If Inflation is bad, why does it feel so good?

People love getting raises.

Seeing a rising account balance fills them with joy.

We live in a seductive world of increasing prices, and it influences our behavior in dramatic ways (some not so good).

As investors looking to “get ahead”, we need to avoid being lulled into a false sense of progress. To achieve and sustain Financial Freedom, our capital must be grown faster than inflation can erode it.

As a student of Inflation, I seek to understand the enemy while becoming aware of the psychological impact it has on my decision making.

Know thy self, know thy enemy. A thousand battles, a thousand victories. -Sun Tzu

Instead of “protecting” or “hedging” (playing defense... yawn), learn how to harvest Inflation directly (playing offense) for predictable profits.

But isn’t Inflation bad?

Wouldn’t any increase in wages, be cancelled out by a respective increase in prices for the goods and services we consume?

Probably, however…

We “consumers” don’t seem to mind it for three reasons. But before outlining those reasons, it is important to clarify something…

We’re not referencing Venezuelan-flavored Hyperinflation, where the price of dinner can double between breakfast and lunch. (This is a very different situation altogether). We’re instead speaking to the slow, yet relentless, inflationary experience of all Americans living today. After all, Inflation is arguably one of the most stable, reliable and government sponsored trends in economic history.

Here are the three reasons inflation feels so good:

Reason #1: Wage Increases Always Increase Relative Buying Power (in the short run)

While price inflation is constant and gradual, a raise is usually an instantaneous event.

Perhaps this explains why so many people are grateful for an overdue raise.

But the timeliness of those pay increases can be the difference between falling behind or getting ahead.

Let’s think about two employees that work at the same company.

They both get paid a fair market rate over their career and have the same Cost of Living expenses. However, one is “getting ahead”, while the other one is constantly “falling behind”.

If you are a wage earner, try to picture which best describes you.

Tommy Go-Getter vs. Agreeable Adam

Tommy Go-Getter, an assertive achiever, is highly valued by his employer and receives a 4% increase EVERY year. Tommy’s pay increases by 4% overnight, yet, his Cost Of Living is about the same since yesterday.

He experiences an instant relative buying power increases of 4% within 24hrs.

Moreover, people like Tommy who get raises proactively tend to experience a real increase in buying power.

As you can see in the diagram, Tommy’s buying power is highest for several months after the raise before inflation eventually catches back up with him. This small window of time allows Tommy to get ahead!

Conversely...

Agreeable Adam is a solid performer; however, he doesn’t communicate his value. Luckily his employer finally acknowledges his contributions after 3 years by bumping his pay an impressive 12%.

Pretty great, right? No, not great at all.

Agreeable Adam’s relative buying power ALSO instantly increases overnight. He is incredibly grateful and joyous for his whopping 12% raise.

He is simply catching back up. Compounding the problem further, he isn’t getting back pay for lost earnings in the prior 3 years.

If you are a wage earner, one of the best ways to “get ahead” is to make sure you get raises early and often. As prices are always increasing, you should be looking for more frequent ways to increase your earnings vs. waiting for your ship to come in. Are you listening starry-eyed Tech Startup employees?

Earning-bumps may be the most critical recurring event we need to capitalize while on the path to Financial Freedom. They represent fleeting opportunities to up our savings rates without upending our lives.

Inflation Bonus Tip: Even if you get raises that are in line with inflation, (if possible) negotiate to get them earlier and more often. Second, Inflation is coming for us all! Get that money invested before inflation catches up with your ability to save the surplus.

Reason #2: Not All Prices Go Up All the Time For Everyone

There is no average inflation of everything.

While over longer periods of time inflation is undeniable. It can be hard to observe in the short run.

The prices of certain types of goods tend to be more or less correlated with Wage Inflation. For example, in our research, we have found that housing costs are very tightly tethered to wage inflation (which is one of the reasons we use Median Wage data to inform our real estate valuation models).

Other types of prices can actually experience persistent deflation (drop in prices) overtime.

Technology and globalization, for example, are both massive deflationary forces driving down the price of certain products. Technology increases our productivity and globalization gives us access to more competitively sourced goods.

Remember when a 40” flat screen Plasma TV cost $4,000?

Deflation can often hide in plain site.

Certain products seem to cost more, but we get way more for our dollar in terms of quality and features.

A great example of this is the price of the common car. When you adjust for the amount of life saving technology installed in cars today versus 30-40 years ago, the price of the car has barely increased (and may have decreased).

Other types of prices can seem random all together, like commodities (gasoline, coffee, corn, beef). This is because these types of goods can be highly impacted in the short run by supply and demand forces and market fluctuations.

One interesting example has been the short run profitability that many high end steakhouses enjoyed over the past few years. A steady increase in nominal wages allowed them to command higher menu prices, while falling beef costs helped them achieve exceptional profit margins.

Because of this dispersion in prices, there is great debate about how to measure and benchmark inflation and COLA (Cost of Living Adjustments).

Inflation ends up being fairly personalized. Which products do you use and in what percentages? It is entirely possible for one neighbor with different purchasing habits to experience deflation while the other experiences inflation. Sound far fetched? Here are some examples...

