Month: February 2011

Everybody talks about incipient inflation and what it really means, and the most recent data from China – suspect that it is – indicates that the consumer prices there rose  4.9% year over year from January of 2010.  When I mention suspect, bear in mind that they rejiggered their marketbasket and had it been left alone, the rise would have been 5.1%.  So what does it mean to the typical family when they see increasing inflation hitting the grocery stores?  Percentages can be scary, but what’s the real impact?

Let’s play with the use the Chinese rate of 4.9% and extrapolate it with some American data. 

First, remember that inflation means that there’s a decline in the buying power of the currency so that with the same amount of money, you’re able to purchase less than you could before.  If the inflation rate from one year to the next is 4.9%, then the same amount at the later date is 4.9% higher; the inverse is that if you maintain the amount spent as a constant, then you’re only able to purchase that much less.

Let’s work through the numbers.  According to Bureau of Labor Statistics courtesy of creditloan.com, the average American "consumer unit" of 2.5 people spent $3753 annually in 2009 for food at home for a monthly average of $312.  Bear in mind that when dining out was included, the total annual amount on food rose to $6372.  For our purposes, we’ll use the $312 as a baseline while understanding that if you’ve got kids, you’re spending more per month than this example bears out.

 

Effect of Constant 4.9% Inflation Upon $312/mo Budget

Year	%	Inflation Adjusted	Inverse	Budget	Buys
now		1.00	1.00	312.00	312.00
1	4.9	1.049	.953	312.00	297.34
2	4.9	1.100	.909	312.00	293.61
3	4.9	1.154	.867	312.00	270.50
4	4.9	1.211	.826	312.00	257.71
5	4.9	1.270	.787	312.00	245.54

 Assuming all else remains the same, the impact upon the food budget is significant as a $312 monthly budget only purchases what you can buy now for $245. 

The other problem is that income is at best, flat and for the lower wage groups, actually dropping.  According to the BLS at the same site, the average pretax income of that odd 2.5 average consumer unit declined from $63,091 in 2008 to $62,857 in 2009.  Likewise, inflation is a nebulous and inexact thing and to think that it only happens in an orderly and predictable manner is like saying that you can capture a specific number of insects with a single swoop of the butterfly net.

So where do we begin to cut?  The first source is most likely the amount that’s spent on dining out, which was about $218/month for the consumer unit.  And after that comes a rejiggering of the family menu as brand names go by the wayside in favor or store brands and then a shift in the menu to lower cost alternatives.  And that’s for families – not consumer units – who still some leeway and aren’t already to the point of doing without or going to the food bank.

When this does start to really percolate through the domestic economy, the final acts will be a complete realignment of our priorities as we reevaluate what’s truly necessary versus that which we’ve come to consider as necessary.

Got cable?

Inflation or deflation?  After ongoing debate, the fog is clearing and significant rises in the commodity arena – sugar, wheat, corn – are harbingers of the inflation that the Federal Reserve has sought.  It also means that costs will be rising for the end users in the supermarkets.  I’m young enough to have a kid in the primary grades but old enough to remember the inflationary 1970s and have been asking myself, what did families do to manage with inflation then?  What are the best courses of action if inflation, whether stag- or hyper-, takes hold?

For those who are a bit fuzzy on the 1970s, inflation began prior to the decade when the consequences of funding both the Vietnamese War and the Great Society became apparent.  Too much money was chasing through the economy and prices started to rise.  Housewives protested the butcher shop when the price of hamburger began to hurt the food budget – where do you think Hamburger Helper came from?  Prices however, rose across the board in a wide variety of items apart from food and inflationary expectations took flight.  While everybody talks about the supply shocks of having oil supplies cut off in 1973 and 1979, the reality is that inflation was already alive and thriving.  President Richard Nixon attempted to rein in the situation with statutory wage and price controls as far back as August 1971, a full two years prior to the first Oil Embargo. As you might expect, that effort failed – miserably.  It took painfully high interest rates by then-Fed Chairman Paul Volcker to bring inflation to ground.  In thirty years however, the company line on inflation has changed.

