Warren Buffett’s Thoughts on Inflation
And how to protect yourself.
At the 2021 Berkshire Hathaway Annual Shareholders Meeting, Warren Buffett was asked what he thought about esteemed economist and former secretary of the treasury Larry Summers’ remarks: “I am much more worried that we will have more inflation or that we will have a pretty dramatic fiscal monetary collision. This goes way beyond what is necessary.”
Summers also said, “This is the least responsible macroeconomic policy we’ve had in the last forty years.”
After hearing the question, Warren Buffett looked visibly surprised, his eyebrows raising up his forehead. What was more funny was the Oracle of Omaha’s response, “You’re asking me on that?”, a question quickly followed by nervous laughter.
Buffett went on to say the Larry Summers is a very smart guy and that he was posing potential consequences that were being increasingly voiced by others. He admitted that no one really knows what will happen from current fiscal policy until something does happen.
Charlie Munger put in his two cents, saying, “It is not clear at all whether Larry is right or wrong… He’s frankly the only one talking that way, which I admire by the way…People who kind of tell it the way they think it is, I like it.”
Berkshire is Seeing “very substantial inflation”
A bit later on, Buffett was asked the follow up question: “From raw material purchases by Berkshire subsidiaries, are you seeing signs of inflation beginning to increase?”
This time, Buffett elaborated a bit more. Without hesitation he said that Berkshire was seeing “very substantial inflation,” remarking “it’s very interesting.” That’s one way to describe it.
“We’re raising prices, people are raising prices to us, and it’s being accepted.” Then he brought up the example of home prices.
Berkshire has 9 homebuilders and the largest housing manufacturing operation in the country, Clayton Homes. Buffett emphasized that Berkshire does a lot of housing, saying that prices were “up, up, up.”
His second example was steel, of which he said the costs were increasing every day. The billionaire investor also expected that wages would inflate as well, although he pointed out that there is generally a lag in wage increases because unions typically write multiyear contracts in which the cost of labor is more or less determined. However, after those contracts expire, wages will increase as well, putting further pressure on American businesses.
“It’s an economy which is red hot,” Buffett summarized.
However, what was perhaps most surprising of all Buffet’s remarks was his admission that Berkshire was not expecting inflation before the economy reopened. He said that all of his companies going back to work could not stop people from buying things. Not only could Berkshire subsidiaries not deliver their products, other businesses couldn’t either. So a backlog of orders started to pile up, and no one could do anything about it.
“We thought it would end when the $600 payments ended around August of last year. It just kept going, and it keeps going and it keeps going and it keeps going… It just won’t stop. People have money in their pocket and they pay higher prices,” said Buffett.
He continued, “It is not a price sensitive economy right now, in the least…There’s more inflation going on — quite a bit more inflation going on — than people would have anticipated just six months ago or thereabouts.” In reply to this, Charlie Munger chimed, “Yeah, and there’s one very intelligent man [i.e. Larry Summers] who thinks it’s dangerous, and it’s just the start.”
Buffett’s Inflation Protection Strategy
Actually, there was another individual warning about rising and persistent inflation even back in early 2020: American stock broker and podcast host Peter Schiff. Schiff’s argument was that Jerome Powell and the Federal Reserve (the Fed) were pursuing a nonsensical policy by printing trillions of dollars in a contracting economy.
His point was that, in the face of the pandemic, America was producing fewer goods and services. By printing more dollars and artificially lowering interest rates, the Fed was encouraging spending in an environment where there was nothing to buy. The outcome, according to Schiff, was very obvious. Prices were going to skyrocket. He was right.
Schiff said that the Fed’s actions made no sense in any economic framework, neither Keynesian nor Austrian. What the Fed needed to do was exactly the opposite: contract the money supply and raise interest rates in the face of a contracting economy. However, the Fed did not want to do that because it would wreak havoc on an economy that was over-leveraged with debt and had no savings to the weather the storm. Even the United States Government would not be able to pay back its own bills (i.e. service the debt). This would inevitably lead to a recession. However, Schiff argued that a recession was necessary to heal an economy that had become too sick.
Warren Buffett and Charlie Munger are very intelligent men themselves. They understand what is happening to the economy, and they understand the dangers of inflation. However, they aren’t going out of their way to remark on what is happening as much as one might expect. They only really elaborate when they are persistently asked the question. Perhaps that will change once official inflation numbers become much more alarming.
