The Creation of Inflation

Frankly Speaking

The Creation of Inflation

In my September letter I warned about the potential the economy was swerving into the inflation ditch. In my November letter I noted investors were on board with the Federal Reserve's theory that problems like inflation were transitory, but they might lose patience waiting for inflation to recede. (You can view my past letters on our website). They may be at that point. The other day I read an article explaining why so many economists have continuously failed to predict the current inflation surge. One big reason is they rely on computerized forecasting models.

So, it appears a big reason economists misread inflation was failed computer models. These models are carefully designed programs that do a fairly good job as long as the world is operating within typical parameters. Think about a carefully designed car. Its manufacturer intended it to work within its design limits of -50 to +150 degrees. Push it outside of that range and bad things happen.

In a similar fashion, economic models are built to work when things are within their typical range. Things like pandemic induced labor shortages, supply chain disruptions, and $9 trillion of government stimulus are outside the models operating design limits, so it basically breaks down. However, unlike a dead car, a broken computer model shows no obvious signs of failure. It will still respond by spitting out a (highly dubious) economic forecast.  I think many economists failed to realize their models were broken. They kept using their model's output, including projections of low inflation.

Why would they keep using models projecting 2%-3% inflation when inflation was 6%-7%? First, they suffered from group think. When everyone else in your profession is also projecting low inflation, it's easy to conclude you can't be far off base. Secondly, the Chairman of the Federal Reserve greatly influenced the group think by continuing to concur with economists. He assured us all that inflation was “transitory” and would quickly recede. Then in early December he reversed telling Congress, “it’s probably a good time to retire that word transitory”. Oops!

This brings us to today. Markets are just now starting to adjust to the reality of inflation, with more adjustments likely to come. I've been a big advocate of value stocks (vs. growth) for over a year. While they are often in boring industries, they traditionally do better than growth stocks in an inflationary environment. Don't make the mistake of assuming “growth” always equals positive results.

Frank Rizzo, Certified Financial Planner

The opinions in this material are for general information only and not intended to provide specific advice or recommendations for any individual. The economics and market forecasts set forth in this material may or may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Inveting includes risk, including fluctuating prices and loss of principal.