June 2018 is 251.989. The index has increased 36.638 points since the last minimum wage increase, or about 17%. If the minimum wage were indexed to inflation the minimum wage would now stand at $8.48 per hour. My guess is that in the near future the federal minimum wage will be increased to $8.50 – $9.00 per hour. This would accurately reflect the increase in average consumer prices over the time period.

So, the argument the minimum wage should be $22.50 doesn’t work calculating from 2009.

Adjusted Minimum Wage from 1990: The minimum wage was increased on April 1st, 1990 to $3.80 per hour. The CPI was 128.9. The CPI increased 123.089 points since April 1990, or a 95.49% increase. Adding 95.49% to the then minimum wage of $3.80 gives us $7.43 an hour, pretty close to the current minimum wage. Maybe we need to go back further.

Adjusted Minimum Wage from 1978: The minimum wage was increased at the beginning of 1978 to $2.65 an hour. The CPI stood at 62.5 in January, 1978. This is an increase of 189.489 points or 303%. Increase the then current minimum wage of $2.65 by 303% and we get $8.03 an hour. Hmmm. Maybe we need to go back all the way to the beginning.

Adjusted Minimum Wage from 1938: The first federal minimum wage in the U.S. began October 24, 1938 at $.25. Yes, that is 25 cents an hour. The next year they raised it to $.30 an hour. We will still use that original minimum wage starting point to determine if the minimum wage is worse today than it was in the past.

The CPI stood at 14 in October of 1938. The index has climbed an additional 237.989 points since. The CPI is a whopping 18 times what it was in October 1938! This means the original minimum wage, adjusted for inflation was {drum roll}: $4.50 an hour.

Oh-oh. The claim minimum wage should be over $20 an hour now doesn’t hold up. But this isn’t the only myth batted around.

Myth #2: Increasing the Minimum Wage Causes Job Loss

This scare tactic crops up every time a minimum wage increase is mentioned. As you can see from Myth #1 above, the minimum wage has been a minimum burden on business since the beginning. Since 1938 technology and productivity have increased massively. If business can’t keep up with the barely minimal minimum wage increasing at somewhere in the vicinity of the inflation rate, business needs to do something else.

Does increasing the minimum wage cost jobs? Well, business tells us if we increase the minimum wage business will automate the jobs away, eliminating the entire labor cost. McDonald’s and Wal-Mart gave us this song and dance. For the record, in the last 10 years Wal-Mart has replaced a large percentage of cashiers, requiring customers to check themselves out. McDonald’s is replacing workers fast with automated order taking (similar to Wal-Mart’s check-out kiosks) and cooking robots. The minimum wage remained static for a decade and automation happened anyway! The minimum wage had little to no bearing on that corporate decision; finding qualified workers willing to work at minimal wages was.

Of course, the economic professor in me says that when prices increase, demand drops. It’s Macro Economics 201 (or is it 202, it’s been a long time since my college course). A higher minimum wage does reduce jobs minimally! Wages tracking inflation is NOT a REAL wage increase. So what is business talking about? They’re talking about maximizing profits on the back of minimum wage workers. I get it, but it’s still a myth jobs are lost when wages increase. Higher wages increase inflation, not demand for labor. Demand for labor is based on economic conditions.

Myth #3: Workers Paid Minimum Wage Aren’t Getting a Working Wage

Even business owners agree a person should be paid a reasonable wage for their labor. The question revolves around “working wage”. Are workers paid near minimum or minimum wage paid a working wage? Well, I’ll be the first to admit $7.25 an hour isn’t a lot and lacks the motivational ability to move the crowds. For young people starting out its fine, but even then, what’s the motivation to perform maximum when the pay is minimum? Just asking.

But the minimum wage isn’t the only source of income for these workers. The tax code provides an Earned Income Credit for workers with low income. The EIC is a refundable credit and tax-free to the recipient. Many states also add to the federal Earned Income Credit.

All this combined is still hard time. Full-time (40 hours per week) at $7.25 an hour is only $290 per week. Ouch! Payroll taxes take 7.65% off the top. Good thing there is an Earned Income Credit! This equates to $15,080 a year without a pay increase in site.

I never said it was pretty. Then again, the minimum wage was never called a working wage (unless they said it back in 1938).

The Federal Reserve’s Money Printing Problem

Now we can put some of this knowledge to work.

Interest rates peaked well into the double digits in the early 1980’s. Rates have steadily declines, with only temporary increases, since. Anyone under age 35 has never lived through a serious increase in inflation and/or interest rates! This is nearly two generations who have never experienced how bad, bad can get.

We've been looking for income inequality in the wrong place. The minimum wage can level the playing field, even for those earning much more. Equal pay for equal work. The minimum wage and inflation are a correlation. #inflation #wages #minimumwage #equalpay #equalrights #equalopportunityFrom the early 1980s until the mid-2000s the Federal Reserve was able to nudge the economy along by lowering interest rates through a variety of lending facilities. The Great Recession which started in 2008 brought interest rates to zero and the economy still only limped along. The solution the Fed settled on was Quantitative Easing where the Fed bought up massive quantities of Treasuries and mortgage securities. The buying was in the trillions! The Fed balance sheet swelled from around $800 billion to the $4.5 trillion neighborhood. And they couldn’t get a pulse from inflation no matter how many smelling salts were used.

