Halal Money Matters Podcast

Episode 17 – All About Inflation

[music intro]

MONEM SALAM: Welcome to Halal Money Matters, presented by Saturna Capital. I’m Monem Salam.

CHRISTOPHER PATTON: And I’m Christopher Patton. I remember... I think it was the first episode of Halal Money Matters. I made a joke about keeping all of my money in a Pringles can under my mattress and we kind of had just a very short talk about inflation and how... well, you know, it hadn’t really been that bad recently but it’s still a risk if you just have your money in a Pringles can. And now it seems like a great time to revisit that idea, because... inflation. 

MONEM SALAM: Yeah, it’s not only a risk of me coming over and stealing your Pringles can...

CHRISTOPHER PATTON: You don’t know which mattress it’s under.

MONEM SALAM: Exactly. But more it’s a factor of the fact that, I think, that Pringles can, for example, filled with coins, would have bought you, let’s say, x amount of goods. But now it’s going to less than that same amount of goods. And that’s what inflation is all about. And we have a great guest today to talk about that.

CHRISTOPHER PATTON: Yes. Bryce Fegley. He’s an Analyst and Portfolio Manager at Saturna on numerous funds. He’s a stats guy. He’s a risk management guy. And so, I think he would be a great person to chat with about this.

MONEM SALAM: Yeah. I think one thing is to really look at it from... what is inflation? For one thing. How does it affect you? And then, how does it affect your investments? And hopefully we will try to cover all three of those in this episode.

CHRISTOPHER PATTON: Yeah. Because I think people think they know what inflation is, and they may be right, but it’s a bigger picture and for people who think it’s a constant force, they may be confused as it’s all over the place right now.

MONEM SALAM: That’s very true.

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MONEM SALAM: So, Bryce, welcome to the show.

BRYCE FEGLEY: Thank you.

MONEM SALAM: This will be a really good discussion regarding inflation. I know it’s a fairly hot topic right now in the news. And really, I think the best way for me to kind of talk about inflation is that you probably can see it at the grocery store?

BRYCE FEGLEY: Yeah. You know, when people, regular people, think about inflation, they think about their typical consumption basket which is probably food prices and energy prices. What they pay at the pump. What they pay for groceries. Just like you said, Monem. And when the Federal Reserve calculates inflation, they have two measures. They have a core measure and what they call a headline measure. And the core measure strips those food and energy prices out because they tend to be kind of volatile. But at the same time that’s often what consumers—regular people—think of as inflation. What they pay for food and energy prices in particular.

CHRISTOPHER PATTON: I think most people think they have some idea of what inflation means and it’s like, “Well I paid $3 to go to the movies when I was a kid and now everything is more expensive so that’s always a force.” Why is it such a hot topic right now?

BRYCE FEGLEY: Well, inflation, for the first time in the past couple of decades, is running hotter than what the Federal Reserve intends it to, or what I guess people have expected it to. And really, for the previous almost 20 years prior to now, inflation has been running below expectations. And so, I think that change in and of itself is a big deal because we’ve gone from prices not rising as fast as anticipated to suddenly rising quite a bit faster than anticipated. And that’s sort of a mental shock to people for the way they plan and the way that they experience prices. But Chris, you mention the fact of... you know, my father always talked about this as a kid. How much he paid for a scoop of ice cream. How much he paid for a pack of gum or a candy bar and that sort of thing. And you know, he talked about nickels and dimes and now some of these things are two or three or four or five dollars. So, there has been a lot of inflation over our lifetimes, and it tends to come kind of gradually over time so that you don’t really notice it unless you go back twenty years and think about a price. But yeah, more recently it has become more of an everyday phenomenon. You see that something that you bought this week is quite a bit more expensive than it was this week a year ago. And that is more of a shock than we’re used to.

MONEM SALAM: So, let’s maybe back up a little bit kind of. So, how would you define inflation? Like, what causes prices to go up? Why can’t it just stay the same?

