Tackling Questions About Inflation

We look at 10 burning questions about inflation, including why it's so high, whether it's worse in the U.S., and what can be done about it. And Fool analyst Aaron Bush answers a listener question about choosing the new Bitcoin futures ETF over actual Bitcoin.

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This video was recorded on Nov. 15, 2021.

Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick and I'm joined by Robert Brokamp, personal finance expert, here at the Motley Fool. This week, all anyone can talk about is inflation and that's us, too. All that and Bitcoin on this week's episode of Motley Fool Answers.

What's everyone's aberration fixation causing consternation and an inflammation of economist contemplation? As we consult the CPI fluctuations and supply chain limitations for causation. It's inflation, but what does that mean for your allocation and financial vexation? Will it all result in devastation? Calm your palpitations because Bro is here with his ruminations. One take. I have a few sometimes embarrassingly simple questions about inflation and luckily I have a Bro to deliver me some answers. Last week inflation concerns hit a fever pitch as the Bureau of Labor Statistics announced that the consumer price index rose 6.2% in October. Now, let's be clear, that 6.2% compared to the previous year, not 6.2% over the month but this is still the largest rise in three decades. Side note. The older I get, the less outrageous three decades sounds. The '90s were not that long ago. Tell me something hasn't happened since the '70s and I'm going to sit up. But the '90s, I mean, oh, man, Bro, is Nirvana considered oldies now?

Robert Brokamp: I sure as a helicopter hope not.

Southwick: Oh, jeez. Anyway, I have questions, I can depend on you Bro for answers. Let's get into it, shall we?

Brokamp: Let's do it.

Southwick: Here we go. Remember how I said some of the questions were going to be a bit embarrassing? What is inflation?

Brokamp: [laughs] Well, inflation basically is the rise in the prices of goods and services offered for sale. Now, given that there are hundreds of millions of things and services you can buy nowadays, measuring it can be a little challenging and frankly, somewhat debatable. The federal government attempts to measure inflation via two primary gauges, which then can be further parsed if you want to. You mentioned the consumer price index, which actually comes in a few flavors, but the figure most commonly sighted is the CPI for Urban Americans, known as the CPIU, which covers about 93% of the U.S. population. That's calculated each month after the prices of approximately 80,000 items are collected via surveys. Just imagine that. It's someone's job out there to call out businesses and find out how much they're charging for things. The other primary measure of inflation is the Personal Consumption Expenditures Price Index, also known as the PCE. That's actually not as high these days. It comes in at 4.4% over the previous 12 months. The Federal Reserve's preferred inflation gauge, which is the Core PCE, which strips out food and energy, climbed to 3.6% over the past year. Generally, the CPI is going to be higher than the PCE for several reasons. One is that the PCE includes more rural areas and then there are different weightings that each measure gives. For example, the CPI has a higher weighting toward housing, and the PCE has a higher weighting toward medical care. But by however you measure it, prices are definitely going up.

Southwick: We haven't really been scared about inflation for a while so why now?

Brokamp: Well, economists will tell you that inflation occurs for many reasons, but the primary cause is too much money chasing too few goods. If you think back to a year and more ago when the global economy was partially shut down due to the pandemic panic, manufacturers are closed, unemployment skyrocketed, toilet paper was scarce, this would have led to a worldwide depression if governments didn't step up to take the place of paychecks. Uncle Sam alone provided more than $3 trillion of stimulus. That government intervention boosted bank accounts at a time when people were stuck at home with really much fewer things to spend money on. I personally went from filling my car's gas tank once a week before the pandemic to maybe once every six to eight weeks during the shutdown. Now the economy is opening up again and people are spending like mad, but factories haven't yet caught up. U.S. personal spending has now reached over $16 trillion, an all-time high. Consider this quote from a recent CNN Money article: "There were more than two billion instances of a product being out of stock online across 18 categories tracked in October by Adobe Analytics, according to a new report. That's up 33% over the same month a year ago and 325% since October of 2019." When a bunch of money is chasing scarce goods, businesses raise their prices.

Southwick: I feel nowadays if you can't blame seasonal allergies then you can blame the supply chain. What more can you tell me about seasonal allergies' role in all this? I mean the supply chain.