I’ve argued in the past on the reasons why all the money printing around the world didn’t cause runaway inflation. In short, much of the newly created money never entered the economy. Money center banks and central banks around the world stuffed their vaults with digital cash. It made the books look better so banks could lend if necessary. The result? The economy limped slowly out of the Great Recession in fits and starts, but finally grew to record length proportions. It’s been a long recovery and new heights have been reached.

But interest rates are still very low. If another recession arrives (some might say we are due), the Fed will not have much room to maneuver. If they try the old “print more money” strategy used last time it could compound the issues.

This is where the Fed and elected officials need to review the data for additional options. And I have a powerful one.

Getting Inflation (and Economic Growth) the Federal Reserve Wants without Printing More Money

The chart you see in this section I put together with data from the U.S. Department of Labor, the Bureau of Labor and Statistics and When I asked the question: Does increasing the minimum wage cause inflation? I had to dig further than the available charts. It was necessary to determine if there was a correlation between inflation and the minimum wage. If there is a correlation the monetary and fiscal implications are significant. It also effects personal finance decisions in a serious way.

This exercise is more than a macro-economic research project. If a correlation exists, the Federal Reserve and Congress will want to act appropriately in the future. It also means everything we know about the rate of the minimum wage is wrong!

If you examine the chart closely there does appear to be a modest correlation between a minimum wage increase and the rate of inflation. However, the correlation isn’t clear. In the 1970’s, the increasing minimum wage supported inflation rather than lead to inflation. In the Great Recession it seems like the minimum wage increase had no effect at all.

In the same way astrophysicists glean the data for a slight wobble in a star to determine if a planet orbits said star, I had to push away all the noise and look for a wobble in the inflation data. Productivity, Fed policy and economic conditions provided plenty of background noise to distract for the data. But I did find a wobble.

Raising the minimum wage at the right time benefits workers and employers. A fair wage,a working wage is vital to a strong economy. The $15 minimum wage movement was right, even if their timing was wrong. #$15anhour #workingwage #inequality #wages #salary The minimum wage was instituted during the tail end of the Great Depression. Adjusted for inflation, the first federal minimum wage was around $4.50, but a year later it increased to an inflation adjusted $5.40 an hour. This new minimum wage was started in what many call the second Great Depression. From 1929 to 1932 the economy collapsed at a rapid pace. Recovery was incomplete by 1937 when the Fed started raising interest rates causing the economy to once again slow and the stock market to decline hard.

Then we get a new minimum wage in 1938 and prices start to climb. The data used in the chart only includes average inflation for each year. The data detail (found using the link above from reveals a more immediate response. The chart makes it look like the minimum wage could have caused some inflation, but in reality World War II had a lot to do with the price levels at the time.

Deflation was a serious issue early in the Great Recession. Prices were actually declining! Inflation is bad, but deflation makes it incredibly hard to spur economic growth since waiting to purchase a good or service is likely to be cheaper tomorrow.

The Fed had its hands full with declining prices, high unemployment and the banking industry in ruins. Interest rates dropped to zero percent. Some countries experimented with negative interest rates to no avail. The economy was growing at an anemic pace (still declining in some countries) with virtually no inflation. Creating massive quantities of new money didn’t do the trick hoped for. It in the end did save the day, but at what cost. The next time we need help from monetary policy we are out of bullets. Do we keep creating more money? How far do we push the economic system out of balance? What if we can’t kick the can further down the road?

The wobble is in the data! Increasing the minimum wage does cause mild inflation very quickly. Unfortunately, the lift is short lived. But it is another planning tool for the government and a key point you, kind readers, need to understand.

The minimum wage was increased during the Great Recession and it kept prices stable. Only after the wage increase subsided into the past did prices start to fall. The printing press was all we had. Even in the second leg of the Great Depression the new minimum wage didn’t harm the economy. Few jobs, if any, were lost. Prices started to increase, encouraging demand and production, creating even more jobs.

Armed with this information the government should avoid raising the minimum wage during economic “good times”. Rather, when business says they can least afford it is when it needs to be done. Inflation is sparked by demand. Since the minimum wage is increased after long periods of flat lining, the increase tends to be a larger than average percentage. People earning minimum wage spend all their paycheck and quickly. The added demand encourages more production and helps reduce deflationary pressures.

How does this affect you? Well, the best time to increase the minimum wage is when the most people need it. Myth #2 is clear; increasing the minimum wage reduces very few jobs. Business can afford an increased minimum wage during an economic slowdown. It’s been done before without serious disruption. It also lays the foundation to renewed economic growth and increased business profits. It’s in business’s best interest to raise the minimum wage as the economy begins to cool. This encourages more demand while spurring mild price inflation; a catalyst encouraging continued growth.

