Why is Inflation Scarier than a Market Crash?

Inflation is now the #1 fear with “6 in 10 Canadians concerned they might not have enough money to feed their family”, according to an Ipsos poll. Most Canadians have never experienced high inflation. It has been flat at 2% for 3 decades, but now jumped to 7.7%.

Many people are asking me what is going on and can I give them some context. Looking at inflation in the past is very helpful to understand what is happening today.

  • Why is inflation scarier than a market crash?
  • Should we be worried?
  • How long will it last?

Why is Inflation Scarier than a Market Crash?

This important concept can have a major effect on your life and your finances:

Market crashes are temporary, but inflation is a permanent increase in our cost of living.

There have been 26 “bear markets” (a decline of 20% or more) since 1900 and the market has recovered 100% of the time. 88% of recoveries were in 1-2 years or less. The risk of a market crash is you – if you panic and sell after the decline.

We are officially in a “bear market” now, since markets are down more than 20%. They may or may not fall further, but if they do, they will recover all of it. There is a good chance we will have a recession, but stocks usually rise during a recession. They are always anticipating, so they usually fall before a recession and then rise during a recession anticipating the economy recovering.

For long term investors, your main fear should be missing the inevitable recovery.

Today is clearly a buying opportunity for investments. Our growth fund manager considers this the best buying opportunity of the last 30 years. Stocks are on sale – and the sale is temporary.

When the market crashes, but you stay invested and it recovers, you have not lost anything. This does not happen with inflation.

Inflation is a permanent increase in our cost of living. It piles on top of all past years. A year of high inflation is not followed by a year of negative inflation (“deflation”) to offset it.

One or 2 years of inflation is not a major problem, but if it lasts for quite a few years, it’s a huge problem. Your cost of living takes a big jump every year and they pile on top of each other.

A long period of high inflation is what I worry about most for our clients. I have studied the effect and experienced it. The 1970s and 1980s were 2 decades of high inflation, which were really the worst time for investors in the last 150 years.

I learned this by looking at reasons the “4% Rule” failed. I tested this general rule of thumb that says you can retire and withdraw 4% of your investments each year, increase it by inflation and it should last for a 30-year retirement. With a portfolio of 100% stocks, the “4% Rule” succeeded 97% of the time in the last 150 years.

It failed only 5 times:

  • 1 time because of a market crash – Retiring in 1929, just before the Great Depression.
  • 4 times because of high inflation – Retiring in the last 1960s, just before 2 decades of high inflation.

In this chart, every line is a 30-year retirement for someone doing the 4% Rule. Notice the times the portfolio fell below zero.

In short, high inflation for 2 decades is almost the only reason the 4% Rule has ever failed in history. This is why high inflation that lasts could be the single biggest risk to your long-term finances.

Inflation expectations are the fear.

With my first jobs in the 1970s, inflation was 10%, so we all expected a 10% COLA (“cost of living”) raise every year. A buddy quit a job after an 8% raise. He considered it a pay cut. It was insulting to get a raise lower than inflation.

Inflation had been high for a while and was the expectation. It was ingrained. We all assumed everything at the store would go up 10% every year and our incomes would go up by 10%/year.

If inflation lasts long enough that the public expects it, then it’s really hard to bring it back down. It took interest rates at 20% and 2 recessions to bring inflation under control. This was a valuable lesson we all learned.

I worked for a savings & mortgage company in 1982 at the peak of interest rates. We offered GICs paying 19.9%/year and 5-year fixed mortgages at 22.75%/year. The 1-year mortgage was only about 15%, but people were taking the 5-year fixed because rates were shooting up. They expected interest rates to go to 30% or 40%. Many people lost their homes when their mortgage came due and their payment doubled.

These unaffordable interest rates were the only way to stop inflation once it became an expectation. It caused recessions in 1982 and 1992, which finally brought inflation down to the 2% low inflation we have enjoyed the last 3 decades.

Here is our inflation history. Note how long it stayed high and what a great period of low inflation we enjoyed the last 30 years.

