It has been a long time since US investors have had to contend with inflation and many are completely unacquainted with the experience. Despite that benign history, there are good reasons to start preparing for such a possibility now.
One reason is conditions are ripe for inflation to reappear in the not-too-distant future. Another is inflation can be extremely harmful to financial assets if it does materialize. Finally, the tools and the mindset to successfully manage investment portfolios through inflation are dramatically different than those that succeed in disinflation.
Although inflation as a concept is widely recognized, its causes and contributing factors are varied and can be hard to pinpoint. In simplest terms, prices change as a result of imbalances. However, those imbalances are caused by complex interactions and ever-changing dynamics.
Many accounts of inflation, however, simplify explanations to such a great extent as to be misleading. One goal of this report, then, will be to identify ways to obtain useful content from inflation arguments while at the same time minimizing the risk of bias and misinterpretation. As a result, this report can also be thought of as a practical guide to assessing inflation potential and the implications for investment strategy.
In order to accomplish this, the report will begin by identifying many of the common shortcomings of inflation arguments and in doing so, disentangle the useful insights from the assumptions and conditions that can be misleading. Then, a framework for understanding inflation will be discussed. Next, the environmental conditions which contribute to inflation will be investigated. Finally, the findings from each of these exercises will be synthesized into a discussion of the potential for inflation and the implications for portfolio strategy.
I. Shortcomings of common inflation arguments
For many reasons, much of the information we receive on inflation (and many other subjects) comes in short form and incremental bits. At worst, these reports can be narrow, promotional, and misleading. At best, however, they can be quite insightful and contribute to better understanding.
Largely because the information environment is so fragmented, an important focus of this report will involve identifying the shortcomings often associated with inflation arguments. Far and away the greatest single deficiency of inflation arguments is that of oversimplification.
In many cases, the problem is not so much the accounts are wrong as they are incomplete. In these cases it is important to establish the appropriate context. Once that is done, then useful insights can be obtained and incorporated into a broader thesis.
The following are what I see as the most important deficiencies in arguments about inflation:
a. Overly simplistic narratives and perspectives are employed
When I read and evaluate different assessments of inflation, I am struck by the tendency to address only one side of the issue. To some extent this isn't too surprising since many commentaries are written as opinions. Arguments that advocate for a certain position are often compelling mainly because they highlight only the most compelling evidence. In these cases, it is often what is NOT mentioned that is key.
Another problem with many advocacy arguments is they often tend toward sensationalism. Arguments for inflation become warnings of hyper-inflation. Cases for deflation become threats of deflationary depression. Such emotionally evocative language distracts from the logical argument and detracts from the information content. I have also noticed that many times headlines are sensationalized in order to gain attention and often do not accurately represent the underlying argument.
One relatively unique characteristic of economic arguments is they are often deeply biased by a particular school of thought. This situation is made worse by the tendency to provide policy recommendations even in the presence of disconfirming evidence and false assumptions.
For example, many economists believe inflation is primarily a function of economic imbalances. It is caused by demand exceeding supply. When such imbalances occur, they are reconciled through rising prices. This situation is common when an economy is growing and supply has yet to catch up.
Other economists believe inflation is more a function of monetary imbalances. This school was popularized by the adage, "Inflation is always and everywhere a monetary phenomenon". While money can certainly play a role in inflation, it can't easily explain every inflationary episode. For example, the condition of disinflation in the 1990s can be more easily explained by the growing impact of imported goods from lower cost Chinese manufacturers than from monetary factors.
Further, these two camps also fail to identify other inflationary situations. Currencies can be intentionally depreciated either to increase the competitiveness of exports or to reduce the value of government obligations. In neither case does conventional economic theory provide the whole story. A broader perspective is needed.
Another manifestation of overly simplistic narratives entails a singular focus on one force or one perspective at the expense of others. Inflation is not a single trend but rather the net effect of millions of price trends for different products and services and for different customers in different places. It is a combination of all of them.
The phenomenon of offsetting effects is also an important consideration in regard to broad-based economic forces. For example, it is fair to expect the rapid growth in money supply will eventually create upward pressure on prices, all else equal. But all else is not equal. At the same time, demographics and debt are exerting downward pressures on prices. What matters is the combined effect.