You can use this information in your personal finance decisions as well. An increase in the minimum wage will increase business activity, a good sign for investors. If everyone digs in their heels and refuses to increase the minimum wage when this data suggests its value, get ready for a long economic war with no winner until somebody blinks.



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Could We Get a Single Digit P/E Ratio?

Recent volatility and decline in the broad markets in the U.S has people wondering if the correction returned the market to typical valuations. There are several tools used to measure the market’s value. One of the most widely used is the price/earnings (P/E) ratio, derived by dividing a stock’s price by its trailing twelve months (TTM) earnings.

The P/E ratio on the S&P 500 stands at 24.46 as I write (February 11, 2018). The ratio has been above 20 since early 2015.

When you take long periods of market data and shake them together you end up with an average P/E somewhere in the mid-teens. There is no hard and fast rule stating what a fair or reasonable P/E should be though plenty of opinions exist.

Another way to look at the P/E ratio is to flip it upside down where you divide the earnings by the price. This is called the earnings yield.

The earnings yield is an easier way to understand if your investment is paying enough to justify the risk and lost opportunity cost of investing elsewhere. The S&P 500 earning yield is 4.09% as I write. This means if all the companies in the S&P 500 paid all their earning out as a dividend you would have a 4.09% yield.

Again, there is no hard and fast rule on what an appropriate earnings yield should be. However, if Treasuries are considered a risk-free investment and yield more than 4.09% you might want to reconsider your strategy.

History of the P/E Ratio

The P/E ratio has been all over the map. We sit near record highs in the  ratio currently, but have been above 20 for several years. This in and of itself is a bit unusual.

The other side of the spectrum had the ratio in the single digits with the earnings yield double digits. (If the P/E is 10 then the earning yield is also 10%. If the P/E is 5 then the earning yield is 20%. Example: A $100 stock has a $10 per share profit. If they paid all the profit as a dividend it would equate to a 10% yield. If the $100 stock earned $20/share the P/E (100/20) would be 5 and if the $20 were all paid out it would equate to a 20% yield.)

The actual dividend is almost always less than the profits of the underlying company as a higher dividend would require borrowed money or liquidation of assets to pay. The earnings yield is the highest amount a company could consistently pay out. Realistically, most companies can’t pay more than 80% of profits in dividends so resources are available to invest for future growth.

The P/E ratio has climbed above 20 many times in the past. Concerns over high valuations based solely on the P/E is short-sighted and a poor investing barometer.

Up until the early 1990s when the P/E climbed above 20 either earning grew bringing the ratio back below 20 or stocks declined in price or some combination of both. Since the early 1990s the ratio has been above 20 more often than not. During the dotcom craze the ratio exceeded 40 and during the Great Recession (2008-9) the ratio briefly pierced 70 as earnings declined (especially in the energy sector) faster than the market declined.

In both cases the excessive P/E ratios returned to the upper teens in a short period of time. Earnings rebounded even as stocks advanced. The faster growth rate in profits reduced the ratio. The excessive losses due to falling oil prices eventually ended and the ratio declined.

Why is this Time Different?

Why have stock prices stayed so high for so long? Except for brief periods the P/E has been above 20 for twenty-five years! This has never happened before in U.S. markets.

‘This time is different’ is the battle cry just prior to bloodlettings. History doesn’t repeat itself, but it does rhyme. Each era of stock market history has different events moving prices. If you dig down you will find the differences are only cosmetic.

What drove stock prices in the past drive them today.

The P/E chart shows the ratio climbing steadily from the early 1980s until shortly after the turn of the millennium where it made traumatic moves as it settled into the lower 20s zone.

What caused this steady ratio increase? First, the increasing ratio means the stock market has been climbing faster than earnings for a long time. People are paying more and more every year for the same dollar of earnings. At first blush this seems insane. But there is a valid reason for the activity.

Inflation was rampant (double-digits) in the late 1970s. Interest rates were increased repeatedly by the Fed until borrowing costs reached well into the double-digits.

After years of high interest rates to fight inflation, the price of goods and services stopped the rapid climb. The back of inflation was broken. Price increases moderated. Each economic hiccup reduced price pressures further until the 2008 recession when deflation (declining prices) made an appearance.

With each step lower, interest rates dropped in tandem with inflation pressures. It’s been so long since we felt the sting of inflation most people investing today don’t remember what it was like. A certain accountant in the room does, though.

Inflation and Stock Prices

Many factors drive stock prices. Earning top the list. But what is the value of those earnings?

Why did investors pay less than 8 times earnings in 1980 and now pay close to 25 times? Investors today pay three times what they did in 1980 for a dollar of earning!

In 1980 inflation was high; today inflation is low, almost nonexistent, and has been for a decade.

Inflation drives interest rates. The higher inflation the higher interest rates will climb.

If prices are steady (no inflation or zero inflation) and a company grows earning 10% the future value of those earnings are worth their full value.

If the same company were operating in a 5% inflation environment the discounted value of those future earnings are reduced by half. (This is an over-simplification to keep our story moving. Each successive year earnings are reduced by the risk-free rate of return. It has a compounding effect.) That means investors will pay less for those earnings. This is why investors pay three times what 1980 investors did for the same dollar of profits.