Brokamp: It really is the supply chain. There are a lot of moving parts literally and figuratively to getting a product from conception to creation, distribution, and consumption. But let's take vehicles as an example. The typical car has 30,000 parts. Those parts all start out as raw materials somewhere and then they need to be transported to a factory and turned into parts, which then gets sent to assembly plants and turned into a car, then the car has to be transported to a dealership. This process involves tens of thousands of people across multiple countries. Any disruption to that supply chain has ripple effects throughout the whole process. The supply chain does involve both parts and people. Reuters recently reported Toyota, which is the largest seller of cars in the world, hopes to restart production in December in their Japan plants that has been curtailed due to COVID-19 outbreaks in factories in Vietnam and Malaysia. Then you have all the container ships waiting off-coast, just twiddling their propellers because they can't offload their goods, partially due to shortage of dock workers and truck drivers. The issue is really despite the robust recovery over the past year, the U.S. labor force is still more than 3 million workers below the level at the end of 2019. You add in significantly reduced immigration and you going to understand why many American businesses are struggling to find workers, which means they have to increase their pay to attract employees, and those higher costs get passed along to consumers in the form of higher prices.

Southwick: What are the biggest drivers goods-wise of current inflation? Is everything more expensive or are some things really driving it here?

Brokamp: Some things are definitely more expensive than others. The biggest items in the recent consumer price index are gas, up 50%, car rentals, 39%, both used cars and hotels are up 26%, beef, 20%, and furniture and bedding at 12%. However, not all items are seeing such large price increases. In fact, many items, including airfares, prescription drugs, and smartphones, are actually cheaper than they were a year ago. While food prices overall rose 5.3%, many items such as cheese, lettuce, frankfurters have experienced price declines. Yes, the CPI report does have that level of detail. I think it's also important to note that these increases are just compared to where prices were in October of 2020. It doesn't necessarily mean that prices are now at all-time highs for all items. For example, a gallon of gas and a gallon of milk were both more expensive in 2008 and in early 2010s than they are today.

Southwick: How bad can it get? I have visions of wheelbarrows of currency can't buy. You think of countries that are really taken over by inflation. How bad could it get for us?

Brokamp: Let's start with history. In the United States, the worst bout of inflation over the past century was the nine years from 1973-1981, during which inflation averaged 9% a year and got as high as over 13%. There were many causes for that stream of high-costing years, but one was in oil embargo from OPEC in retaliation for American support of Israel. While tensions aren't as high today, rising oil prices can be traced at least partially to geopolitical tensions. OPEC along with other oil-producing countries such as Russia, are limiting production and they're resisting entreaties from the U.S., Japan, and India to pump more oil. I don't think we'll see the inflation we saw in the '70s and certainly not the hyperinflation of Weimar, Germany, where they really were pushing around wheelbarrows of money. Hopefully, things won't get that bad as they were 50 years ago.

Southwick: How do we combat inflation? By we, I mean the Fed and I assume a few other someones in the federal government they would stay up late fretting about this.

Brokamp: The federal government is taking steps to ease the supply chain bottlenecks at places such as ports. The White House has actually established a supply chain disruptions task force, they even have a blog. The Biden administration claims that many of the provisions in the Build Back Better plan will alleviate some inflationary pressures caused by outdated infrastructure. We shall see. As for the Fed, at the start of the virus crisis in the winter of 2020, they took all kinds of drastic steps. They reduced the Fed funds rate to near zero and they've been purchasing more than $100 billion worth of bonds and mortgage-backed securities every month. What that does is it increases the demand for bonds which puts downward pressure on interest rates. However, beginning this month, the Fed will begin reducing or tapering, as they say, the bond purchases. It has not yet committed to when it will outright raise rates, but a fun little site called the CME FedWatch Tool predicts that the most likely time frame is probably next summer. Higher rates cool off the economy, which can reduce demand and thus inflation. Significantly, higher rates can put the economy in recession, which is what happened in 1981 with then-Fed Chairman, Paul Volcker. It worked. They set the Fed funds rate over 19%. Yield on the 10-year treasury was almost 16%. Set the country into a recession and it brought down inflation, but at the cost of some temporary pain.

Southwick: You talked about, in Japan, they can't build cars because of parts in Vietnam. It sounds like it's not just America that's suffering. Even though as Americans we really only care about our own suffering. [laughs] Let's be honest. This sounds like it's a global problem.

Brokamp: It is, because what happened in the pandemic and the resulting supply chain issues happened everywhere around the globe. The median inflation rate of the 185 countries tracked by tradingeconomics.com is 4.3%. The current 6.2% in the U.S. is higher than most other countries. If that makes you feel bad, just be thankful you're not in any of the countries experiencing hyperinflation, including Iran, which has an inflation rate of 39%, Argentina 52%, Lebanon 144% and the winner is Venezuela, an inflation rate of 1,946%.

