5/2/18
I've been trying to write about what the stated position of the Fed means, however, any explanation implicitly requires an understanding of inflation, interest rates, and currency as an intermediary of exchange to be understood first. I believe that my case requires the reader understand the basics of fiat currency before reading it, so this is my attempt to explain them.
In my experience, nearly every person who has ever had a job claims to understand inflation, money, and value yet, in reality, doesn't to the extent necessary to understand the minutia of finance generally nor the implications of the Fed rate. The confusion is understandable as these aren't easy concepts. If you're an American you've probably used dollars the majority of your adult life. What few people are willing to acknowledge however is that at its most basic level the USD we know today is just something we made up, has value only because we say it does, and that arbitrary value is relative to the things we want to exchange money for whose value is also essentially arbitrary.
The U.S. dollar works so well as a medium of exchange because its value is reasonably stable over the course of days, weeks, months, and even years - depending on your definition of stable - there are enough dollars to facilitate exchange, places to exchange them, confidence in their future value, and belief in their function (as a medium of exchange) for dollars to actually work.
We're not talking bitcoin or Zimbabwe dollars here, right? Jesus, take the economic wheel.
At it's most basic level, an ounce of gold would buy a fine suit of clothes. In 2010 an ounce of gold would buy a fine suit of clothes. And in 2018 an ounce of gold will buy a fine suit of clothes.
In 1879 an ounce of gold could be freely exchanged for $20.67 because the value of the dollar was directly linked to the value of gold, called "The gold standard". Gold wasn't "cheap" back then, the dollar was worth a lot more then than it is in 2018. By 1971 the US was completely off of the gold standard and the dollar became a fiat currency.
Terms Nominal value: The number value used when pricing things, typically denoted in the local currency. If gold is worth $1312 today, thirteen-hundred-and-twelve United States dollars is that ounce of gold's nominal value.
Currency: The intermediary used when exchanging goods. An ounce of gold might be worth $1312, but if you need to buy $20 in gas or $200 in accounting services that transaction gets complicated without an agreed upon intermediary. Just try to get the correct change when buying gas with a double eagle, Euros, or Rubels at a pump in rural Tennessee. Currency, in the form of twenty-dollar-bills, a check, or a credit card is used as an intermediary precisely because of the ease of exchange, similar day to day value, and the federally approved agreement among the people to accept it. Gold might maintain it's day to day value better, but it's harder to transact with, and when the prevailing price is based on local fiat currency nearly impossible to exchange directly at the point of sale no matter what a gold bug tells you.
Inflation: The decrease in the real value of the currency.
The concept of value
There isn't one, because we conflate "value" and "price". Value is, at least in principle, arbitrary and based on the humans involved. I don't think your signed La Bron James Miami heat jersey is worth anything, it's only value to me is the PRICE it would fetch to you or someone else. And this is what value is. Value is individual (both utilitarian and sentimental) and based on the community conception and it determines our individual price as an item is worth whatever its purchaser will pay for it. It changes from person to person, over time, distance, place, scarcity, and situation as dose the price. It certainly isn't absolute, and it isn't entirely arbitrary either because we can exchange things of value. What is something's price? What is it's value?
While we think of store prices as being fixed, this is a relatively recent invention. Haggling used to be prevalent and remains so in many societies. In the end, we in the states simply have a different version of haggling, buy it or don't. If you value something more than I do, I'm unlikely to be able to obtain it from you at the price you offer.
In the case of trade and exchange, each individual places a price within the currency of transaction and value on the object to be transacted and these values & prices are often different. Additionally what we ourselves value over time, circumstance, and location changes. Both for that which is to be transacted and the currency involved. In London, my dollars were all but useless and all the GBP I brought back are all but useless here (my local Bank of America wanted 8% to exchange it into USD - a price to exchange currency - what a business).
This is why it's all so complicated. The value of the dollar is almost arbitrary, I can buy a commodity or durable good with it, but the price of that potential store of value fluctuates. The search for stores of value increases their nominal price while inflation affects both sides again and the web continues to tangle when one considers the prevailing interest rate, which is sadly necessary.
Preserving value
Simple capital preservation is nearly impossible in practice. Bonds and Treasury notes are auctioned and sold to the highest bidder. The higher the price paid the lower the rate of return (it's final value is constant). If everyone is afraid of inflation then the value of Bonds and Notes goes up, which means their nominal price increases so you can buy less of them with a lower yield, making them a poorer hedge to inflation than you would probably like.
If you buy Bond or Treasury indexes, these funds are balanced at the end of the month. So before the end of the month Notes and bills can be purchased at a discount to the amount at which they'll be sold to the funds at the end of the month. Additionally, Notes sold before the Treasuries auctions will be discounted as they will have to compete with the Treasury's own auction and hold an increased value between auctions.