Future Growth Problems

When inflation climbs, interest rates follow and hence the risk-free rate of return.

As interest rates climb on the risk-free alternative (Treasuries for U.S. business and investors) it gets harder to justify many projects considered for future growth.

Value is created when the return on invested capital exceed the cost of capital. The cost of capital on excess cash held by businesses is the risk-free rate. When Treasuries pay almost nothing virtually every project projected to show any return is viable. Increase the risk-free rate to 5% or higher and many projects no longer make sense.

Of course, a margin of safety will be added by the company. In a zero rate environment a company will not accept a project with a projected rate of return of 1% just because it exceeds the risk-free rate. They will need a margin of safety to account for errors in calculated returns and to compensate investors for the risk taken.

As rates rise and fewer projects are approved, the number of goods and services eventually declines along with the number of jobs until equilibrium is found.

What Could Cause Inflation and Lower Stock Returns?

For 35 years investors have watched stocks climb faster than earnings. Deflationary pressures were more common in the 19th Century as prices swung wildly with the economy’s ups and downs. Over long periods prices were stable with the exception of the wild internal fluctuations.

Refer back to the P/E ratio chart. You will notice three times in the last 150 years the ratio dropped below 10 for an extended period: after WWI, after WWII and during the late 1970s. The starting point of the chart showing a low ratio came right after the U.S. Civil War.

At first glance you might think war was the cause of low P/Es, but you’d be wrong. Then you might wonder why the most pronounced period of low P/Es was the only one not following a war.

Well, the 1970s low P/E ratios followed a long war in Vietnam. War seems once again the cause of a low market ratio.

War does funny things to an economy. Both World Wars had price controls as the U.S. dealt with the economic stresses of fighting the war. Pent up demand and a higher savings rate allowed people to chase goods and services they were denied for a period of time. Business ramped up production and prices stabilized. With prices under control investors calculated the future value of earning at a higher rate causing the P/E ratio to climb.

The 1970s had additional issues pushing prices higher. Spending to fight the Vietnam War primed the pump for price increases. The first oil embargo in 1973 sent energy prices rapidly higher. President Nixon took the U.S off the gold standard further unleashing prices as the Federal Reserve had no real limit other than self control on how much money they could pump into the system.

Stubborn inflation was pushed even higher with a second OPEC oil embargo in the late 70s.

Now inflation became entrenched. Killing the beast wasn’t going to be easy. People expected wages and prices to climb. It felt normal so the tendency was to push prices higher.

This may seem strange to people living in a world of remarkable stable prices. But that could all change and rather fast.

Fixing Inflation

Stagflation was a new animal for economists in the 1970s. A stagnant economy still generated large price increases. It made no sense.

The newly elected President Reagan had an idea. He built a tax cut around combating stagflation problems with supply-side economic theory.

Supply-side economics has received a bad rap at times, but it was the perfect medicine for low economic growth and high inflation.

What the 1981 tax cuts did was lower rates for business and individuals. This could cause inflation to flare higher. Buuuuuut . . .

For businesses some expenses are depreciated. Back then small businesses had to depreciate assets expecting to last more than a year and costing more than $100. This kept businesses from increasing production as costs came 100% out-of-pocket (or from borrowed money) while it took years to depreciate the entire asset.

What Reagan did was genius! Before the two big tax changes of the 1980’s small businesses could elect to expense assets (IRC Section 179) up to $10,000 with certain limitations instead of depreciating. The tax law was changed to increase this to $20,000.

Small business owners could now write-off more of their investments immediately. Businesses responded. Capital investments increased requiring more employees. The extra supply brought down pricing pressures.

Over the next decades Section 179 asset expensing was constantly increased until it was well into the six figures. Bonus depreciation is similar to Section 179, allowing for additional current deductions for asset purchases. Section 179 and bonus depreciation are so high now any further increases have no real effect at sparking additional economic growth.

Primed for Inflation

The medicine needed to kill inflation worked. Unfortunately, the same medicine was used again and again driving down inflation until deflation was the issue.

Supply-side economics has run its course until the next round of inflation appears. Supply-side tax bills don’t have the desired effect to the chagrin of politicians. Might I suggest to the elected officials in Washington to think of something new once in a while.

Back in 2008 the Fed’s balance sheet was under $1 trillion. It now stands at $4.5 trillion! This is one of the biggest, if the not the biggest, percentage increase in the nation’s money supply in such a short period. Even major wars didn’t create so much additional money.

Once again, this time was different in the details. All the excess money creation was sopped up by central banks around the world and the Fed. (Yes, the Fed holds much of its own money! The offsetting entry in the ledgers is held by the balance sheets of money-center banks to make them look solvent when they had lots of bad loans.)

Lots of new money didn’t cause inflation because it never hit the economy; it’s like it didn’t exist. Money in bank vaults might be a neat gimmick to make banks look sound during an economic crisis, but it does nothing to spur economic growth.