BRYCE FEGLEY: That’s a great question, Monem. I think maybe a little bit of an economic history lesson might help with this. Without going into too much detail, the United States and many other countries used to have kind of a hard money standard that was tied to a commodity or precious metal like gold or silver. One thing that happened in the old era was that it was a lot harder for the central banks, like the Federal Reserve, to respond to shocks in the economy by changing the rate of inflation. In the Great Depression, for example—this is kind of crazy in the context of the world we live in today—but Roosevelt basically forced investors, private citizens, to give up their holdings of gold. And the Federal government collected that gold and paid everybody a little more than $20 an ounce for all the gold they had on hand. And then, basically, the next day, Roosevelt changed the price of gold from $20 to $35 and that was a very rapid inflation kind of instantaneously. But it was also important to rescue the economy because it had the effect of basically making many people much richer in dollars on paper relative to the gold price. Kind of an unusual time. It’s hard to imagine the government today coming to people and our heavily-armed populace and demanding them to turn over their gold but that’s actually what happened in 1932 and ’33.

MONEM SALAM: So, the difference would be basically, you know, hard-backed currency versus a fiat currency.

BRYCE FEGLEY: Yeah.

MONEM SALAM: But wasn’t it also... what I think they used to do in the old empires and stuff was the fraction of the gold that was in a coin, they could manipulate that to be able to print more money or make more coins and distribute more. That would be similar to inflation, right?

BRYCE FEGLEY: That’s exactly right, Monem. And up until the mid-70s, 1971, when we dropped the gold standard for good during Nixon’s presidency, that was kind of the case in the US. There was actually a hard tie between the amount of dollars that the Federal Reserve could print and the amount of gold that the Federal Reserve held. And I think it was 40% of the dollars in circulation needed to be backed by gold and there was a set price for that exchange. And so, people could turn in gold for dollars or turn in dollars for the same amount of gold. When we dropped the gold standard for good in 1971, that meant that the currency essentially had no backing. No kind of official hard money backing at all. And it became more of a convenience as a unit of exchange. And so, the value... there’s no intrinsic value of dollars anymore. But what there is a value of is in allowing people to exchange one thing for another at prices that are intermediated through dollars. So, everything has a dollar price, and the dollar has an official backing with the government and the Treasury and the Federal Reserve and so forth. It makes it really convenient as a way to transfer value from one kind of good to another or from services to goods or from labor to consumption and all of those sorts of things. And that’s really the value of a fiat currency, even if it doesn’t have an intrinsic value. So, maybe now is a good time for me to tie this into what the fiat currency has to do with inflation. You’ll know that in the 70s we experienced a pretty big increase in inflation and prices. It’s an era that basically had higher inflation than we have now and for quite a prolonged period. And maybe it’s not a coincidence that that came after dropping the tie to gold and becoming a fiat currency. And since that time, they seem to have gotten the inflation component of running a fiat currency under control. We’ve had a period known as the Great Moderation, where prices weren’t really that volatile and inflation expectations were kept pretty stable. So, now, the current environment is a little bit of an interruption for that but in the scope of history, that’s what has been going on.

MONEM SALAM: You know, it’s funny, a lot of companies don’t raise prices; they actually add more stuff to the same price that you’re getting for whatever it is that you’re getting. An iPhone for example. It’s very rare that you’ll get incremental price increases on an iPhone without having greater stuff that you’re getting for the same price that you were getting before.

BRYCE FEGLEY: Yeah. You know, technology is a real deflationary force. The rate of technological improvement in a lot of goods like televisions and phones and electronics in general... you get more in quality for the same price. And so, that’s kind of a deflationary phenomenon where you paid $1,000 for a tv this year but it comes with 20% more value than the one last year or before because of the rate of technological progress. That’s not true throughout the economy. There are lots of things like education and health care and other facets... particularly in the service economy where it’s hard to increase productivity or technology in a way that generates that. And so, that’s an interesting phenomenon within the economy, of... what prices are going up? What prices are going down? Where is value being added more than prices are increasing and vice versa? There’s a great example... about an orchestra. A guy called William Baumol has this idea of a “cost disease.” He talks about the output of a symphony orchestra. It’s really hard to squeeze more productivity out of the players in the orchestra. There’s not a whole lot you can do. And so, their wages just tend to increase with the general price level. And they’re not necessarily going to produce more output. Whereas your television, as technology increases, you’ll have more pixels, you’ll have bigger screens. All of these sorts of things that make today’s televisions so much better than they were five or even ten years ago. That’s quite a bit of a different thing.

MONEM SALAM: Mmhmm.