Southwick: Wow, that's mind-boggling, and we're freaking out over 6%?

Brokamp: Yes, exactly.

Southwick: Wow. What can you do to protect your money, your moola, your nest egg? I don't know, all of it.

Brokamp: All of it, the whole kit and caboodle.

Southwick: The whole kit and caboodle.

Brokamp: Inflation is caused by businesses charging higher prices. One way to benefit is to own businesses, which you can do by buying shares of stock. As Wharton Business School professor Jeremy Siegel has established in his research, including his classic book, one of my favorite, Stocks for the Long Run, stocks have provided an after inflation 6.5-7% per year over most longer holding periods. In fact, this figure has come to be known as Siegel's constant. However, in the short-term, inflation can weigh on stocks, especially if it prompts a spike in interest rates, which then slows down the economy. Let's look back at that 1973-1981 period and see how various assets performed. Remember, during that period, inflation averaged 9% a year. Let's look at fixed income. Cash earned 8% a year, intermediate government bonds, 6%, long-term government bonds, 3%. All of those fixed income categories underperformed inflation, so you lost purchasing power and longer-term bonds did worse. Nowadays, we have something called inflation-protected bonds, they didn't have those back then. Those are definitely doing better nowadays. Over the last year, Treasury Inflation-Protected Securities earned about 9% as opposed to actually a small loss for the total bond market. Then there's the 7.12% you can now earn on iBonds, a topic we talked about last week. Now looking at stocks, how did they do from 1973-1981 actually it was mixed. Inflation was 9% a year, S&P 500 5% a year. It actually underperformed inflation 4% a year over that period. But small-cap stocks, 19% a year, real estate investment trusts, 12% a year. It's mixed. I certainly think that for the investors out there, it makes sense to consider whether the companies you own will be able to pass along higher prices without reducing profits. A couple of other assets that you may hear about when inflation gets brought up. Commodities can do well during spikes of inflation, and that's certainly been the case this year, commodities are up about 60%. But over the long term, the performance of commodities is pretty much below the stock market and even much more volatile. Perhaps surprisingly, the asset that some people believe to be the best inflation hedge, namely gold, is actually down 10% since August of 2020, and close to the price it was a decade ago.

Southwick: I don't know if I had told everyone that I had exactly 10 questions to ask you. But we're on No. 9 here, so we're in the home stretch. This question is, is this really all that serious? A lot of the comments, for example, in The Washington Post articles I've been reading about this, people are like big whoop, I'm paying six bucks for $100 worth of groceries last year. Biden is saying this is all temporary anyway, so how serious should I take this?

Brokamp: Well, I would say no one likes to pay higher prices, of course, and it certainly depends on what you're buying, your particular basket of goods, in economic speak. For example, if you do a lot of driving, you're certainly feeling inflation more than someone who works from home. It can certainly be a challenge for lower-income families whose incomes aren't keeping up. That seems to be the case. Pay is up 4.9% over the past year, but that is less than the 6.2% for the CPI. The big question is, will prices just keep rising at the current rates or worse, and the answer is, of course, no one can say for sure. But the Federal Reserve believes that the factors that are currently driving up prices are mostly temporary. I'm no economist, but I would say that my current feeling about it all was summarized in a recent article by Cullen Roche of Disciplined Funds who writes the Pragmatic Capitalist blog. He explained why he believes the current level of higher inflation will last until maybe around mid-2022, but then come back down. Essentially, he argues that the same forces that kept inflation in check before the pandemic will pretty much remain in force. Four things that he thinks will keep inflation down long-term. No. 1 is demographics. When you have an aging population and a declining population that puts downward pressure on aggregate demand, technological innovations which are inherently deflationary. There's inequality in our economy and less money in the hands of those with a higher propensity to consume, means lower demand. Then there's globalization, and that puts downward pressure on domestic wages and prices. Hopefully, a year or so from now we won't be so consumed by this whole inflation consideration.

Southwick: My 10th and final question is, what is a question a really smart person would have asked you that I didn't?

Brokamp: Well, just to make it clear, you are very smart.

Southwick: I have my moments.