Understand that inflation is precisely what the Federal Reserve wants as it seeks to devalue the dollar.  With no end in sight to out of control federal spending and a grotesque national debt, the plan is to devalue the dollar so that this debt is paid for in dollars that hold less purchasing, if not actually valueless; the presumption however, is that the spending will be brought under control so that the debt really no longer grows and can be ultimately eliminated with these faux dollars.  The conventional thinking is also that the average family will return to spending – with renewed credit – as they use their dollars before they become further devalued.  For the Fed, it’s a policy two-fer as consumption increases while the national debt and interest payments are rendered manageable.  With the Volcker experience of the 1980s under their belt, the central bankers believe that they can bring inflation back under control after they’ve achieved the policy gains.

So, what did our parents and grandparents do during the inflationary 1970s?

First, they surely didn’t spend more, as the following graph demonstrates.

 They went the opposite way, ratcheting up savings during periods of economic stress.  Granted, not only had the average real income risen for decades previously, but the percentage share that the average US consumer spent on non-necessities (exc food, clothing, housing/affiliated expenses) had grown significantly.  In 1934-35, the average US family spent 23.8% of it’s money on non-necessities while that rose to fully 49.9% in 2002-03.¹ 

The surprising part of the savings increase though, is that it really didn’t come from the non-necessity category.  The previous inflationary period was from the early 1970s to the mid 1980s; non-necessity spending as a percentage of total spending rose from 42.6% in 1972 to 48.6% in 1985.  If savings during that period ranged from 8 to almost 12% while spending on discretionary items rose, where did the savings come from?  It would have had to come from the necessities category of housing/food/clothing.

So what else did our parents and grandparents do?

Many of them went back to gardening and growing their own food to reduce the rising costs.  In a 2009 USA Today article, an executive with a seed company noted that vegetable seed sales were fully 40% higher than in 2007 and they hadn’t "…seen this kind of spike in 30 years."  Which places us back in the period when savings were peaking  between 10% and 12% of income. One of the retrospectives at the time pertained to the Victory Gardens that their parents had grown to supplement the World War II war effort.  Between this gardening and the subsequent low domestic food prices, the percentage of income spent on food dropped from almost 20% in 1973 to 13% in 2003.  With an inflationary  uptick in food and commodity prices, that percentage spent on food will rise upwards again unless families return to gardening on a scale reminiscent of the 1940s era.

Our parents and grandparents likewise made due with consumer durables, such as automobiles and appliances.  Vehicles in the 1970s were nursed along so that a family had a vehicle for much longer than today’s family might.  Cars and appliances would be repaired again and again until they really were at the point of complete breakdown.  Legendary investment manager Peter Lynch once wrote that he realized that the auto industry – and by extension, the market – was ready for a run in the 1980s when he recognized how far along was the age of the typical American family vehicle.

They also were at a distinct advantage in terms of clothing costs.  Sewing was far more prevalent then than today and families had fewer clothes – and repaired them more frequently – than would occur today.  The percentage spent on clothing by the average family then, which was much larger than the 2.9 figure today, was 7.8% while as of 2003 had dropped by almost half to 4.2%.  The Walmartization of the American economy is a principal cause of this as American textile jobs flowed overseas to regions with far lower labor costs so that mass market clothing, on a historical basis, became incredibly cheap.  Think about it:  when Junior rips a hole in the knee of his jeans, do you patch them or just get another pair at Walmart?

The impact of even relatively stable inflation would be significant, although there are things that we can do.  We can manage to hold the line by:

• extending the lifespan of high-ticket items;
• re-thinking our clothing needs and shopping habits;
• shifting back to some self-sufficiency with our own gardens;
• simply deciding to forego some of the luxuries that have come to permeate our lives, such as the ever-present cup of Starbucks.
• understanding that true leisure time might be in short supply as non-work hours are taken up in the tasks necessary to tend gardens, cook more frequently and sew and mend more.