CHRISTOPHER PATTON: Before we get into more specifically with what’s going on right now... Are the contributing factors to the rate of inflation always clear? Or are there sometimes disagreements about what is causing it at a particular moment?

BRYCE FEGLEY: Yeah, the determinates of inflation are kind of tricky to get a grasp on. I think in the big picture, there tends to be supply side inflation and demand side inflation and maybe we’re having a little bit of both now. But one thing we can point to is that the coronavirus and the pandemic did interrupt some of the supply of goods, particularly of semiconductor chips. And the particular example that people talk about a lot recently and is a big deal is the fact that it’s hard to build modern cars without a lot of semiconductors because they control a lot of the electronic functionality of today’s automobiles. So, without those chips, which have been interrupted by the pandemic, labor and supply chain disruptions, we can’t build cars and that means that existing cars are going up in price pretty dramatically and there’s a shortage. And that shortage is causing prices to rise. Alongside that you have gasoline, which is also rising in price. Those are big components of an inflation index, are the price of automobiles and the price of gas that people pay at the pump. And that right there is, you know, part of the economy that is inflating. So, that’s kind of the supply side example. On the demand side, you have pretty easy monetary policy since the coronavirus pandemic. The Federal Reserve acted swiftly to pump a lot of money into the economy and lower interest rates. That creates easier credit conditions for businesses and consumers. It lowers mortgage rates. It lowers borrowing rates. And at the same time, congress pumped quite a bit of money into the economy in fiscal relief by making unemployment assistance really generous, increasing childcare allowances, and basically giving people additional cash to spend. And so, that created an additional layer of demand. And those two things, the supply shortages and then the availability of cash in consumer’s wallets to bear those price increases, may have worked together to kind of create a self-perpetuating cycle of higher prices, at least for the time being. So, that maybe is an explanation of forces that create inflation. And they can vary over time. But right now, we seem to have a little bit of both supply and demand side inflation.

MONEM SALAM: So, Bryce, why even have inflation? Why not just keep the prices the same?

BRYCE FEGLEY: That’s a great question, Monem. After some of the depressions and recessions in the past, economists kind of came around to this view that a small and stable amount of inflation is actually a good thing in an economy. And so, we have this sort of 2% target that is in modern acceptance today among central banks. I guess across the world. And I guess what that does is if you have a slowdown in the economy... maybe companies aren’t earning as much as they expected, and they are trying to cut costs. If there was no inflation, they would be forced to reckon with the idea of cutting costs by either lowering people’s wages or firing workers. And workers don’t really like to have their wages lowered, so companies tend, in those environments, to just fire people or lay people off. And you know, the people that are left will have their wages staying the same, but the company will have to pay less to its workers because it will have a smaller workforce. So, that’s one of the manifestations of stable prices is companies basically fire a bunch of workers. And in the US, the Federal Reserve has been charged by Congress with what they call this dual mandate to have stable prices and support maximum employment. And the tradeoff that they make by allowing a little bit of inflation is that employers can maybe avoid laying as many people off by having a small amount of inflation. So, now they are not getting as much revenue as they expected, and they don’t raise people’s wages at all for a few years while inflation kind of eats into those workers’ real earnings—inflation adjusted earnings—because their pay is no longer keeping up with inflation. But they’re not getting a pay cut. So, the company has kind of earned back some of its lost profit just by not raising people’s wages but they didn’t have to cut them in nominal terms and maybe they didn’t have to lay as many people off. So, that’s kind of the tradeoff. The people in the economy, actors in the economy, expect a certain amount of inflation, they make long-term plans based on that. If inflation is a little bit higher or growth is a little bit lower, they can react to that without making big changes to their business, whereas if there was no inflation and the economy was a little bit slower and revenues were a little bit lower, maybe they have to fire a bunch of workers and that creates knock-on effects because now those workers are not consuming as much and that can lead into sort of a feedback cycle that makes recessions or even depressions more prolonged.

MONEM SALAM: So, speaking of the forces that create inflation, I know in the Muslim community there’s a lot of talk about, you know, “Well the bank borrows money at a certain rate and then when it gives out a loan, it gets it at another rate, and because there is that profit margin delta in there, then you’re always going to have inflation because the banks are the ones printing more money and you have the velocity of money.” What do you think about that?