The same dynamic occurs with money supply. Certainly, the creation of new money is an important variable to monitor. However, it is also important to monitor the destruction of money through defaults and deleveraging. If the rate of monetary creation does not exceed the rate of monetary destruction, the net effect is negative.
A final form of overly simplistic narrative considers the dynamics of inflation solely from the perspective of the US. While there are clearly internal factors that are important to the inflation equation, there are also important external factors. Trade relationships, exchange rates, geopolitical agendas, industrial policies and other factors can all significantly affect the pricing environment.
b. The role of public policy is often exaggerated
Another broad area of weakness in discussions about inflation is in regard to the role of public policy measures, both monetary and fiscal. A big reason for this is that such policies are often at least as much a part of the problem as of the solution.
A great many public policy prescriptions originate from economic theories and therefore bear many of the same weaknesses as those theories. A big weakness is that many economic theories rely on unrealistic assumptions. Another is that they often do not incorporate feedback loops. When policies are enacted, they rarely test for effectiveness or include mechanisms that adjust to changing conditions. Nor do they anticipate interaction effects with other policies or practices.
As a result, it is not unusual for policies to significantly undershoot or overshoot a problem. Indeed, many economic imbalances have their start with misguided policies. Nonetheless, these are important variables to incorporate into any analysis of inflation.
An important weakness of inflation discussions, then, is that often too much credit is given to public policy measures working as intended. Not only are the consequences of interventions uncertain, but time lags and lack of transparency make them even harder to assess. This can be further complicated by a communication agenda that focuses more on intended perceptions than on reality.
The main shortcoming, then, is ascribing too much certainty to any public policy measure. It is true that public policy can have an enormous impact on the pricing environment. However, when I hear arguments that warn X will definitely happen because of policy Y, I immediately start thinking of all the things that could cause that statement to be wrong.
c. The reaction function of economic participants is under-emphasized
Feedback loops are an important factor in economic interactions and too often excluded from the economic theory that drives policy. This highlights another shortcoming of arguments about inflation: many of them do not incorporate second, third, and higher order effects of policies and developments.
For example, many of the factors that affect prices are not just mechanical but also behavioral in nature. People can see past current conditions and plan for the future. As a result, behavior may not change much if conditions are seen as temporary. Perception of the future plays an important role in the broader equation.
Because of this, policy makers can fail - and succeed - on many different levels. For example, throughout the GFC, many were surprised by how many homeowners mailed in their keys rather than continuing to make payments on underwater mortgages. This caused major problems for mortgage insurance which was priced on an assumption of continued payments. Indeed, policies can fail to provide the right amount of aid, fail to target the right beneficiaries, fail to protect against fraud and fall short on a whole host of other counts.
Any of these shortcomings can undermine confidence that policy initiatives will be effective, and that skepticism can spawn second order effects. If it is widely perceived that policy measures will be ineffective or capricious, the smart thing to do is pull back spending to provide more of a financial cushion. Just as consumers react to policy, so too do investors react to monetary policy and policy makers react to economic conditions and political priorities. Arguments that do not consider these higher order effects run a high risk of missing important dynamics in the inflation equation.
II. A framework for understanding inflation
a. The go-to model
Much of the thinking about inflation, as much of the thinking about economics in general, is shaped by models that create a simplified representation of economic reality. One simple, but especially important, model is known as the equation of exchange. It states real economic growth times price increases equals the money supply times the velocity of money (Y * P = M * V).
This is important not just for the insight it provides. Because it is widely taught in college economics classes it is widely recognized and therefore extremely influential in shaping views on inflation. As a result, understanding the limitations of this model will go a long way toward spotting deficiencies in a lot of inflation arguments.
One of the most common arguments is that if money supply increases substantially, which certainly happened after the selloff in March (2020), then it is likely that prices will have to rise in order to keep the equation in balance.
The main problem with this simple explanation is that it downplays the important role of money velocity. While it is true that velocity has remained constant for long periods in the past, there is no necessary reason for this to happen. What is important to understand is that velocity can, and does, change. In fact, velocity has declined substantially over the last several years and in doing so, has offset the impact of growing money supply.