Brokamp: Well, that question might be, how else does inflation affect my finances? One answer is that Uncle Sam uses inflation figures to determine all limits, payments, and tax-related numbers. For example, many numbers related to Social Security get adjusted annually based on inflation. Beneficiaries receive a cost of living adjustment each year and in 2022, those checks will be 5.9% higher, the biggest upward adjustment in 40 years. As for people who are still working, the amount of income subject to social security taxes gets adjusted each year. For 2022, that figure is up to $147,000. That's an increase from $142,800 in 2021. The biggest punch in the gut for retirees is next year's premiums for Part B of Medicare, which are going up 14.5% based partially on inflation, but also on other factors such as higher use of healthcare services. There are plenty of other examples of how Uncle Sam adjusts for inflation. The amount of income needed to move into the next tax bracket will also be higher in 2022, and the contribution limits to 401Ks and 403Bs are increasing by $1,000. When it comes to how inflation affects various government-related figures, it's a mixed bag.

Southwick: All right Bro, that was all my questions for this week anyway. We'll see if I come up with some more for later. But thanks, you're always the best.

Brokamp: It's time for Answers Answers. Normally, Alison asks the question and I provide the answer. But this time, I'm going to ask the question and someone way more qualified is going to provide the answer. That someone is Aaron Bush, an advisor here at The Motley Fool who works on our Rule Breakers, Blast Off, and platinum services. Welcome Aaron and thanks for joining us.

Aaron Bush: Hey, Bro. Thanks for having me.

Brokamp: The last time you were on our show is almost exactly four years ago and you helped us learn more about Bitcoin. We've asked you back because we have a listener question about Bitcoin and it comes from Soufan and here it is. "Roughly 5% of my diversified portfolio is in Bitcoin, held on a reputable exchange, Coinbase. Even though the exchange is big and reputable, I am still worried about either the exchange or my account getting hacked and my Bitcoin holding going to zero. Now that the futures-based Bitcoin ETF exists, I'm wondering if it is a good idea to switch my Bitcoin to the ETF. No one could hack my ETF or the underlying futures contracts? Would a hack of a large exchange create some counterparty risk to the futures holdings? Finally, would the Bitcoin futures ETF closely track the price performance of Bitcoin over the long term?" Aaron, what do you think?

Bush: There's a lot of good questions in there, and let me unpack that a little bit, starting with a couple of notes on hacking risk for those listening. The risk with hacking regarding crypto has almost always centered around exchanges. For example, Bitcoin itself has never been hacked, but exchanges that pull money together in a centralized way to facilitate everyone else's trades have. It's generally considered best practice to not hold money on exchanges. Something like Coinbase is more of an exception because the security team is first-rate, it's designed for professional custody, and they offer partial crime insurance, too, if Coinbase would ever be breached and funds were stolen. But at the end of the day, it's still is a trusted third party, which is why many of the OG cypherpunks recommend that people should own their own private keys. Private keys are what give you access and control over the crypto you own. We could dig into some rabbit holes there. But at a high level, many people are proponents of hardware wallets, which were like USB sticks. Many people use software wallets, which are things like browser plug-ins. Some people have their assets spread around in different places to mitigate the risk of any one place getting put in jeopardy. Really, there is a plethora of options out there, and people can take whatever level of risk and personal responsibility they want. I do think that for most people, though, who are just looking to buy and hold, something like Coinbase truly is a great option. But it's not necessarily for everyone depending on how you want to use crypto and how in control you want to be of your own private keys. 

Those are just a couple of things to keep in mind regarding the risk of security. As for the Bitcoin ETF question, my stance for a while has been that people who want to buy and hold Bitcoin for the long term should own actual Bitcoin. Not some tracking entity like Grayscale Bitcoin Trust, or futures ETF. The problem with a futures ETF is less to do with Bitcoin, actually, and more to do with the fundamentals of how a futures ETF works. I'll unpack that a little bit, and you can follow up with anything that doesn't make sense. For those who are not in the weeds of finance, a futures contract is the obligation to buy or sell an asset at a later date at an agreed-upon price. Really long story short here, a futures ETF doesn't actually own the underlying asset. In this case, the Bitcoin futures ETF doesn't actually own Bitcoin. It's a derivative that owns contracts of the asset that enables future trading of it. How it often works is that every month, the fund rotates out of the current futures contracts that it holds, sells those, and then buys new ones. That rotation of futures contracts comes with a unique type of cost. If the futures contracts are trading above the spot price, as it's typically the case with Bitcoin, then the market is in what's known as contango. Contango is a hidden cost on top of the normal ETF fee that can chip away 5-10% or more of the ETF's value through the process of rolling contracts, so that transaction that takes place over any given year. If you piece that together, if Bitcoin stays flat, you will actually end up losing money through that process of just fees and the arbitrage working against you as the futures get traded month to month.