If you drive for four hours to work and back each day, you may feel extreme hardship from a 40% increase in fuel costs. However, if you are a very wealthy technofile, the market keeps over-delivering more gadget per dollar.

To drive this point home, I dug up the price of an Iphone over time and compared this to the median income of Americans over the same time periods. I then analyzed the feature set of the Original iphone(2007) to the iphone X (2017).

In 2007, the median american family raked in about $51,000 and would have needed to spend roughly 1% of income to purchase the base iPhone model.

Ten years later in 2017, the American family increased their median earnings to about $62k and would need to spend about 1.5% to get the base iphoneX model.

So, it appears that the Iphone is about 50% more expensive relative to wages.

But look at how much more powerful the product is….

Inflation Bonus Tip: New tech is often a better value even if a higher absolute price. For an even better value only buy the best of last year’s tech.

Reason #3: We are heavily swayed by ABSOLUTE numbers (not percentages)

We only notice the large changes, missing or marginalizing large % changes on low ticket items.

When our paycheck increases by 4% a year, we experience the joy of multiplying a small number (4%) by a big number (your current salary).

If you make $100,000 base salary, then a 4% raise represents a boost of…

$4,000 a year (a new hot tub) or

$333 per month (a car payment on a depressingly boring car) or

$167 bi-monthly (almost-fancy date night with your spouse twice a month)

Because our paychecks tend to be larger than the things we buy (if not, you're doing it wrong), we miss the relatively small absolute price increases spread across the hundreds of small purchases we make.

For example, when the price of milk increased by 10-15 pennies this year (2019), we don’t notice (or care). In fact, I buy milk all the time yet had to look up what it cost (further proving my point).

Milkflation? U.S. Bureau of Labor Statistics | Division of Consumer Prices and Price Indexes

A keen eye will notice that milk prices actually decreased from $3.57 to $2.91 from Jan 09' to Jan 19'. This was due to both natural short term supply/demand impacts as well as changes to subsidies to dairy farmers. This is another reason I prefer to look at Nominal Wages to get a more stable Inflation measure. The price of milk is definitely increasing despite short term noise. 100 years ago an entire gallon of milk only cost 9 cents according to the Census Bureau (1915).

Our Brains On Inflation...

Humans are pattern recognition machines trying to predict what is coming next.

Living in a world of ever increasing prices, from assets to paychecks, emboldens us, altering our attitudes and thus financial decision making.

Rising prices help validate our past decisions and increase confidence in the future.

I have even experienced this phenomenon on a small scale built into the 401k reporting at my first job (and I think brokerages do this on purpose!).

When I first started investing, my bi-monthly account contributions dominated the total value of my account.

Even through periods of significant out-performance or under-performance, the tiny profit/loss changes were just white noise in my account.

No move in the markets could come close to amplifying or stalling the growth of my account every two weeks.

The net result… a beautiful chart that starts at the bottom left of my screen and ends in the top right (regardless of market environment).

My savings were acting like an artificial account inflation mechanism.

Nothing would give me greater pleasure than seeing a higher balance every time I checked.

I noticed that I would have this feeling regardless of my underlying rate of return; Even if it was negative.

Simply experiencing the increased value provided me with a tiny hit of dopamine, reinforcing my brilliant decision to max out my 401k contributions (don’t worry, this worked out great for me).

I remember how effortless it was to hold aggressive investment allocations because even large % changes in my holdings were small in absolute dollar terms compared to my savings rate. For example, if you are adding 20k a year to your 401k (with matching) you would completely “smooth out” a 20% drawdown on a $100,000 account.

However, after several years of aggressively saving and diligently compounding, my account had grown large enough that it was not uncommon for my balance to rise or fall by an amount equal to my monthly take-home pay on any given day.

Even though I was still maxing out my 401k, the daily change in the underlying holdings now dominated the account value. I now needed to channel a Warren Buffet-like fortitude to hold the same exact allocation compared to years earlier.

We all experience a false sense of progress when living through perpetual price inflation. An entire society grows more confident on a diet of increasing prices. Businesses and Investors take more risk while consumers save less, borrow more, and spend it all. (After all, we’ll get a raise soon to pay for it.)

And so we go on happily and naturally stimulating the economy.

Perpetual Inflation is Government Sponsored Policy

Inflation has been arguably the most reliable and consistent trend over the last 100yrs. The odds are it is here to stay.

Even if you don’t understand all the factors that drive inflation (anyone who says they do, doesn’t), it is hard to ignore that every modern government has adopted inflationary monetary policy.

To fund deficit budget spending, the world’s governments need to borrow money and (attempt to) pay it off through a combination of taxes and currency deflation tactics.

Case in point, the US Federal Reserve has a specific mandate to maintain a 2% inflation target. They believe this is a healthy level for the economy and I think it is easy to see why.

Getting Ahead (of inflation)

Investors who want to “get ahead” need to understand that success is measured against inflation.

Even if you already “won the money game” and are only focused on preserving your wealth… you need to make sure you grow it at least as fast as inflation.

Don’t let a steady stream of increasing prices over the long run lull you into a false sense of progress.

The next step is to stop viewing inflation as the enemy. The Dollar’s relentless erosion represents one of the most powerful and persistent trends that investors can harness for predictable (inflation crushing) profits.