BRYCE FEGLEY: Definitely, the idea of debt and the amount of interest that people pay on debt is very closely related to inflation and inflation expectations. So, if you borrow money to purchase a house at a set interest rate and inflation is higher than expected in the period after that... as a borrower, you come out good because your interest payments are set. Where the value of your house might be increasing faster than expected, causing you to gain more equity. As a Muslim investor or investors who don’t use debt to finance activities, you know, that can be a problem.

CHRISTOPHER PATTON: So, you talked about how it’s running a little hotter than expected, maybe. What is the concern? What are some of the ramifications of that?

BRYCE FEGLEY: Yeah. Inflation going faster than expected can cause a number of distortions in the economy. I’ll give a couple of examples. One example is that it can kind of become a self-perpetuating phenomenon. If people expect prices to rise at a faster rate than they have in the recent past, they may pull ahead purchases that they had not budgeted for in hopes that they can pay a lower price now than they will a year from now. And so, that in itself sort of forces prices in the shorter-term to rise more than expected because of competition for goods. So, then, that kind of race sets into motion a feedback loop where companies are running out of things they need to go to their suppliers and purchase more of them in the shorter term than they had planned and the suppliers raise the prices and they go to their raw materials and try to buy more of the materials to make the supplies and the raw materials producers don’t have enough so they have to increase their output and hire more workers and, you know, buy more equipment. That whole cycle kind of takes a little bit of time to play out but it’s kind of all generating this sort of feedback loop where people’s willingness or desire to purchase things now that they might have put off into the future sets in motion this whole chain of events that perpetuates itself.

MONEM SALAM: So, and that links to higher costs and stuff like that. You know, for the Muslim consumer, I mean it’s kind of a double thing, right? Because you have money in the bank, for example, and prices are rising. And so, you have to pay zakat on that. Not only are prices rising but you have to pay zakat on it. So, you don’t want to leave your money in the bank. So, what are some good places or investments that, maybe, you can invest in that would keep up with inflation at least or be able to dodge it?

BRYCE FEGLEY: I just want to touch on the idea of zakat for a moment because when prices are rising because of inflation and you pay zakat on that, the money that you are... the additional money that is going to zakat, it’s not actually money that is, you know, real? It’s, in a sense, basically just an increase in prices that you have to bear. It’s similar with taxation. If you own an investment that increases in value by 3% but inflation during the time was 4%, after inflation you have actually lost money. But, you still owe tax on that 3% return. So, when we are talking about inflation from an investment perspective, you’re trying to avoid that loss of purchasing power and particularly the distortion of paying tax and paying zakat and other kinds of fees that are eroding your purchasing power even further because, you know, we are thinking about a situation now where investment returns or interest rates are lower in many cases than the current rate of inflation. And so, investors are already losing money in purchasing power terms and then being asked to pay tax and zakat on that loss of purchasing power that’s not even real. So, to get back to your question. What can an investor do in that environment? There are a number of different investments that do tend to be better during inflationary times and others that tend to do worse, and it depends on whether you’re a borrower on an investor. For an investor, real estate tends to keep up with inflation because it’s tied to a real asset. And real assets, in general. Land, real estate. Sometimes commodities. Precious metals like gold and silver tend to be better hedges against inflation than other things. The stock market has traditionally done okay in inflationary times. It’s not the worse place to have money invested. What types of investments do poorly during inflation? Well, those are bonds and fixed income because they tend to pay a fixed interest rate and when inflation increases, that interest rate becomes less attractive because it doesn’t compensate you for the loss of purchasing power which is what we were talking about a moment ago. So, yeah, things that are tied to real economic output or have a tangible value tend to do better in inflationary periods than those that are more financially oriented. 

CHRISTOPHER PATTON: Are you saying that I can’t hedge against inflation through NFTs of episodes of Halal Money Matters?

[laughter]

BRYCE FEGLEY: Well, the cryptocurrency phenomenon... proponents of it have talked about cryptocurrency sort of being an inflation-proof type of asset. Whether a cryptocurrency is an asset or not or is a security or not are probably beyond the scope of our conversation. But they do have characteristics that do make them tangible in some ways. Their prices are very volatile and there’s a lot of emotion and speculation in that market that really, I think, obscures and I think totally overwhelms any kind of monetary correlation to inflation.