Even Treasury Inflation Protected Securities (TIPS) which seem tailor-made for the process aren't exactly ideal. They hold a lower interest rate than their brethren but increase in value as the CPI (Consumer Price Index) increases. As CPI is a central factor within the definition of inflation, TIPS do succeed better at preserving value than many of the alternatives. Its worth noting that in the case of deflation, a decreasing CPI, their final value decreases. However, they are more difficult to trade than other securities and any gains are taxed. So while the goal might be to simply preserve capital the difference between their initial price (nominal) and ending price (nominal) is taxed even though this nominal increase in value is not a change of real value. Because of this, they aren't great at doing the one thing they are specifically designed to do. Why not just hold actual assets like farmland or shares of MSFT?
Buying foreign currencies is simply a bet that those currencies will be less affected than yours. Unfortunately for the investor, the nature of the world market implies all markets and currencies will be affected by any move you'd like to make. Are you betting on the DJIA or the Central Railroad Company of New Jersey?
Being well positioned
Hedging against currency devaluation then is simply investing. Investing is one of those things that should be harder than simply saving on paper but in practice is actually easier. Buying real assets with potential positive returns, maintaining a cash balance to seize opportunities, diversification, and probably some form of government bonds to round it out. Possibly TIPS if the rate of inflation is increasing. Among all options, however, growth remains king and will yield the best returns. Finding those opportunities in a devaluating currency market is much harder than usual, however, you don't want to pick the wrong Railroad.
In my experience, nearly every person who has ever had a job claims to understand inflation, money, and value yet, in reality, doesn't to the extent necessary to understand the minutia of finance generally nor the implications of the Fed rate. The confusion is understandable as these aren't easy concepts. If you're an American you've probably used dollars the majority of your adult life. What few people are willing to acknowledge however is that at its most basic level the USD we know today is just something we made up, has value only because we say it does, and that arbitrary value is relative to the things we want to exchange money for whose value is also essentially arbitrary.
The U.S. dollar works so well as a medium of exchange because its value is reasonably stable over the course of days, weeks, months, and even years - depending on your definition of stable - there are enough dollars to facilitate exchange, places to exchange them, confidence in their future value, and belief in their function (as a medium of exchange) for dollars to actually work.
We're not talking bitcoin or Zimbabwe dollars here, right? Jesus, take the economic wheel.
At it's most basic level, an ounce of gold would buy a fine suit of clothes. In 2010 an ounce of gold would buy a fine suit of clothes. And in 2018 an ounce of gold will buy a fine suit of clothes.
In 1879 an ounce of gold could be freely exchanged for $20.67 because the value of the dollar was directly linked to the value of gold, called "The gold standard". Gold wasn't "cheap" back then, the dollar was worth a lot more then than it is in 2018. By 1971 the US was completely off of the gold standard and the dollar became a fiat currency.
Terms Nominal value: The number value used when pricing things, typically denoted in the local currency. If gold is worth $1312 today, thirteen-hundred-and-twelve United States dollars is that ounce of gold's nominal value.
Currency: The intermediary used when exchanging goods. An ounce of gold might be worth $1312, but if you need to buy $20 in gas or $200 in accounting services that transaction gets complicated without an agreed upon intermediary. Just try to get the correct change when buying gas with a double eagle, Euros, or Rubels at a pump in rural Tennessee. Currency, in the form of twenty-dollar-bills, a check, or a credit card is used as an intermediary precisely because of the ease of exchange, similar day to day value, and the federally approved agreement among the people to accept it. Gold might maintain it's day to day value better, but it's harder to transact with, and when the prevailing price is based on local fiat currency nearly impossible to exchange directly at the point of sale no matter what a gold bug tells you.
Inflation: The decrease in the real value of the currency.
Real value: It's easiest to think of "Real value" as an "inflation adjusted" price. While someone might tell you gas was really cheap in 1939 at $0.10 that doesn't account for the devaluation of the currency between then and now. In reality, 10 cents in 1939 is between $1.75 and $2.50 in 2018 depending on how you choose to adjust for inflation (CPI vs GDP inflation index).
Deflation: The exact opposite of everything I'll describe in this post. Essentially goods & services becoming nominally cheaper as the Real value of the currency increases. It is the bane of a market that relies on currency. On the plus side, maintaining the value of your savings is as easy as putting money in a shoe box.
What is inflation?
What is inflation?
With those terms in mind:
- If you put $50,000 in a shoebox in 1939 it would still have a nominal value of $50,000.
- If you had bought $50,000 in gas in 1939 (and magically allowed those 500,000 gallons to be stored for free and useful in 2018) that gas would have a nominal value of over $1,405,000 at my local pump.
- If you bought $50,000 in widgets in 1939 they would worth $1,000,000. Because in 1939 having $50k was exactly like having a million dollars today because widgets maintain their real value. That is $50k in 1939 = $1,000k in 2018.
