Inflation, Deflation, Bailouts & Tax Increases! What Should We Expect?

Inflation, Tax Strategies, U.S Investments

What is happening is unprecedented! Two multi-trillion-dollar bailout packages in less than a year and a third in the works.

The Charlotte Business Journal reports:

“In the past few years, we have experienced three major tax and financial changes that we typically only expect once a decade.

…. This year, we are expecting another major bill (if not multiple) to be signed that may affect how you wish to structure your finances.”

What should we expect?

Keeping score is hard enough; however, the main concern for all of us is what can we do? Should we expect inflation, deflation, a booming economy, a bust, or all of the above?

Dr. Lacy Hunt, co-authors the Hoisington Investment Management Quarterly Review and Outlook. His opening line in the First Quarter 2021 report grabbed my attention:

“Contrary to the conventional wisdom, disinflation is more likely than accelerating inflation.”

Like the old E.F. Hutton commercial, “When Lacy speaks, I want to listen!” It’s always a great learning experience and I asked him to share some thoughts with our readers.

DENNIS: Once again Lacy, thank you for taking your time for our reader’s benefit. Many pundits are predicting inflation. You said:

“Since prices deflated in the second quarter of 2020, the annual inflation rate will move transitorily higher. …. The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation.”

Our readers probably understand inflation; a rapid escalation in wages and prices. They would see it every time they buy something.

Before we get into predictions, please define deflation and disinflation?

LACY: Dennis, thank you for the opportunity to speak to your readers.

Disinflation is where the rate of price increases slows. Deflation is the special case of disinflation when the rate of price change falls below zero.

DENNIS: So, disinflation is like lower interest rates; whereas deflation is like negative rates? In deflation, prices and wages would be going down?

LACY: Correct, disinflation means the rate of inflation is coming down. Wages and prices may still be rising, but at a slower rate. During deflation, prices and wages are falling.

DENNIS: In your report, you brought up something I hadn’t thought of:

“Restoration of supply chains will be disinflationary. Supply chains were badly disrupted by the pandemic. Low-cost producers in Asia and elsewhere were unable to deliver as much product into the United States and other relatively higher cost countries. This allowed U.S. producers to gain market share.

…. The low-cost producers will want to regain market share while the high-cost producers whose fortunes were unexpectedly helped will try to hold market share. Bottlenecks are widely prevalent at U.S. ports, reflecting the incoming surge of goods. This will lead to price wars.”

Should this lead to disinflation; the inflation rate slowing down?

LACY: This should be apparent later in the year after the supply chains are restored and the prices rise temporarily as the economy experiences a reopening effect. Price wars slow down the inflation numbers.

DENNIS: You mentioned inflation is a lagging indicator. Does that mean we will see and feel it, long before it is confirmed by the government?

LACY: Since the end of World War II, the low point in inflation has occurred about 15 quarters after the start of the recessions. In some important cases, the increase in inflation is so muted, inflation remains low to what economists call the trough, or cyclical low.

To answer your question, when inflation increases rapidly the consumer will see it ahead of government reports.

DENNIS: We discussed the short-term effects of the Obama bailout, Trump tax cuts, and diminishing returns. Please explain that to our readers.

LACY: When a factor of production – capital, natural resources, labor – is increased, economic output initially rises, but continued use of that factor will lead to diminishing return.

The US and most of the other major economies of the world are greatly over-using debt capital, with the result that the rate of growth in economic activity is falling, which means the rate of growth in the standard of living is also decelerating.

DENNIS: I want to be sure I understand this. I always looked at growth as a business growing and selling more products or services.

The bailouts and tax cuts pumped money into the stock market and economy.

You said growth in economic activity is falling, which means the rate of growth in the standard of living is also decelerating.

During boom times, companies are building new factories, hiring more workers and corporations make more profit because they are selling more goods and services. Since the 2008 bailouts, have we seen real corporate profit increases?

LACY: No. After-tax profits, when adjusted for inflation, in 2020 were unchanged from eight years ago.

DENNIS: Some time back I wrote about how corporations were binge borrowing to buy back their stock, sometimes at an all-time high. Historically they borrowed to build new factories and invest in other ways to grow their business as opposed to buying back their stock. Stock buybacks were out of profits, not borrowed money.

Does slow growth mean no real increase in demand for their goods?

LACY: The rate of growth in business fixed investment, adjusted for inflation, has fallen far below the historic norms. In turn, this diminishes the prospects for a normal gain in the standard of living.

DENNIS: We recently had the first Biden stimulus package and potentially another to follow. In the next breath, we are reading about some very large tax increases. What should middle-class America expect when the two are mixed?

LACY: The main effect will result from the higher corporate taxes. Ultimately households pay corporate taxes even though the corporations collect them. With limited pricing power, corporations will be forced to bring in more robots and/or shift jobs to lower-wage economies overseas.

DENNIS: Several years ago, I had breakfast with a ranking senator on the finance committee. He candidly admitted that politics trumps economics.

If corporate taxes are increased, one would assume those increases would be passed on to the consumer. Some politicians say no. If we head into price wars as you mentioned, wouldn’t increasing prices cause US corporations to lose market share; particularly to foreign companies?

LACY: Absolutely.

DENNIS: During my career, I served as a consultant to 40 of the top 500 US corporations. When their profits were threatened, their first course of action was to try to increase prices. In a price war, and no real increase in demand, that would be a recipe for disaster; they could lose market share.

Concurrently they would seek ways to cut costs. They could invest in better technology seeking ways to reduce their cost of materials and labor – sometimes moving jobs to different countries.

Let’s face it, stockholders demand those running the company do what they must to produce profits and a good return on their investment.

Many feel they can cost cut their way to prosperity. If they can’t raise prices, wouldn’t that affect American workers in other ways?

LACY: It already has. Real per capita GDP grew 2.2% per annum from 1870 to 1997. But since then the gain is only 1.4% per annum. If we had been able to grow at the historic rate since 1997, real per capital GDP would have been 25% higher than it actually was.

When it comes to the economic bailouts, it is the law of diminishing returns. Until there is real growth, boom times where corporations are selling more goods and building more factories, our real per capita GDP will continue to slow.

DENNIS: One final question. If I were a pilot, I would suspect some real turbulence ahead. Inflation may not rise as high as some predict. The never-ending bailouts will have little effect. Investors nearing retirement will see the rate of change move even faster.

Fixed interest rates are so low, they provide minimal income. Lacy, it always comes back to diversification; own some inflation protecting assets and investing conservatively in assets to provide income and growth.

In addition, you can’t be passive; the changes are coming quickly and you must stay ahead of the game.

Did I miss something?

LACY: Sound advice. Those that do as you suggested will fare better than most.

DENNIS: On behalf of our readers, thanks again for your time.

LACY: My pleasure.

Dennis here. Lacy is a true economist who does his homework and is a straight shooter. He shares our concerns about how Baby boomers and future generations are going to provide for themselves and their families, now and in the future.

I urge all readers to sign up for their FREE publicationHoisington Quarterly Review and Outlook. The in-depth analysis and commentary is not something you will find in many places.

While Lacy is not expecting the high inflation many of us are, our strategy will not change. As we outlined in our recent article, diversification and staying on top of things is a must. I’m not selling my gold, that’s for sure!

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