CHRISTOPHER PATTON: So, what can investors do to mitigate the threat of inflation?

BRYCE FEGLEY: Yeah, the threat of inflation is really the threat that a dollar, year from now, won’t buy you as much as it does today. So, it’s that loss of purchasing power. And as an investor, what you want to look for is a way to earn income that makes up for that, that recoups your loss of purchasing power. One thing that the central bank does when inflation is rising is they tend to raise interest rates. That not only is intended to slow down the economy and cool inflation, but it also provides the benefit for investors to earn more money to offset that loss of purchasing power through investments in fixed income securities or bank deposits and so forth. For Muslim investors, that’s problematic, though because you tend to want to avoid usury and the earning of interest. So, we have to look at ways to earn income, investment income, outside of fixed income. And there are a number of options for that, including real estate which is typically packaged into vehicles called Real Estate Investment Trusts. There are many different kinds of properties that can be put in a Real Estate Investment Trust. And some, for Muslim investors, are inappropriate—potentially—because they earn interest on mortgage income. But others, where the exposure to interest income or the reliance on debt financing is under minimum thresholds... those types of Real Estate Investment Trusts could be appropriate for Muslim investors. A disadvantage with real estate investments is because they are packed into these trusts, there are several layers of fees. There are fees to actually administer a piece of real property. There are landlords and companies that are involved with property management. There are the Real Estate Investment Trust managers who have to go and buy these pieces of property and maybe hire the property managers, and then pay themselves as well. And those fees can add up to the point where maybe that is a less advantageous way of earning investment income than alternatives like investing in the stock market and earning dividend income. It’s worth knowing that the history of the Amana Funds is based on a desire to have an income alternative for Muslim investors beyond what they could earn at a bank by holding cash in a savings account. And so, the Amana Income Fund, even though it’s invested almost all in the stock market, was a Fund that invested in the dividend income of equity securities. And so that, in its original inception, was intended to offer a cash alternative to Muslim investors. It comes with some volatility, but the returns of the Fund had been quite a bit higher than what you would have earned in a bank account to offset that. And we hope that will continue into the future, obviously. But those are some of the ways that we think about inflation... you know, having an income stream to offset the loss of purchasing power. Those are dollars and cents, hopefully, that are flowing into your portfolio’s income that you can count against that inflation. It’s worth mentioning that equities tend to do okay in inflationary environments relative to some of the other asset classes, but within equities, there are economic sectors that are more advantaged or disadvantaged by the inflation numbers. So, for example, commodity oriented companies and sectors like energy and materials, have an ability to pass on their higher prices to their customers and so their stock prices can do better as their earnings and revenues are less affected.

MONEM SALAM: Not to make you a prognosticator, Bryce, but what are your thoughts about where does inflation end up? And how does that affect not only the economy but the market itself?

BRYCE FEGLEY: Right. I mentioned earlier that we had gone from this period of continually having inflation lower than the Federal Reserve’s target. The target has been about 2% and for a number of years in the US we were struggling to even have prices increase at 2% at all. So, with that context, I do think it’s interesting that in the last year or so, when inflation has been running higher than expected, the Fed could have said, “Well, this is exactly what we said would happen. We were going to allow prices to kind of catch up on the upside for the shortfalls that have happened in previous years on the downside.” But what actually happened is the Fed seems to have panicked a little bit because, I think, they remember that inflation on the upside can cause these feedback cycles and distortions that are hard to get a handle on if they get running too long. Prices have caught up to fill in some of that past deficit rather dramatically and quickly and are probably at risk of overshooting fairly substantially if they were to continue. The two views that you could take about the future are... inflation has become entrenched, and consumers are going to race each other to purchase goods and services now rather than late because they are worried about prices rising and that will beget additional inflation until the Fed does something dramatic like raise interest rates to slow the economy down and forestall that behavior. The opposing view might be that there has already been a fair amount of inflation and it’s already started to pinch consumers’ pocketbooks. And as much as they might be worried about prices rising next year and try to pull ahead purchases from the future, they’re also looking at their pocketbooks and thinking, “Wow, prices have already risen so much. I hesitate to even pay what’s being asked now,” and maybe that has a self-braking aspect where the economy will adjust to that automatically rather than have it turn into this feedback cycle of higher prices.

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DISCLOSURES (read by Christopher Patton):

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