All the money in bank vaults didn’t disappear. It was waiting for a spark to be release it. That spark came late last year with the Tax Cuts and Jobs Act. Gas was thrown on the flames with an additional $400+ billion in new spending in a bill meant to keep the government open.

To Infinity and Beyond

The money is printed and the match lit. It is of vital interest to investors what happens next.

When the P/E ratio climbs as it has over the last 35 years the stock market advances at a rate faster than earning growth. The opposite happens when the ratio declines!

I have no crystal ball. Predicting where the stock market goes next is a fool’s errand.

With the facts listed above there is ample concern for an underperforming stock market for an extended period. Those most at risk are those in retirement, just entering retirement or retiring in the near future.

History is clear. Inflation causes higher interest rates and lower market multiples. Higher earnings can keep the market ratcheting higher, albeit at a slower rate as investors pay less and less for each dollar of earnings as inflation increases.

Excess money thrust into an economy has a high probability of affecting prices. The current economic experiment is gargantuan. The pile of new money waiting for freedom has a green light. As money flows through the economy at normal velocity, the effects of the new money are magnified.

It could be self-feeding; it could be an old accountant reading the tea leaves wrong.

Ah, who am I kidding? My cup of hot tea is just fine! Massive new spending by the government means the balance sheets at banks look better so they can now lend out all that money they’ve been dying to earn a profit on.

I don’t know the future, but I bet it’s going to be one helluva ride.

The Real Reason the Stock Market is Going Up

After nine years of steady growth in the economy and stock market both indicators have taken a sharp turn north. Economic stimulus in the form of tax cuts in an already good economy holds the possibility of destabilizing the whole economic structure.

There is ample concern over the staying power of the advancing stock market. Valuations are at or near record highs in all measures. All news seems to be good news. Predictions for future gains have reached nosebleed territory.

Investors need to know why the market is climbing so fast to protect their ass-ets. Those close to or in retirement need to take special precautions.

To accomplish the goal of explaining why the market is climbing I need to get technical. Numbers and charts have to be part of this discussion to understand why the economy and markets are behaving the way they are.

In the Beginning

A long time ago in a country close by there once was a housing bubble. The savings rate dropped to record lows while debt levels were growing more difficult to service. In 2007 the first cracks appeared under our feet and accelerated quickly.

Housing prices collapsed and the economy ground to a halt. There was real fear in the air. Many investors today have no idea what market fear means. Fortunes will be lost when the inexperienced get their first taste.

Congress passed several bills to protect failing banks. If not for these efforts we could have looked at an economic catastrophe similar to the early 1930s.

Fed’s Balance Sheet

Saving insurance companies, banks and car companies wasn’t enough to turn the economy around.

The Federal Reserve and central banks around the world dropped interest rates to zero or close to it without the intended results. The economy didn’t want to respond.

Some central banks experimented with negative interest rates. In the United States it came close. With exception for a few T-bills issued interest rates stayed a whisker above zero.

Draconian problems require draconian policies. The Federal Reserve started buying massive quantities of Treasuries (government debt). Normally the Fed buys and sells very short-dated T-bills in their effort to keep prices stable, employment full and adequate liquidity to keep the economy functioning smoothly.

Due to the high levels of purchases the Fed was making the purchases started to extend to longer-dated securities and mortgage backed securities.

The Fed’s balance sheet held $869 billion in assets on August 8, 2007. The balance now stands around $4.5 trillion. Yes, with a “T”.

Surprising Results

The Fed creates money as part of the debt process. When Congress spends more money than comes in from taxes the Fed can come in and buy some of those bonds and make a notation in their ledgers. This and the literal printing and coining of currency are how money is created. (I’ve greatly oversimplified the process of money creation. There are plenty of YouTube videos on the subject.)

Adding trillions to the Fed’s balance sheet (see Fed’s balance sheet chart) should have more than jump started the economy. Instead, all we got was an eventual crawl out of the Great Recession with modest, yet steady, economic growth.

Predictions were everywhere inflation would run rampant due to all this so-called money printing around the world. There was ample reason for the inflation fears. History is filled with instances where the money supply is increased significantly only to destroy the economy involved with uncontrollable increasing prices.

Why was this time different? There are no examples I can think of where this level of money creation didn’t cause an inflation shock.

Where Did All the Money Go?

With nearly $4 trillion added to the Fed’s balance sheet the economy should have boomed. In a way it did, but in a stealthy way.

Asset prices have been climbing. Housing in many parts of the country are at record highs. The stock market has added trillions to the net worth of investors.

Alternative investments sopped up some of the excess cash. Bitcoin is a good example.

But it wasn’t enough to account for all the “money creation”.

To understand what “should” have happened we need to look at some charts and explain some terminology.

There are different kinds of money in a way. The Fed tracks these types of money as M0, M1, M2 . . .

M0 is the currency and coins you hold in your wallet. M1 includes cash and checking accounts. M2 includes all of M1 plus bank CDs, money market accounts, mutual funds and bank savings accounts. Each higher level of “M” includes all of the previous categories of M plus increasingly less liquid assets. For our discussion we can stop at M2.