For example, in 1979 the reported inflation rate was at a whopping 11.35%. In his 1979 annual letter to shareholders, Warren Buffett wrote:
“Just as the original 3% savings bond, a 5% passbook savings account or an 8% U.S. Treasury Note have, in turn, been transformed by inflation into financial instruments that chew up, rather than enhance purchasing power over their investment lives, a business earning 20% on capital can produce a negative real return for its owners under inflationary conditions not much more severe than presently prevail.”
In other words, even if your investments are doing amazingly well, you could still realize a negative real return in a high inflation environment. One must subtract the rate of inflation (i.e. the rate at which purchasing power is lost) as well as income tax on investment dividends and capital gains taxes from one’s investment profits. If these exceed the investment gain, the investor’s purchasing power has decreased in real terms.
In 1980, Buffett made the analogy, “The average tax-paying investor is now running up a down escalator whose pace has accelerated to the point where his upward progress is nil.”
Current consumer price index (CPI) inflation is now at 6.2%. However, many people, including Peter Schiff, have argued that the CPI metric has become less reliable over time, and that real rate of inflation is much higher.
Schiff actually performed an experiment of his own, in which he monitored the price of a market basket of 20 goods he selected and compared it to government reported CPI. In the decade from 1970–1980, CPI rose by 112%, while Schiff’s 20 goods rose 117% (a 4% difference), which is pretty reasonable agreement. However, in the decade 2002–2012, CPI rose only by 27.5%, while Schiff’s basket of goods rose 44.3% (a 61% difference), showing a much larger discrepancy.
Schiff’s analysis makes the case that the CPI numbers Buffett was following in the 70’s and 80’s were quite reliable at a time when he was heavily commenting on the dangers of inflation. However, the current numbers may be underreporting the true magnitude of inflation. Perhaps Buffett is aware of this, which is why he is reticent to comment too much on the current state of affairs.
In times of high inflation, many investors search for investments that are thought to be resistant to a weakening currency, such as assets which are scarce. Some examples sought by investors include gold, real estate, or Bitcoin. However, Buffett has expressed disinterest in ideas like gold or Bitcoin because he views them as nonproductive assets, or assets that do not generate new wealth by producing something (in the way that a business would).
So how does Buffett think investors can protect themselves against inflation?
“The best investment against inflation is to improve your own earning power, your own talents. Very few people maximize their talents. If you increase your talents, they can’t tax it while you’re doing it, they can’t take it away from you. If you become more useful in your activities, your profession — you know…doctor, lawyer, whatever it may be — that is the best protection against a currency that might decline at a rapid rate. The best investment, passive investment, I think, is a good business. If you own an interest in a good business, you are very likely to maintain purchasing power no matter what happens to the currency.”
In his 1981 annual letter to shareholders, Buffett elaborated on the types of businesses that are more resistant to elevated levels of inflation. He said such businesses have two characteristics:
“(1) an ability to increase price rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and
(2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital.”
In other words, the ideal business is one which is able to push the burden of higher costs onto their customers without driving them away from the product. Therefore, the product needs to be so compelling that it is essential to the customer’s activities, and an alternative of comparable quality is not available from its competitors. One real world example is the Apple iPhone, whose price has been steadily marching upwards over the years. However, the quality of the product and the stickiness of the Apple ecosystem have made the iPhone an extremely compelling product, which keeps customers returning for more.
The second quality of an inflation resistant business is the ability to increase the scale or scope of its activities without needing to invest too much additional money. One real world example is Google ads on youtube videos. Google can increase the number of ads on its youtube platform with only minor increases in the cost of displaying those ads or streaming new videos.
Therefore, Buffett believes there are still ways to protect against inflation even when not investing in traditional inflation hedges.
Summary
Overall, Buffett recognizes that there is a lot of uncertainty today. Many of the great minds in economics and investing agree that the economy is in uncharted territory. The money printing continues at a rate that is outpacing the production of goods and services. The value of everything in our everyday experience is being increasingly called into question. As Buffett put it, “People have become numb to numbers. Trillions don’t mean anything to anybody, and $1400 does mean something to them. So we’ll see where it all leads. Charlie and I consider it the most interesting movie, by far, we’ve ever seen in terms of economics.”