Inflation has been our constant companion for more than a century.
According to the US Official data inflation calculator, the purchasing power of $1 in 1918, would be the equivalent of $17 today.
The annual erosion in the value of a dollar is something we’ve lived with all our lives. We don’t know any different.
Central Banks tell us that we need an inflation target. We accept it blindly.
But why would you deliberately choose to turn a $1 today into 98 cents tomorrow? It makes no sense.
It also makes even less sense (if that’s possible) that meeting our inflation target has relied on increased energy prices, childcare costs and health insurances. How daft is that? What household wants these costs pressures?
The benefits of this two-pronged approach are obvious. Lower (in real terms) debt levels means our debt-addicted economy can continue to access the drug of choice. And higher wages deliver governments with increased tax revenues to finance more public debt and to buy more votes.
Those who borrowed to buy a home in the 1990s benefitted greatly from the state sanctioned inflation policy. It’s a different story for present day borrowers. The dialled-in inflation of the past is proving to be a little more elusive these days.
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What Does Deflation Look Like?
In recent years, we’ve had a sneak peek at what deflation might look like. In the sectors of the economy deemed to be discretionary spending — retail, travel, entertainment, hobbies, etc — price reductions are common place.
Shopping centres have permanent ‘sale’ signs in the windows. It’s getting tougher to make ends meet. Constrained wage growth has required households to be a little more discerning in how they spend their discretionary dollar. The ‘fixed costs’ — energy, government charges, insurances — keep rising.
The latest ME Bank Household Financial Comfort Report (released on 6 August 2018) contained these insights into what’s happening in the real world:
‘With subdued and stagnant incomes, more Australians are feeling strapped for cash, and are being forced to dip into their savings to cover the rising cost of living expenses…
‘Consulting Economist for ME, Jeff Oughton, said more households are overspending to cover necessary living expenses and are drawing down on savings, with mortgage and rental stress remaining high.
‘More Australians are also overspending — households who “typically spend all of their income and more” increased 3 points to 11% during the six months to June.
‘The latest report found that the cost of necessities continues to be the major financial concern for households…
‘Consistent with ABS wage data, the latest HFCR data found nearly half of households (42%) still had the same income as a year ago, while a quarter (24%) reported income cuts and 34% received a raise.’
And this rather bleak state of affairs has come after we’ve had a decade of central bank stimulus.
In other words, this is about as good as it gets economically and yet, the pain continues to intensify.
The ME report went on to note:
‘If we see big negative shocks in the coming year, whether they are higher loan rates or an international trade war, then a lot more families will suffer increased financial stress.’
These — and other flashpoints in the global economy — are very real risks that threaten the fragile stability of Australian households.
When the crisis — in whatever shape or form it takes — hits, then the hairline cracks in household budgets will turn into chasms.
Spending is reined in. Borrowing stops. Defaults mount up. Deflation comes out of the shadows — as it did in Japan after the market collapse in 1990.
The other major global deflationary force, that’s lying in wait, is in pension schemes.
This is an extract from a research paper published by the Brookings Institution on 29 May 2018 (emphasis added):
‘Like all U.S. pensions, multiemployer plans are underfunded. They are not underfunded because employers did not make contributions. They did, unlike some public plans. However, they relied on actuaries to decide how much to contribute.
‘In the 1990s, the markets did better than actuaries predicted, so plans were overfunded. Since 2000, markets have done worse, so virtually all plans are now underfunded.’
The pension underfunding dilemma is not isolated to the US; it’s also a global problem.
However, for the purpose of this exercise, we’ll focus on the US situation.
Pension funds promise to pay employees a percentage (based on years of service) of their final average salary for life. Calculating the extent of this ‘very long tailed’ liability rests with actuaries.
Assumptions are made on life expectancies, number of members and annual rates of return. The crunching of these numbers determines the level of contribution from employers.
If one or more of these assumptions is incorrect, then ‘Houston we have a problem’.
When it comes to forecast rates of return, this is the range actuaries are currently using.
The majority fall within the 7% to 8% per annum range:
Source: Philosophical Economics
When government bonds are only yielding 2–3%, how do achieve a 7% plus return?
You increase the pension fund’s exposure to the best performing asset of the past decade the share market:
Source: Philosophical Economics
Exposure to shares is now around 70%. Even with this overweight position and AFTER the longest bull run in history, pension funds STILL don’t have enough money in the tin to cover promised payments.
Again, we find that ‘this is about as good as it gets economically and yet, the pain continues to intensify.’
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Every Boom Has A Bust…
But we know from history that every boom has a bust.
With every passing day, we get closer to this record-breaking boom, ‘busting’. That’s not an earth-shattering prediction, just an acknowledgement of market reality.
The extent of the downside — based on recent busts — could be as ‘little’ as 50%. But it may well be a whole lot worse.
Either way, the pension funds have a huge problem.
The overweight allocation to shares leaves the funds exposed to significant losses. Turning an underfunded situation into one of sheer hopelessness. Promises will never be kept.
What are the consequences of this retirement incomes catastrophe in the making?
This is from the Brookings Institution research paper:
‘However, actuaries do not guarantee their estimates, and someone else ends up holding the bag. Who pays for this? Employers who promised employees a pension and benefitted from a lifetime of their work are legally responsible to provide them.
‘But what happens if the employers have gone out of business? Do other employers, pensioners themselves, government, or all three pay in that case?’
If something cannot continue, then it won’t.
Funds without the means to honour the pension payments will be forced to make some very tough decisions.
My guess is one of the compromises will be for members to (begrudgingly) accept a reduction in their monthly retirement payment. With waves of boomers headed for retirement, any reduction in monthly income payments means a lot less spending power in the economy.
This scenario is going to play out in the US, Europe and, to a lesser extent, in Australia.
With working households AND retired households being squeezed, economic contraction is all but assured.
The central bankers will not sit idly by and let markets take their course.
The ‘mother-of-all’ stimulus packages will be unleashed.
But as we’ve seen over the past decade, inflation is not as easy to manufacture as previously thought.
In the arm wrestle between markets and central bankers, my money is on the markets.
Deflation is coming.
Editor, Money Morning