We also need to understand something called the velocity of money. Basically, the velocity of money is how many times money changes hands within a certain timeframe. Example: If all M0 changes hands eight times in the last year we say the velocity on this money was eight for M0.

There is also a multiplier effect when the Fed “creates” money. Banks are required to keep only a fraction of their deposits on hand while lending out the rest. This is called fractional banking and many people hate it with a passion declaring the downfall of Western civilization if it isn’t stopped.

Now that we have a few terms under our belt we can ask our original questions intelligently. Where did all the money go?

The short answer is all the extra money created by the Fed and central banks around the world stayed in bank vaults and at the central banks!

The necessity for increasing the money supply was to bail out faltering financial institutions! Banks had so many bad loans on their books they had to shore up their balance sheets so the Fed used various vehicles to get money onto their balance sheets so they appeared solvent.

Central banks around the planet also loaded up on sovereign debt, both domestic and foreign. Today, trillions of U.S debt is held by the central banks of foreign countries.

Who Moved My Money

The real reason the economic liftoff from the Great Recession was so slow was because the economic stimulus wasn’t as stimulating as it should have been.

With more money available than ever it sat quietly in bank vaults. Economic growth wasn’t fast enough to justify increased lending so banks kept their powder dry so the money never hit the broad economy. The slow trickle of funds into the “real” economy provided modest, yet steady, growth.

But even modest growth for long periods of time starts to add up. Unemployment dropped from double digits to four and change. Greed and distant memories of fear from the Great recession emboldened lawmakers.

Unsatisfied with modest growth they got greedy and wanted it all NOW! Tax rates were cut massively and the market was off to the races.

But there is an unspoken problem in the room. Remember all that money? To get it into the economy the Fed had to lower interest rates to zero for a very long time. If that money were to ever be unleashed into the marketplace bedlam could ensue!

And now banks for the first time in a long time see plenty of reasons to open the vaults and start pouring out the money. Fractional banking will do the rest.

Take a look at the charts for M1 and M2 money supply. M1 (currency and coins in your pocket) has climbed steeply from $1.4 trillion in late 2009 to over $3.6 trillion today. Cash and coins (literal money printing) more than doubled in eight years! The fractional banking system can convert this physical money into about five times as much additional digital money! M1 seems to be the main driver of the steady economic growth over the past decade.

Now look at the M2 money supply chart. The money supply rarely declines in the U.S. so don’t be alarmed by the upward sloping curve. M2 also grew rapidly since the Great Depression with just under a doubling in supply.

The money supply charts in and of themselves mean nothing. (Okay, they mean a lot. Just play with me a bit longer.)

Money supply is only one facet of the equation. How fast that money percolates through the economy also makes a difference.

Look at the M1 velocity of money chart. The number of times currency changed hands in a year declined heavily since the Great Recession. Some readers will find comfort we are back to numbers similar to the 1970s. Don’t be.

Part of the reason the M1 velocity of money changed over time is due to how we spend. We spend with our debit and credit cards so cash starts to move less leading the Fed to print less currency as a percentage of the total money supply.

As less actual currency exists it tends to move faster as we saw in the economic boom of the 1990s. M1 velocity declined since the Great Recession due to additional supply, potential hording and reluctance to spend over fear of returning economic hard times.

More current data suggest M1 velocity is starting to increase. (Sorry, no chart.)

Finally, look at the M2 velocity of money chart. When you look at CDs, mutual funds and other bank deposits the velocity of money (M2) hit lows since records were kept.

Now think of this. If all the money tucked away safe and sound is unleashed on the economy what do you think will happen? Regardless what you think the unleashing has begun!

The only way for the Fed to sop the excess money out of the system is to keep raising interest rates. It could take equally high rates to equalize the supply and demand of money as it took for low rates to kick-start the economy.

With unemployment near 4% it will be hard to fill positions created by the rapidly expanding economy. This will require wages to increase (a good thing) while forcing prices to climb in tandem (not as good as wage increases).

Higher inflation requires higher interest rates. The good old days of zero percent rates is about to disappear.

What Does This Mean for the Stock Market?

Equities are on a sugar high right now. Low interest rates and inflation coupled with growing profits is the perfect recipe for substantially higher stock prices. But we have a problem.

The stock market had a few hiccups this week as interest rates on the long end of the curve are rising sharply in anticipation of what I explained above. The Fed will have a hard time controlling the long dated Treasuries. Investors will sell until rates increase to a level commensurate with the inflation risk of their income stream.

The stock market is in for a rude awakening as well. The Goldilocks economy has been over-stimulated. And as with any drug overdose the other side is filled with pain.

Interest rates and inflation are still low. That can change fast. As the massive quantities of money finds its way into the general economy from bank vaults and as fractional banking multiples the effects, the economy is sure to grow in at least nominal terms. Inflation is sure to follow unless you think this time is different.