We see this play out in other futures ETFs like the VXX, which is a futures ETF on the VIX, the volatility index. That's something that's super financy, but something to be aware of because it is important when you own these things. Also, and I don't know the specific case with the Bitcoin ETF that got approved, but typically, futures ETFs can't hold 100% of their position in futures. They usually target somewhere around 85%, I believe, which creates even more lag comparing to owning the actual underlying asset, especially if you think that that asset is going to go up quite a bit. Really, these future ETFs maybe make sense for certain types of traders, but they don't really make good sense for buy-and-hold investors. This ETF is allowed to exist because it doesn't hold Bitcoin. I do think at some point, we will actually see a spot Bitcoin ETF that actually represents true ownership of Bitcoin. That would make a lot more sense for people to own, especially in accounts like IRAs and 401(k)s. But the SEC has not been doing a great job of getting something like that out the door. We'll have to see how that plays out. But really, my bottom line of all this is that it's generally better to own the actual crypto, and you can take steps to make it secure for yourself. It's not as hard as it may seem.

Brokamp: That futures ETF is offered by ProShares. The symbol is BITO, and it gathered over a billion dollars in assets in the first two days, so a lot of interest in it. But I looked at the contents of the portfolio, at least according to Morningstar, and only half of it is futures contracts, and the other half is cash. Because as you pointed out, it can't be completely in the contracts. A Wall Street Journal article quoted the CEO of Bitwise, which was trying to do a Bitcoin ETF, and then they backed off because the costs were too high, saying that contango situation can cost you 5-10% a year in return. The futures contract is not going to give you the same price performance as Bitcoin.

Bush: No. That contango, it adds up. If you look at the volatility index, for example. Typically, volatility is a metric that mean reverts over time. It goes up, it goes down, but it typically reverts to the mean. Over the span of a decade, you could end up at the same place that you started price-wise for the volatility index. But the futures ETF of that, because of contango losing 5-10% of its value every year, it's going to be down 95% or so. That's not to say exactly that will happen with Bitcoin. If Bitcoin goes up, then this futures ETF over a long period of time can still marginally go up, too. But when you have 5-10% contango working against you on top of just a normal ETF fee, that's a pretty high hurdle of returns that you need to see from the underlying asset to be worth your time.

Brokamp: One last question here. The segment proceeding this segment, we talked a good bit about inflation. What's your take on whether Bitcoin is a good inflation hedge?

Bush: That's a good question. I think that hedge is a strong word because it implies a direct, mathematically proven correlation. I don't think that Bitcoin has proven a direct correlated ability to technically hedge inflation. It's been too volatile honestly to be correlated with much of anything or hedged with much of anything. That said, it does have qualities, namely the scarcity of its tokens that will likely make it less inflationary than fiat currencies that are always printing new money. From that lens, maybe it's hedge-like, but it's not designed to be a hedge and likely won't serve exactly like one. I actually had a similar conversation with David Gardner recently. My over-simplistic take that the academics out there may not like really is just that the best hedge against inflation is to own things that go up a lot. Traditionally that's been to own companies that can raise their prices or real estate that can raise their rent. These entities beat inflation because of more fundamental microeconomic reasons, and I actually do think the same can go for crypto. All cryptocurrencies work differently, so do your own due diligence on that. But if you think that Bitcoin or another cryptocurrency will perform well based on its fundamentals, it probably will help you beat inflation. However, I would not recommend owning it purely to hedged inflation. That is not what it's for or how it'll probably work.

Brokamp: Sounds good. I really appreciate you taking the time to help us out here, Aaron.

Bush: Of course. I can't believe it's been four years, but I'm happy that we went full circle on Bitcoin. Thanks for having me.

Brokamp: There were also the years that you and I sat right next to each other at Fool HQ. I apologize for all the dancing and air drumming you had to put up with during that time.

Bush: You're a great co-worker. I miss it.

Brokamp: Aaron, take care.

Bush: Thanks, Bro.

Southwick: Well, that's the show. We're taking next week off because of Thanksgiving, and so should you. But we'll be back on the 30th when Bro interviews Michael Kitces, who is probably the second most interesting financial planning wonk I've ever heard speak. It should be a good show. As always, this show is edited, rain or shiningly by Rick Engdahl. Our email is [email protected] for Robert Brokamp, the first most interesting financial planning wonk I've ever heard speak.

Brokamp: I thought you were talking about Suze Orman.

Southwick: No, it's you, you big dummy. I'm Alison Southwick. Stay Foolish, everybody.