The Hidden Tax

Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair. -Sam Ewing (author)

We ended 2021 similar to how we began, challenged by Covid as the virus continues to alter holiday plans, disrupt commerce and frustrate a world weary of the conversation. Covid was supposed to be conquered by this point, but virus mutations and vaccine hesitancy have allowed this visitor to remain with us.  What is different this time around is the Omicron variant appears to be more prevalent, but less deadly. Hospitalization risk appears to be 1/3[3] that of the Delta variant but, given that Omicron is more infectious and has a shorter incubation period, hospitalizations are going up. We began 2022 with an all-time high of 1 million active new U.S. cases.

Against this backdrop, the market achieved new record highs and U.S. GDP is estimated to have grown by about 5.5% in 2021, which is the fastest rate since 1984. This growth has shifted the narrative to a new concern: inflation, the decline in a currency’s purchasing power due to rising prices.  Inflation is real and it is here. Its presence is largely a result of the tremendous success we experienced in navigating the pandemic: 

  • Fiscal and monetary policies (i.e. government spending) that prevented the pandemic from driving the economy into a depression
  • Increases in household savings from working from home and having limited spending outlets while in lockdown (household finances emerged from the crisis in better shape than they entered)
  • Pent-up demand led to increased spending on big ticket items once lockdowns eased, driving consumption well above its pre-pandemic trend
  • Fractured global supply chains increased costs for many goods
  • Unemployment declined from 6.7% at the beginning of the year to 4.2% in November, and labor shortages drove increased wages for most industries

And there were residual effects.  A strong job market combined with an increased appreciation for “Work from Home” life compelled more buyers to enter the housing market. Buying a home is really a statement of confidence in your employment and financial situation. And when supply can’t meet demand, prices rise swiftly.

Our success has pushed price indexes to levels not seen in decades:

These inflation pressures are expected to persist through at least the first half of 2022. But given that economists failed to predict the 2021 inflation surge, and even longer to acknowledge that inflation won’t be “transitory”, we should prepare for a scenario where these forces last longer than expected. 

Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.

– President Ronald Reagan

What are the implications?

Economist Milton Friedman described inflation as a “hidden tax”. It has the pernicious effect of eating into paychecks as the prices for basic goods and services increase seemingly overnight, and it undermines positive gains in the economy. Older Americans are especially sensitive to inflation as many depend on income sources which are relatively fixed (i.e. pensions) and can expect to live an additional 17 years longer than the generation before them. Add in creeping medical costs and you have a little problem. 

Reversing the trend remains a top priority for both the White House and the Federal Reserve.  The expanded Child Tax Credit is set to end in January.  And the Fed is currently winding down its monthly bond purchases and will end them in mid-2022. Additionally, we can expect multiple interest rate increases throughout the year. History tells us that the Fed has the tools to beat back inflation. The challenge is finding a Goldilocks interest rate path that doesn’t allow inflation to grow and doesn’t stall the economy into a deep recession.

The move in interest rates will likely nudge mortgage rates higher and possibly put a damper on the current housing growth cycle…or bring more buyers in from the sidelines.  More importantly, for stocks, the change will prompt a shift in sentiment from growth to value as the market reprices risk.  When interest rates rise, the cost of borrowing (debt) increases, and the value of cash flows in the future are discounted at a higher rate.  High growth companies typically have limited (or no) earnings because their resources are focused on future growth over present profits.  With higher interest rates, investors want to see profits today and thus place a higher value on companies generating cash flow today: value stocks.  

Over the long term, inflation will be counterbalanced by deflationary pressures from technology. Technology advances will ultimately win. 

The goal of technology is to provide better products and services cheaper than existing options. Robotics/automation, artificial intelligence, blockchain technology, energy storage are all deflationary technologies. Automation and artificial intelligence increase human productivity. A warehouse full of factory workers can be replaced by an engineer overseeing an assembly line of robots. Artificial intelligence (self-driving cars) can replace a fleet of taxis and Uber drivers. If inflation pushes worker wages to unsustainable levels, employers will invest in technologies to reduce the number of workers required. Technology has the potential to accelerate GDP while adding to unemployment: deflation.

In the long term, technology (and deflation) will win.  For 2022, inflation will likely be the star of the show and dominate conversation. Over time, the supply chain bottlenecks will ease, manufacturing and shipments will return to pre-pandemic levels, supply/demand will reach equilibrium. Life will resume as we complete another market cycle. 


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