A mere 3% or so growth rate the President promises isn’t enough to deal with all the excess money. I played with the numbers (back of the envelope) calculating what would happen if money started to move like it did in the early 2000s and the banks started lending all the extra money they’ve been holding in reserve. I come up with a U.S. economy at least double the size it is now (~$20 trillion) to as much as $64 trillion.

These are staggering numbers requiring massive growth in the economy coupled with significant inflation. The Fed may have no choice soon to raise rates faster or risk losing control on prices.

The next few years are going to be interesting. The grand experiment undertaken during and after the Great Recession has another side, a side we are about to enter.


Why Does the Stock Market Tend to Struggle in High Interest/Inflation Environments?

Before we finish I want to outline why the market tends to have an initial upward thrust before falling sharply in environments similar to the one we are currently in.

There are two reason markets struggle with high inflation and interest rates. The first deals with value. Remember the definition of value creation:


where the return on invested capital exceeding the cost of capital equals value creation.

As the cost of capital increases fewer deals get done because they are less profitable than parking the money in a risk-free investment, generally Treasuries. Fewer deals mean less economic growth eventually until the economy cools and we wait until another generation of uninitiated makes their debut.

The second reason stocks suffer in high interest/high inflation environments is the quality of earnings. When inflation is low interest rates tend to be the same.

If a company is generating 10% profit growth steadily with zero inflation and increases their growth rate to 15% with say 7% inflation, the earnings are worth less.

Either way equities suffer. With the amount of money we know exists out there, what it takes to suck it out of the economy and with the likelihood the velocity of money returns to traditional levels, inflation issues are probable.

Any readers remember the 1970s and stagflation? I do. I was a wee tyke, but I remember.


There is a lot of money out there looking for a home, kind readers. When a portion settles into your account the only question will be: How much will it be worth?


How Fast Does Inflation Rise?

U.S. Yearly Inflation Since 1900Media continually warns of impending inflation due to all the money printing by central banks around the world. The concern is real. If inflation spikes bonds will suffer massive loses and stocks will also suffer a painful decline. It is past time we look at the facts about inflation, how fast it rises, and what causes prices to spike.

Planning for retirement and when reviewing investments, inflation is a consideration. A review of historical inflation data will help in the decision-making process. By reviewing the historical data also clearly shows why inflation accelerates, including solutions to protect yourself. We will focus on inflation data in the U.S. I have reviewed price data for other countries and further back than the U.S. data. The conclusions are the same.

Recent Inflation/Deflation Dilemma

The current deflation started in the stagflation days of the 1970s. Back then unemployment and inflation were both high. Economists were beside themselves on what to do. How can you have high inflation (caused by excess demand) and high unemployment (caused by low demand)? Except they had it all wrong. Demand was high and businesses were not incentivized to increase production, thereby creating high unemployment and high inflation at the same time.

Paul Volcker at the Federal Reserve and President Reagan applied a two-prong approach. Volcker raised interest rates to kill inflation and Reagan pushed supply-side economics through Congress, providing tax incentives for businesses to ramp up production. It took time to steady the economy, but within two years inflation was down and the economy was humming.

Supply-side economics has been in vogue since the success of the early 1980s. Unfortunately, the medicine required by the economy back then is different from today. Supply-side policies puts downward pressure on prices as it encourages more production. The economy today needs the incentive of mild inflation. Worldwide production potential will keep a lid on prices for the foreseeable future. As much as we all like tax cuts, they will not salve the woes of low inflation or deflation. Supply-side policies have gone as far as they can and may do more harm than good if pushed further.

Where Did All the Money Go?

If central banks around the world have printed so much money, where has it gone? Trillions of dollars, euros, yen, et cetera, should have caused massive price increases. The reason inflation has not accelerated is because most of the money printed sits in bank vaults of money center banks and at central banks around the world. The additional money created was used to improve balance sheets of banks. Money not in the system cannot cause inflation. You can see this in the velocity of money numbers. Historically each dollar changed hands about 16 times per year. That number is now around 4, lower than during the Great Depression. If velocity increases to historical norms inflation is sure to follow since the Federal Reserve increased their balance sheet from $800 billion to $4.5 trillion.

InflationChartSpeed of Price Changes

Prices have fluctuated wildly in the past, oscillating between bouts of inflation followed by gut-wrenching deflation. The illusion of modest price increases over long periods of time is recent. The bout of inflation in the 1970s was not followed by deflation until now, 35 years later. Inflation has remained steady under 4% for most of the last 35 years.

Price changes tend to be orderly under normal circumstances. It takes a shock to the system to send prices rocketing higher. The backside of an inflationary spiral is a deflationary period allowing prices to find an equilibrium. The recent deflation in the U.S. is mild compared to price declines of a century ago.

Official inflation records began in 1913 in the United States. The numbers I use here are the change in prices from the same month the prior year. I’ll start at the beginning. The U.S. decided to start tracking prices due to inflation caused by World War I. In September of 1915 there was mild deflation at -1.0%. By October 1916 inflation reached double digits at 10.8%. In April of 1917 the U.S. entered WWI with inflation hitting 20.4% in June of that year. Then the war ended and the expected deflation arrived. It took a while for inflation pressures to subside. Inflation for 1920 was still a whopping 15.6% as the returning troops increased demand for consumer goods. The next year prices declined 10.5% followed by a 6.1% reduction in prices of goods and services in 1922.