Similarities between now and 1970s to 1980s:

Are we at risk of a long period of high inflation like those 2 decades with high inflation? Will inflation become an expectation? Most of the causes of inflation are similar today, but not all.

Interestingly, the causes of inflation include some eerie similarities:

a. Oil supply shock: Inflation took off with the Arab oil embargo of 1973. The cost of gas leaped, and with it the cost of gasoline and everything that is shipped. Today we have an oil supply disruption from the Ukraine war and a supply shortage from the restart of demand after the Covid shutdowns.

b. High government deficits: Governments printing money is a major cause of inflation. Too many dollars chasing too few products and services.

Almost all our government debt in Canada was accumulated in the 1970s and 1980s. We had a Trudeau government with Pierre Trudeau in power from 1968-84. Now we have a Trudeau government since 2015 and our government debt has almost doubled (mostly from Covid spending).

We learned our lesson after the 2 decades of high inflation. Governments balanced their budgets and debt did not rise from 1996-2015 (other than a few years right after the 2008 “Great Recession”). Here are the last 60 years of federal government deficits (current year over-spending). Note the large deficits in the 1970s and 1980s, and the surpluses since 1996.

Here are the last 60 years of federal government debt (total we owe). Note how little we owed before 1970, shot up during 2 decades of high inflation, slowly came down after 1996, jumped up during the 2008 Financial Crisis, stayed flat for a few years, and has been rising since 2015:

Is inflation temporary?

If I have scared you up until now, don’t worry. 😊

It is important to understand why inflation can be a big fear. However, I believe it will not last long, and should not really be a major problem for us.

The general expectation of economists and my personal expectation is that inflation is “temporary”. It should be back down to the 2-3% range in a year or 2. This is the most likely scenario, which is why I am not really concerned today. However, this is far from definite.

Economists are often wrong. It was only a few months ago that they considered inflation “transitory”, meaning it should only last a few months, but that was clearly wrong. The current expectation of a year or 2 is likely right, though.

To understand why, let’s look at the main causes of inflation to see whether or not they will continue:

Gas

Prices at the pumps have been painful. They jumped about 50% from February to June 2022. This affects the cost of everything delivered. Many experts think gas prices are close to the peak and are likely to stop rising. Whether it declines is unclear. Why?

a. Supplies are starting to catch up after the global supply shock from the Ukraine War and the end of Covid. The gear-up of supply, especially at oil refineries, was slower than the gear-up in demand. We are getting back to normal either now or soon. The Ukraine War will end eventually.

b. Oil prices are a global commodity. Here are oil prices per barrel for the last year. “WTI” (“West Texas Intermediate”) is considered the US oil price. “Brent crude” is considered the global oil price. They shot up in January with Covid reopening and again in March with the start of the war. They seem to have stayed about that level since then and may have peaked at the beginning of June.

Remember, inflation is the rate of price increase. If gasoline stays high, but stops rising, then it is not causing inflation. Oil prices are political all over the world. It’s not just a local supply/demand issue, so they are hard to predict. It is most likely, though, that gasoline does not rise a lot from here, but may or may not reduce.

Food

Sharply rising food prices at the grocery store affect us all directly. They should stop rising and even come down as supply chain bottlenecks ease, which may take a year or two. Whatever happens with the price of oil has a major effect here. Oil is the main cost of both transportation and fertilizer, so it is a major cost of all food.

Housing

A major part of inflation is the cost of housing, both real estate prices and mortgage payments.

a. Real estate prices are pulling back as the froth and overbidding is gone. Super-low interest rates fuelled real estate prices, but are probably gone for years. However, prices are not likely to fall much because we have a systematic housing shortage.

We have the “Battle of 2 governments” going on between the federal government and municipalities that is likely to keep real estate prices rising over time. The federal government wants increasing immigration, which helps grow our economy. A larger population means larger economy. Immigrants are also on average more highly educated and more entrepreneurial than people born here.