The key to understanding the direction of velocity is to associate incremental lending and productive investment. Investments are considered productive if they generate returns that both pay interest and return principle. When such investments are made, velocity is positively affected. When debt is used to finance consumption, however, velocity falls.
With insufficient demand for productive borrowing, increasing the money supply is like revving a car while the transmission is in neutral: None of the potential power from the engine gets transferred to the road. Of course, once that power does get transferred, things change quickly.
b. Evolution of the global financial system
Over the last forty years the global financial system has become larger, more global, and more complicated. Each of these changes complicates the discussion of inflation. As a result, models (such as the equation of exchange) and perspectives that do not incorporate these developments fail to capture important inflationary factors.
One of those changes is the rapid growth of credit. As credit has become increasingly prominent as a means by which to complete transactions, the concept of liquidity needs to be broadened as well. Historically, liquidity has been comprised of various forms of money but in today's financial system, it makes more sense to think of liquidity as the combination of cash and credit.
Another, big change involves the displacement of traditional banks by non-bank financial institutions (referred to as shadow banks) in regard to several types of financial activities. As a point of reference, the size of the shadow banking industry was actually bigger than the banking industry going into the GFC. Today, they are about the same size. The main point is any analysis that does not include shadow banks misses half of the potential liquidity.
Shadow banks have a couple of important characteristics that distinguish them from regular banks. One is capacity is determined by balance sheets. As a result, when stocks and bonds (that serve as collateral) decline in price, so does the capacity of these organizations to provide liquidity. Also, because these organizations are not regulated, no authority exists to oversee risk management or to govern risky activities.
The significant growth in the eurodollar market represents another important element in the evolution of global finance. At approximately $13 trillion the market is quite large and is also not regulated. Much of its growth has occurred in conjunction with the massive growth in globalization.
The net result of the growth of credit, shadow banking, and the eurodollar system is a larger and much more interconnected global financial system. This significantly complicates the study of inflation because inputs from economic growth, monetary policy, politics, and credit conditions can emanate from almost anywhere in the world and interact in unpredictable ways.
Exchange rates also figure into inflationary inputs to the extent that imports and exports comprise economic activity for any given country.
Normally, a country's fiscal condition weighs heavily on its currency. A weak fiscal condition can cause the currency to weaken which makes imports more expensive and exports less valuable. Depending on the amount and composition of trade, exchange rates can be an important component of inflationary conditions.
The US is an interesting special case since the dollar (USD) is also the world's dominant reserve currency. The result is that fiscal conditions factor less prominently in US inflation because there is so much more demand for dollars than any other currency. As a result, there is little reason in the short-term to expect a weakening USD to cause significant inflationary pressure.
Over a longer planning horizon, however, there are reasons to believe changes in the value of USD could affect general price levels. For example, USD could continue to lose value relative to real assets. In this case, real assets would become more expensive in dollar terms and therefore cause inflationary pressure.
In addition, it is distinctly possible that the value of USD relative to other fiat currencies gets renegotiated at some point. As it stands, USD’s role as reserve currency bears both great power AND great obligations. Effectively this leaves the US as the buyer of last resort for excess global supply. Since it is highly unlikely the US would be allowed to run unlimited deficits indefinitely, it is fair to expect the status of USD will change at some time.
III. The environment for inflation
a. Supply, demand, and other factors
In a broad sense, an assessment of inflation must begin with an assessment of current conditions. Not only is it important to understand where things are, but also where they have been and where they are currently heading. In assessing potential future scenarios it is also important to consider probabilities.
A good starting point for analyzing current conditions is supply and demand. One of the most powerful influences on demand is demographics. In recent years, both fertility rates and population growth have declined – and this reduces demand. In addition, the ongoing retirement of baby boomers is also weighing on demand.
Debt also affects demand and does so in a couple of ways. For one, when debt is used to pull forward consumption, it robs future periods of spending power that would otherwise have been available.
Debt also constrains demand by reducing resilience. In times of uncertainty, high levels of debt are difficult to repay or renegotiate. As a result, reducing consumption is often the only way to avoid insolvency.
Demand is also a function of employment. The job losses that resulted from coronavirus lockdowns were massive and are still occurring on a large scale. Lack of regular income by a large section of the labor force is impinging on demand.
