Your Covid Dividend is a Result of the Fed Trying to Create Enough Inflation

Money and monetary policy are more complex than most people realize. Some think the Fed’s money-printing program will create run-away inflation. People talk about “Zimbabwe” and “the seventies,” fearing that double-digit inflation will return to the US and the developed world. That’s why the price of gold has risen so much lately: 

But does this make sense? Is gold really a hedge against inflation? How much inflation can we expect?

Here I will explain why the Fed should be creating inflation, why they haven’t yet printed enough money, why we won’t have much inflation, and how Fed policy impacts people who have assets. Those interested in more economic theory can see my book on digital money or the video below.

What is deflation?
Deflation is when money buys more in the future than it does today. In that case, people hold money, as it increases in value if they don’t spend it. To make a long story short, Scott Sumner has shown that this is what caused the Great Depression. World War I effectively broke the gold standard in Europe. In the 1920s, dollars were pegged to gold, but everyone knew that the peg would be changed from $20.67/oz to something higher. So all the dollars stayed under mattresses as the economy tanked.

It wasn’t until 1934 that Roosevelt raised the peg to $35/oz, a devaluation of more than 40 percent, ending the depression. The gold standard had failed, but not before deflation had wrecked the economy.

What is inflation?
Inflation is when money buys less over time. The more inflation, the more people would rather spend their money now than hold onto it. Inflation increases the velocity of money. All things being equal, a bit of inflation creates more economic growth than less inflation.

Doesn’t inflation erode our savings?
If you keep cash in a savings account or under a mattress, yes. But most people don’t. Most people hold assets, like commodities, stocks, bonds, real estate, etc.

Doesn’t inflation make wages worth less?
It does not. This is called “the money illusion.” In a short video, Don Budreaux explains that wages tend to outpace inflation, so people’s pay checks actually buy more over time, not less. Coupled with technological advancement, wage-earners in the exact same job have a much higher standard of living than their counterparts of 50 or 100 years ago.

Isn’t too much inflation bad?
Yes. Long-term high inflation leads to many problems. It raises interest rates, it forces quick adjustments in prices, it discourages borrowing, and it makes everyone uncertain about the future.

Why does the Fed want more inflation? The Fed has a mandate to create 2 percent inflation, yet they rarely hit that target (the red line is the target):

Congress asks the Fed to stimulate the economy at a “Goldilocks” amount of inflation that isn’t too high or too low, but “just right.” At 2 percent, prices rise enough to encourage people to spend but not so much that people are worried or have to keep adjusting too often.

How does the Fed create inflation?
As Milton Friedman explained, “inflation is always and everywhere a monetary phenomenon.” This is what Paul Volcker realized in the late 70s. He reduced high inflation by reversing the expansionary monetary policy of his predecessor. The Fed creates inflation by buying assets from banks. Banks receive new money (generally in their account with the Fed, called the reserve account), and the assets go onto the Fed’s balance sheet.

The Fed’s balance sheet is a special place. It contains money and assets that are not in circulation. The Fed manages its balance sheet only for the purpose of managing the economy. It really doesn’t matter what the value of the balance sheet is — it’s out of circulation.

When banks get new money, they can lend more, and that increases the overall supply of money, since banks create new money by lending against their reserves.

This directly affects prices. If the Fed doubled the amount of money in circulation, prices would double in short order. So when the Fed announces they are printing money, the value of everything increases.

But assets rise more than most prices in the everyday economy. Assets like real estate and stocks rise with the amount of money printed, whereas things like appliances and laptops go up only a small amount.

The Fed’s goal is 2 percent constant inflation. They recently announced they will do more to hit that target, so that if they undershoot one year, they will make up for it the next year with higher inflation (so they say — they have a long history of undershooting their inflation target).

Can inflation run away?
No. Just as the Fed injects money into the economy by buying assets, they can pull money out of the economy by selling them. So if the Fed saw inflation above target, they could easily reduce inflation to hit the target.

The Fed is completely in charge of inflation, and they are slowly realizing it’s not about interest rates. There is really no chance that the Fed will let inflation get above 4–5 percent (and only then to make up for very low inflation, like we have now). Their large balance sheet lets them dial in inflation to hit exactly the number they want.

What is a Covid dividend?
Families with assets like stocks and real-estate have received a special gift from the Fed this year. All but two of the 12 richest people have seen their net worth increase substantially this year:

Not all of this is money they earned. Much of it is a gift from the Fed. Without the Fed printing money, the stock market would be in a very different place. Not only is the Fed likely to print more, but they are very very unlikely to contract the money supply in the next decade. This gives wealthy families a huge dividend they can keep investing and using to build more wealth.

Does inflation help working people without assets?
Yes. Even though they don’t benefit from the asset-price increase, everyone benefits when the Fed hits its inflation target. Why? In today’s ultra-low inflation environment, inflation stimulates people to spend. This helps bring people back to work as soon as the health situation allows. Working people should be thankful the Fed is printing money. In fact, they should be asking the Fed to print more, as I explain next.

Should we buy gold?
Gold is for people who don’t understand this, and there are many of them. They could easily push the price of gold higher. But, apart from the general boost gold gets from Fed money printing, smart people should not consider it a hedge against high inflation, because there won’t be any high inflation. As always, a broad mix of assets is best for most of the portfolio, and an antifragile bar-bell portfolio is optimized to preserve capital yet perform well in all market conditions.

What is the optimal monetary policy?
I’m glad you asked. It may have occurred to you that the Fed isn’t really that good at managing expectations. There is a better way forward. I’ve made a short ten-minute video to break down and explain the concepts of nominal GDP level targeting:

If this interests you, please see the resources at my Digital Money Book. 

Convexity
The concept of convexity is important to investors. It means there is a growing positive payoff if there is any payoff at all. Taking a risk is one thing. But the risk should have a non-linear reward that continues to pay off more and more over time. Now that wealthy families have a huge Covid dividend from 2020, they should think of taking some long shots. Shots that may be small now but have a huge impact if they pay out. It would be appropriate for most wealthy families to take around 40 percent of their Covid dividend and put it toward new ideas and moon shots. It would be great if they could work together and create some funds to take many moon shots. If only a few of those pay off, the world will be vastly improved.

We’re asking for a small percentage of your Covid dividend to get our nonprofit going. Please explore this site and contact us to set up a call to discuss how we can work on it together.