But we don’t build enough homes for them. Municipalities want to keep their character and limit growth. Toronto has a history of keeping muti-unit homes out of many neighbourhoods. The 1912 By-law #6061 banned apartments in much of the city. This NIMBY culture is still strong. Vancouver has limited space inside the bridges that surround most of the city.

The housing supply shortage is likely to continue. However, the rate of increase in prices should go back to pre-Covid levels. However, they could go down. Canada did not have the real estate price decline after 2008 that the US had. We are long overdue for prices to fall.

b. Mortgage payments have jumped with interest rates finally coming off their near-zero rates. Interest rates are expected to rise for a year or 2 – as long as it takes to get inflation under control. This means mortgage payments have jumped and will continue to rise.

After this year or two, assuming inflation comes under control, interest rates may come down a bit and should go back to a “normal” pre-Covid level. This rise in interest rates is just going back to normal. We should expect mortgage interest rates to stay in the 3-5% range for years.

Worker shortage

Unemployment is at 5.1% (May 2022) – the lowest since the 1970s. Many businesses are complaining they cannot find enough workers. We see it most with restaurants, nurses, construction and manufacturing. Most industries have a worker shortage today.

This started with the reopening after Covid, with people not wanting to go back to work until their CERB & EI benefits stopped and because of Covid-hesitancy. The initial shock from Covid-related issues should work itself out and normalize.

However, we also have structural labour shortage that is going to get worse over time. The Baby Boomers are our largest generation. About 20% of our workforce are Baby Boomers, born from 1947 to 1964, according to Stats Canada. The peak was 1961, with more Canadians born in 1961 than any other year.

This Baby Boomer peak is people aged 61 today. Millions of experienced and hard workers will retire the next few years. Nearly all of this 20% of our workforce is expected to retire this decade.

Our worker shortage is likely to continue as Baby Boomers retire.

“Stagflation” has been a news story recently, will the 1980s stagflation return?

Stagflation means high inflation combined with high unemployment and low GDP growth.

Note this is a major difference between now and the 1970s and 1980s. We had high unemployment of 8-12% for most of those 2 decades, but low unemployment now about 5% and expected to stay low.

Here is unemployment for the last 50 years. Note how low it was in the 1960s, how high it was from 1975-1995, and how low it is now.

Stagflation includes low GDP growth of the economy. Canada actually had decent growth in the 1970s and 1980s, averaging about 4%. At the time, we though growth was slow, because it was less than the 1950s and 1960s when we had growth over 5%.

I find it quite funny when we talk about the “low GDP growth” of stagflation in the 1970s and 1980s. It was about 4%! 😊 That was a lot higher than growth of our economy since then. Today, 4% growth of our economy is a distant memory. We think of 2% growth as good!

Since then, our growth has continued to slow. From 2000-2015, our growth averaged about 3%. From 2015-19 before Covid, it slowed further averaging below 2%.

This chart is “real GDP”, meaning growth of our economy after inflation. Note the steady decline over all of the last 60 years – over 5% in the 1960s, 4% from mid-1970s to 2000, 3% from 2000-2015, and 2% from 2015-2019.

Our growth is expected to slow even more to less than 1% for the rest of this decade. The OECD predicts Canada will have the slowest growing advanced economy of 38 OECD countries for the rest of this decade – and the next 3 decades.

This is not because of inflation. It is political. Growing our economy and our standard of living, and being competitive internationally are simply not priority in Canada today.

This is one of the main reasons we invest almost entirely outside of Canada. There is lots of growth for global investors.

In short, we do not expect “stagflation”, because inflation is likely temporary and unemployment should stay low.

If inflation does last for years, we would get stagflation, but a bit different, because growth will be low, but unemployment will likely also stay low. In the 1970s and 1980s, we had stagflation with very high inflation, high unemployment and low growth by 1970s standards (although high by today’s standards). Today, we have high inflation (hopefully temporary), low unemployment and very low growth.

Government deficits

“Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” In other words, too much money chasing too few goods and services. We are testing this now.