That’s within our immediate grasp.  We need to also speak more forcefully and vocally about the policies that have brought us to this point, a central bank that’s been corrupted by a financial system and a government that cannot control itself.

A large part of a father’s job is to teach and help prepare the kids for the world and that means that I have to actually follow what’s going on in the world.  Much of my worldview is skewed by the knowledge that I have children who will someday have to contend with issues that are being impacted by actions taken now.  Given that, I just finished reading the US Treasury Report on the reform of the housing finance system, a k a what the hell do we do with Fannie Mae and Freddie Mac?

Everybody knows that the housing market is a complete trainwreck and most are aware that the financial hulls of Fannie and Freddie are so shot full of holes that they’ve gone into government receivership.  This report outlines the potential steps that the government proposes to bring stability back to the housing market and it’s finance mechanism.  The upshot is that the mortgage market revert back to a principally private domain with private funding and the only government involvement would be for targeted markets.  This involves revoking the $729,000 maximum conforming loan limit (probably not impacting our kids), increasing the cost of mortgage insurance (impacting our kids) and increasing the size of the downpayment to a minimum of 10% (again, impacting our kids).  With the expectation that the lion’s share of lending for mortgages will revert back to the private sector, the handwriting is clear that the underwriting standards will be returning to the pre-house mania standards of solid credit history, which will absolutely impact our children.  After all, the banking sector has to be a good steward of the money entrusted to them now that they can’t slough it off on the taxpayer.

So here’s the brief synopsis of what my kids will have to consider when they eventually wish to purchase a house:

• increased monthly premium for mortgage insurance from today’s levels;
• higher downpayment as percentage of house price (from about 3% to at least 10%);
• higher credit scores.

 Intellectually, this is a good thing and something that has to happen for the system to right itself and recover.  But I’ve got a real problem as I look at it.  We know that the real income – corrected for inflation – of the average American is dropping or stagnant at best.  This means that the amount needed just to get into a house will be higher as a percentage of income and assets than the amounts which we’ve had to pay in quite some time.  Given the poor savings habits of Americans, who collectively haven’t saved 10% of their paycheck in decades, this drives the hope of homeownership further away from our children as the ability to gather a sufficient downpayment will be taxed.  Couple this with real concern about incipient food inflation, and the kids paychecks will be stretched just trying to keep food on the table.

I suspect that the Treasury authors understand this as well.  They’re blunt in their upfront assessment that their goal is not to put all Americans in their own homes, as proposed by George Bush.  Their goal is to reform the broken system so as to make it sustainable and  safe.  A later section of the report flatly states that work must be done to improve the state of financing for multi-family housing in order to attract apartment building owners that will put sufficient money into the properties to make them passably habitable.  Hey, if the kids are gonna be priced out, we still gotta find ’em someplace decent to live. 

What truly bothers me however, is that the only way – given these proposed changes and the existant income parameters – for a home to be affordable to the kids is for the price to fall.  But this imperils the financial system as housing prices are the foundation of so many Collateralized Debt Securities and everything possible is being done to prevent that from happening.  So…my kids or the banks?  Guess where that one comes down.

What do I have to do to help prepare my kids for this scenario?  There are several things on which to work, but none of them are simple or foolproof.

• Speak frankly with the kids about buying a house.  First, a house isn’t a home, it’s a structure and ignore the advertising about buying a home.  While the kids might not understand all of the details, they’ll get the underlying message better than you think that they might.

• Speak frankly about the need to save and then go out and model that behavior yourself.  Purchase items with cash that you’ve saved in a coin jar or alter your own behavior.  Kids smell hypocrisy like stink on a skunk and they’ll notice.

• Work with them to understand debt.  What exactly are the varying forms of debt and when are they appropriate?  How much debt should one be able to carry given a certain income level?

• Talk with them and teach them to be skeptical of what they hear and read.

In short, talk to them.  Don’t just chat, but talk to them in the car or at the basketball hoop, ask them if they know anything about whatever and see what they say.  And while you’re chatting about drugs, chat about the money, too.