The remainder of the 1920s inflation picture in the U.S. looks a lot like the last decade of price changes today. Inflation in the U.S. from 1923 to 1929 was modest; 1925 had the largest price change with inflation at 2.3%. 1925 was the only year with no month of data showing deflation during the 1920s.

Rising prices are new to people who don't remember the recent past or 1970s. Prices can climb rapidly once pushed by a catalyst. Once prices start climbing, it's hard to slow them down. #prices #inflation #yieldcurve #interest #inerestrates #wageinflationThe shock of the Great Depression kept prices falling. It took until WWII for inflation to make any kind of showing. WWII had inflation, but the real inflation came after the war, similar to WWI, when the troops returned home and ramped up demand. 1947 saw 14.4% inflation.

The 1950s and 60s were a time of modest price changes. The difference was the lack of any real deflation after WWII. Cumulative price increases became large as prices never adjusted back down due to the Federal Reserve providing additional liquidity to the system. This was done out of fear the Great Depression would resume after WWII spending ended. The recession of the early 1950s only pushed prices lower from September 1954 to August 1955. Vietnam War spending caused inflation worries toward the end of the 1960s.

The money supply growth, government borrowing, and Vietnam War spending only caused 5-6% inflation in the early 1970s. It took a shock to the system to ignite the inflation most readers are familiar with. The first oil embargo pushed consumer prices up 11.0% in 1974. Inflation pressures soon eased to 4.9% in November 1976. The second oil embargo reinforced the inflation pressures supported by past government money printing, borrowing, and spending. Double digit inflation for calendar years 1979-1981, were the worst since WWI at 11.3%, 13.5%, and 10.3% respectively.

That is where we came into this story. Fed Chairman Volcker and President Reagan broke inflation and stagnant economic growth with their one-two punch and for 35 years we have seen declining inflation and lower interest rates. Never have prices been so stable since records began in the U.S.

We fear deflation—and rightfully so—even having never experienced serious deflation in our lifetimes (unless you are a very old reader). Inflation pressures have not ignited for a long time. The charts on this page clearly show we are lucky to be living in such stable economic times. Those times could be ending soon and here is why.

The Rise of Inflation

Prices bounce around modestly as sellers try to get more for their goods and services and buyers try to get the best value for their money. Inflation arises when buyers become scared good and services will not be freely available in the future or the price will likely be higher later. This causes an inflationary spiral. It takes more than a nudge to get inflation feeding on itself. War is the biggest catalyst of previous inflation. Even the 1970s inflation sparked by the OPEC oil embargos was fueled by a decade of massive government military spending.

Your investment portfolio counts on prices remaining relatively stable. Slight inflation, say the Federal Reserve’s 2% target, seems to be a Goldilocks zone for maximizing economic growth incentives for businesses and consumers. Slight deflation is more painful than slight inflation as even modest price declines quickly feed into a ‘wait until tomorrow’ attitude for buying.

The real question centers on how to determine when inflation will rear its ugly head again and the steps necessary to protect your net worth from the consequences. Past bouts of inflation provide valuable lessons. Deflation of -1.0% in September 1915 turned into double digit inflation in thirteen months. WWII had similar results. The 1960s saw inflation pressures building slowly without a spike in prices; the inflation was annoying, but not destabilizing. Annual inflation in 1972 was 3.2%, by 1974 it reached 12.3%.

The lesson to learn is that inflation, when it happens, happens fast and then burns itself out after a few years as consumers lack the money to keep pushing prices higher. This time could be different as the amount of money created is larger than any time in modern history. Out of control money printing reminds us of Germany between the wars or Zimbabwe. I am unable to find any instance where a world power, along with most of the rest of the world, engaged in such massive money creation.

One thing is certain, inflation will come again. Will Durant, the great American philosopher, said history is inflationary. My research affirms his statement. Inflation has a tendency to recur. We are overdue. All the pieces are in place for a massive inflation spike. All we need now is a spark.

MoneyHiding Places

When you see the spark ignite the first one out the door wins; the rest get trampled. Bonds will get killed in an environment of rising prices. Stocks suffer, too. Until Chicken Little starts screaming about the sky, index funds are about the only game in town. Inflation, when it returns, will require a powerful response from central banks. Moving money from equities to short-term bonds of safe sovereign debt when inflation returns is the only alternative until price begin to ease and equities are the place to be again. Or you can ride out the storm in equities. Companies will bust tail to protect their interests. The stock price will not reflect all the value created by companies, but the dividend yield should expand, providing ample cover until the dust settles.

Perhaps the only choice is an index fund and wait. Nobody can predict the next inflation outbreak until it is well on its way and then it is too late. Since businesses will protect their interests, and hence investor’s interests, it is best to keep your money with the largest and most successful enterprises on the planet.



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