The Covid stimulus was truly unprecedented “money printing”. It was by far the largest in history. Essentially, we borrowed $400 billion from investors by issuing government bonds. This money ended up in the hands of Canadians either directly or indirectly (see chart).

Canadians now have record cash holdings and pent-up spending demand. This has been one of the main causes of inflation now. After being locked up for 2 years, we are out driving, going to restaurants and entertainment, and lots of shopping. Supply issues, such as supply chain & transportation issues, oil refineries slow to open, and workers slow to return could not keep up with the surging demand.

Bank of Canada should make sure inflation comes down.

The main reason I believe inflation will come down is because that is the main job of the Bank of Canada (and the Federal Reserve in the US). Our central bank is mandated to keep inflation between 1-3%, with a target about 2%. They were very successful at is from 1992-2019. Inflation stayed close to 2% for 30 years.

If the Bank of Canada does its job, inflation should come down to 2-3%, hopefully within 1-2 years. The only question is how high do interest rates have to go to bring down inflation? They will keep raising interest rates until inflation comes down to their target range.

There are 2 risks to this:

a. The Bank of Canada’s mandate was changed in 2021.

They now have 2 jobs – keep inflation about 2% and create “maximum sustainable employment”. For the last 30 years, they had one job – 2% inflation – and they succeeded at keeping it about 2%. Now they have 2 jobs.

It took 20% interest rates and 2 recessions to bring down high inflation in the 1980s. Will the Bank of Canada focus on avoiding a recession because it would increase unemployment? If so, will that make them less effective at reducing inflation?

In my view, adding employment as a second job for the Bank of Canada was a political decision, but is a risk financially. Unemployment is a lagging indicator, which means it usually takes a year or more for employment to respond.

The Bank of Canada is already almost always very slow to respond. The investment industry widely wanted interest rates to start rising in October 2021 and believes the Bank of Canada was about 7 months too slow in starting.

This mandate change may make them much slower & less effective. Scenarios where they lose control of inflation to avoid creating a recession are unlikely, but much more possible with this mandate change.

The 2 mandates should not be a problem this time, since unemployment is very low and likely to stay low, even if we have a recession.

b. “Battle between the federal government vs. the Bank of Canada”.

Governments have 2 main tools to control the economy: “fiscal stimulus” (governments running deficits to create growth) and “monetary policy” (the Bank of Canada raising interest rates to slow the economy). Today, these 2 are pushing against each other.

The Bank of Canada intends to raise interest rates until inflation is under control. The government plans to continue to have large deficits and print money, which stimulates inflation.

This year’s federal deficit is projected to be $155 billion. There are projections of reducing to $50 billion in a couple years, but this federal government has not come close to their projections in any year.

Many permanent new programs have been added, so deficits may well stay about $100 billion/year. Until the last few years, a $20 billion deficit was thought to be huge and governments targeted living within their means by balancing their budget (no deficit).

We learned our lesson after previous inflation and balanced budgets for 20 years. However, we seem to have forgotten that lesson since 2015.

In the end, the Bank of Canada should win. The worst-case is that the money printing may just mean interest rates will have to go a bit higher and stay high a bit longer to get inflation down to the target range of 1-3%.

How to solve inflation.

Here are 7 ways to solve inflation. How likely do you think these are to happen?

a. Supply chain issues work themselves out.
b. Ukraine War ends.
c. Supply of oil increases enough to keep up with growing global demand. This should keep the price of oil and gasoline at current prices or a bit lower.
d. Keep immigration high to replace retiring Baby Boomers.
e. Build enough housing for immigration. Or reduce immigration to the net new homes we build so we can provide homes for them. If municipalities won’t allow more building, then it needs to be higher concentration in the cities.
f. Governments go back to fiscal responsibility and balancing budgets. We all have to live within our means. Governments should be a good example.
g. Bank of Canada stays focused on inflation and keeps raising interest rates until inflation comes down to their 1-3% target. Raising interest rates too high is less of a problem than letting inflation lasting longer and becoming an expectation. This may cause a recession, but probably not high unemployment.