- If you had bought $50,000 in Gold at $35 an ounce in 1939, in 2018 you'd still have 1,428.57 ounces. Gold not only typically maintains it's real value it has thousands of years of emotional and cultural value as well (with some industrial uses and speculative value) causing your gold stockpile to have a nominal value of $1,874,285.71
Since inflation is part of our modern reality you should never save money in a shoe box or, by extension, anything that has a rate of return less than the rate of inflation. (Deflation hurts everyone but consumers so it's generally agreed it must be avoided at any cost so there is little value in discussing it.)
Inflation is the incremental reduction in money's ability to be exchanged for things of value as the currency itself is devalued. So if you hang on to money, inflation makes that money less valuable. If you invest your money at a rate that is merely equal to the rate of inflation, widgets in the example above, you don't really earn anything in real terms you've just avoided the devaluation of your currency asset by placing it in an asset not affected by inflation. This is where gold bugs mention the IRS taxation of interest which, from this fundamental viewpoint, has some merit - but won't be discussed here.
Just for reference and a word of caution:
- $50,000 into the DowJones in 1939 at 155, with today's price being 23,924.98 your investment would be worth approximately $7,717,735 after these 79 years.
- And if you had put that $50k into shares of the Central Railroad Company of New Jersey around 1940, you would've been wiped out in1947. Your $50,000 investment would be worth nothing today.
While ideally, we'd all like to make money with the money we've saved (and the point of this blog) at the very least we want to preserve its value.
The concept of value
There isn't one, because we conflate "value" and "price". Value is, at least in principle, arbitrary and based on the humans involved. I don't think your signed La Bron James Miami heat jersey is worth anything, it's only value to me is the PRICE it would fetch to you or someone else. And this is what value is. Value is individual (both utilitarian and sentimental) and based on the community conception and it determines our individual price as an item is worth whatever its purchaser will pay for it. It changes from person to person, over time, distance, place, scarcity, and situation as dose the price. It certainly isn't absolute, and it isn't entirely arbitrary either because we can exchange things of value. What is something's price? What is it's value?
While we think of store prices as being fixed, this is a relatively recent invention. Haggling used to be prevalent and remains so in many societies. In the end, we in the states simply have a different version of haggling, buy it or don't. If you value something more than I do, I'm unlikely to be able to obtain it from you at the price you offer.
In the case of trade and exchange, each individual places a price within the currency of transaction and value on the object to be transacted and these values & prices are often different. Additionally what we ourselves value over time, circumstance, and location changes. Both for that which is to be transacted and the currency involved. In London, my dollars were all but useless and all the GBP I brought back are all but useless here (my local Bank of America wanted 8% to exchange it into USD - a price to exchange currency - what a business).
This is why it's all so complicated. The value of the dollar is almost arbitrary, I can buy a commodity or durable good with it, but the price of that potential store of value fluctuates. The search for stores of value increases their nominal price while inflation affects both sides again and the web continues to tangle when one considers the prevailing interest rate, which is sadly necessary.
Preserving value
Simple capital preservation is nearly impossible in practice. Bonds and Treasury notes are auctioned and sold to the highest bidder. The higher the price paid the lower the rate of return (it's final value is constant). If everyone is afraid of inflation then the value of Bonds and Notes goes up, which means their nominal price increases so you can buy less of them with a lower yield, making them a poorer hedge to inflation than you would probably like.
If you buy Bond or Treasury indexes, these funds are balanced at the end of the month. So before the end of the month Notes and bills can be purchased at a discount to the amount at which they'll be sold to the funds at the end of the month. Additionally, Notes sold before the Treasuries auctions will be discounted as they will have to compete with the Treasury's own auction and hold an increased value between auctions.
Even Treasury Inflation Protected Securities (TIPS) which seem tailor-made for the process aren't exactly ideal. They hold a lower interest rate than their brethren but increase in value as the CPI (Consumer Price Index) increases. As CPI is a central factor within the definition of inflation, TIPS do succeed better at preserving value than many of the alternatives. Its worth noting that in the case of deflation, a decreasing CPI, their final value decreases. However, they are more difficult to trade than other securities and any gains are taxed. So while the goal might be to simply preserve capital the difference between their initial price (nominal) and ending price (nominal) is taxed even though this nominal increase in value is not a change of real value. Because of this, they aren't great at doing the one thing they are specifically designed to do. Why not just hold actual assets like farmland or shares of MSFT?
Buying foreign currencies is simply a bet that those currencies will be less affected than yours. Unfortunately for the investor, the nature of the world market implies all markets and currencies will be affected by any move you'd like to make. Are you betting on the DJIA or the Central Railroad Company of New Jersey?
Being well positioned
Hedging against currency devaluation then is simply investing. Investing is one of those things that should be harder than simply saving on paper but in practice is actually easier. Buying real assets with potential positive returns, maintaining a cash balance to seize opportunities, diversification, and probably some form of government bonds to round it out. Possibly TIPS if the rate of inflation is increasing. Among all options, however, growth remains king and will yield the best returns. Finding those opportunities in a devaluating currency market is much harder than usual, however, you don't want to pick the wrong Railroad.