Inflation, Supply Side Economics, and Your Investment Plan

 In Financial Planning, Investing

This post is a revised version of a commentary published on the Texas Public Policy Foundation site. Photo by Rock Staar on Unsplash

“Inflation is always and everywhere a monetary phenomenon.” This statement by Nobel Laureate economist Milton Friedman is true today as it was when he first made it in 1963. It’s that simple. If the quantity of money grows faster than the quantity of goods and services the economy can produce, we will experience inflation. While the U.S. money supply increased by 40% between March 2020 and February 2022, the real gross domestic product (GDP) increased by only 3% over the same period, and it has been declining this year. With such an unprecedented discrepancy between the growth rate of the money supply and the real growth rate of the economy, we can expect inflationary pressures to continue.

Supply Chain Issues

How did we get there? We hear a lot about supply chain problems, barriers that reduce the production and the distribution capacity of economies worldwide. These barriers were imposed by governments as a response to the COVID-19 pandemic. And while the initial lockdowns were supposed to last two weeks, many of the restrictions are still present in many parts of the world, including the U.S., which has recently extended its COVID-19 public health emergency.

At the same time that supply has been constrained, the Federal Reserve and Congress worked together to support aggregate demand by households and businesses. While the Fed was pumping money in the economy to the tune of 40% growth in two years, the federal government increased unemployment insurance, gave subsidies to businesses to reduce layoffs, and sent stimulus checks to households, among other measures. More than $4 trillion was allocated to COVID-19 related measures. As comparison, the stimulus bill enacted during the financial crisis of 2008-2009 amounted to about $0.7 trillion.

Putting it together, the economy experienced a contraction in the supply, largely induced by government lockdowns (justified or not), and an unprecedented stimulus to aggregate demand. High demand and limited supply will generate inflation in proportion to the magnitude of the imbalance between the two.

At this point, only an increase in the supply of goods and services can reduce inflation. After all, paper money only has value if we can use it to purchase real goods and services. To produce more, we need to increase the productivity of our economy. However, all the policy actions taken so far are demand-driven policies that have the effect of increasing demand and restricting supply.

Demand vs. Supply Driven Policies

The Inflation Reduction Act increases corporate taxes, gives subsidies for the adoption of renewable energy sources, and extends health care premium subsidies for people who stay out of the labor force. An increase in corporate taxes reduces profits for corporations and households and reduces the incentives to save and invest, a well-documented result from supply-side economics. Lower investment levels slow the growth rate of GDP. Subsidies for renewable resources are a form of industrial policy that displaces resources from high value uses to lower value uses (if not, why do you need the subsidy?), and reduce wealth. Finally, the extension of the health care subsidy is a direct disincentive to work, which lowers the labor force participation, and therefore GDP. The total spending from the bill is estimated to be about $500 billion including subsidies. Economic models show that while the bill may increase net government revenues, it will lower real GDP, personal income, and employment, and may actually increase inflation (despite the name of the bill).

Add to this the $1.2 trillion infrastructure bill, the $280 billion CHIPS bill, and the $300 billion student loan forgiveness program. These are all demand policies that will add to inflationary pressures. What is left to counter inflation? The self-adjusting mechanism of free market economies. The people who make, buy, ship, and distribute goods, organizations like Walmart, Amazon, Tyson, and UPS will solve supply chain problems—not increased government spending, which can actually harm this process.

The Federal Reserve and Congress can help by limiting the growth in the money supply and adopting supply-side policies that remove barriers to the productive capacity of our country. These include restraining government spending, eliminating COVID-19-related subsidies and disincentives to work (such as the ACA premium subsidies), making the tax cuts of the Tax Cut and Jobs Act of 2017 permanent, eliminating the barriers to growth in the domestic production of natural gas and oil enacted in the last two years, and eliminating costly subsidies for the adoption of renewable resources, and significantly increasing legal immigration. These supply-side policies will unleash the productive power of the free market system, which is the most effective cure for inflation.

Inflation and Financial Planning

The supply side approach has not been the focus of this administration. With Congress focusing largely on demand driven policies that can make inflation worse, the job of containing inflation is left to the Fed and the free-market system. Ou research shows that investors should expect lower returns from financial markets in periods of heightened inflation. Investors should build their investment plans with the possibility that market returns can be below the historical average. Planning for lower returns means planning for higher savings or greater flexibility about goals. For example, increase your savings by 1% of your income, plan to retire a year later, and reduce your expected expenses in retirement by 2%. There are many factors that can affect economic growth and inflation over the next few years. With this approach, you will be better prepared if returns continue to be below average for a while. And if returns are better than expected, you will have learned to save more and be ahead of your goals. A win-win situation. For some tricks and tips to help you save more, check our article on the subject.

Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC.  He is also a lecturer of finance and economics at Texas State University. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives.  As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.

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