Summary

1. Why is inflation scarier than a market crash?

Stock markets have recovered from 100% of crashes, but inflation is a permanent increase in our cost of living. It piles on top of the inflation from all previous years.

2. Should we be worried?

I agree with most economists that inflation should come down to the Bank of Canada’s 2-3% target. However, I am very aware that higher inflation lasting quite a few years is probably the single biggest risk to our financial futures. Having a sustainable retirement is a lot more difficult with years of higher inflation. I hope interest rates continue to rise until inflation comes back down. We cannot let inflation become an expectation!

3. How long will it last?

Many factors affect this, so any forecast is far from certain. I agree with most economists that inflation should come down within 1-2 years.

Worst case: Inflation stays high and becomes an expectation. Interest rates keep rising higher and stay high longer. They are unlikely to be anywhere close to 20%, but above 5% is possible. Variable mortgages are about 3% today and likely to be over 4% in a few months.

Best case: Interest rates spike higher now, but bring down inflation in 1-2 years.

Planning With Ed

EdSelect

Ed Rempel has helped thousands of Canadians become financially secure. He is a fee-for-service financial planner, tax  accountant, expert in many tax & investment strategies, and a popular and passionate blogger.

Ed has a unique understanding of how to be successful financially based on extensive real-life experience, having written nearly 1,000 comprehensive personal financial plans.

The “Planning with Ed” experience is about your life, not just money. Your Financial Plan is the GPS for your life.

Get your plan! Become financially secure and free to live the life you want.

7 Comments

  1. PETER HOOIVELD on August 16, 2022 at 9:47 AM

    Hello Ed, Thanks for taking the time to reply with the statistics that we sometimes too easily overlook, but which are always good to revisit.
    ….Pete



  2. Ed Rempel on August 15, 2022 at 9:27 PM

    Hi “Other Ed”,

    Thanks for taking the time to comment. I’m glad you found my post interesting.

    Ed



  3. Ed Rempel on August 15, 2022 at 9:26 PM

    Hi Leonard,

    Thanks for taking the time to comment. I’m glad you found it interesting.

    Ed



  4. Ed Rempel on August 15, 2022 at 9:25 PM

    Hi Pete,

    Don’t worry. This too shall pass. The markets have always recovered from every downturn. It recovers because we are invested in well-run companies with managements that adjust to whatever is happening in the world.

    The problems of today are not large, though. We have had much worse of everything:

    – We have inflation at 8%, but we had 10-15% for 20 years in the 1970s-80s.
    – We have a war, but we had 2 world wars last century.
    – The market declined 20-25% at the worst so far, which is a run-of-the-mill bear market.
    – We probably are in a recession, but we have had lots of them. 2008 was far worse. The stock market usually rises during a recession.
    – We do have historically low economic growth in Canada that looks like is will last decades. It’s still a nice country to live in, but just invest globally, not just in Canada.

    As long as the Bank of Canada and the Fed continue to take inflation seriously, the recession we might be in should end soon.

    Ed



  5. Ed Rempel on July 1, 2022 at 10:44 AM

    Ed, Leonard sent me your link. What a well thought out and constructed argument! Yout article should be read by every Canadian. Including Tiff. He needs a reminder now and again that he has a job to do. Christia Freeland would not understand your article, so scratch one Canadian. As for Justin, I pray to God that the United Nations takes him off our hands.



  6. Leonard Rempel on July 1, 2022 at 10:01 AM

    Hello Ed,
    What a terrific read on Canada Day morning!
    Very insightful, easy for the layman to understand, and let’s hope inflation follows these timelines.
    Enjoy your Canada Day!



  7. PETER HOOIVELD on June 30, 2022 at 9:05 PM

    Hi Ed, Thanks as always for your insightful thoughts. Certainly all of the conditions, that have never before been seen in this combination in all of human history, are globally creating a possible “perfect storm” that may well prove to be the biggest challenge facing world and personal economic scenarios. Not being the praying sort, I simply trust that evil and difficult circumstances will be overcome and life will eventually return to what we think of as normal.
    ….Pete



Leave a Comment