Trade with other countries affects both supply and demand. On the supply side, as sophisticated global trading networks and supply chains collapse into more regional networks, it is likely that some efficiencies will decline and costs will rise. On the demand side, the volume of global trade is tied to a very fragile economic recovery.
Technology is a factor that generally tends to lower prices. When business functions are made more efficient through technology, prices tend to fall. Also, widely available information reduces information asymmetries and increases price transparency. Finally, flattening supply curves facilitate efficient supply adjustments when demand fluctuates. All of these effects are good for consumers.
The net effect of these forces over the last ten to twenty years has been disinflationary. The fact that some amount of inflation has been experienced over that time is due to the efforts of public policy to overwhelm those forces.
b. Fiscal policy
While economic conditions are extremely important inputs into any consideration of inflation, so too is public policy. Fiscal policy has the power to raise funds and redistribute wealth. Monetary policy has the capacity to affect money supply and credit conditions and can influence economic activity as well.
Starting with fiscal policy, one of the more prominent aspects has been the dearth of meaningful policies to promote economic growth. As economic growth has gradually slowed, there has been very little policy response. Political polarization and other factors have rendered this policy vehicle virtually impotent.
This is a shame because there is so much potential. In general, growth can be accelerated by investing in a country's productive capacity. This is especially helpful for projects that are hard for companies and individuals to do on their own due to challenges of scale, coordination, or short-term returns. Historically, for example, programs that improved sanitation, provided public education, and insured against unemployment provided huge dividends in terms of boosting economic growth.
It's not hard to identify new ones. Education and the development of intellectual capital should be at the top of the list. Providing skills for jobs, retraining for those who need to make career transitions, and basic skills and training so people can still be productive in lower skill jobs would all be beneficial. Infrastructure should be refreshed to reduce bottlenecks and increase reliability. Broadband access should be widely available and cheap.
All of this said, it is true that some of these policies would be politically difficult to accomplish. It is also true that there is plenty of room for debate on exactly what the policies should be and how they should be manifested. Those aren't the points, however. The point is that current fiscal policy is not even remotely designed to foster economic growth. While the current direction of fiscal policy provides no reason to believe growth will suddenly improve, there is enormous potential to redesign fiscal policy to serve this purpose.
In addition, fiscal policy can also affect inflationary conditions by redistributing wealth through tax policy and entitlements. Because people at different levels of wealth and income have different spending patterns, this can also affect prices for various goods and services.
c. Monetary policy
Monetary policy also has a great deal of potential to influence inflationary conditions. Unlike fiscal policy which has largely been inactive, however, monetary policy has been in overdrive since the GFC to fill the policy void. This extended period of unusually active monetary policy provides an important perspective on its potency.
Because many of the monetary policy measures in place today originated in response to the financial crisis in 2008, it makes sense to use that as a starting point. One of those measures was to reduce interest rates. While this falls into the realm of conventional policy, rates were held near zero for many years. In addition, rates were immediately lowered again in response to the coronavirus pandemic early in 2020.
Asset purchase programs like quantitative easing (QE) also originated in the financial crisis. These were intended partly to support prices of collateral such as mortgage backed securities, partly to help recapitalize banks, and partly to support shadow banks. These programs did help prevent a large scale debt deflation during the financial crisis.
The Fed also opened swap lines with other major central banks. This helped support foreign banks and the eurodollar system.
Perhaps the most important revelation of these policies was the Fed's readiness to act. In the absence of substantive fiscal policy, markets were heartened by the Fed's interventions. Low rates eased financial conditions. Asset purchases helped recapitalize banks and supported collateral values.
Despite these short-term successes, monetary policy has not been normalized in any way. Further, with the persistence of these measures their limitations and shortcomings are becoming increasingly evident.
Low rates, for example, can stimulate some incremental business development on the margin, but cannot create attractive business opportunities. In the absence of real growth opportunities, artificially low rates have encouraged excessive debt and financial engineering, reduced income for savers, and created incentives to hoard cash.
Similarly, asset purchases cannot facilitate growth in the absence of good lending opportunities. Such programs increase bank reserves, but do not (and cannot) increase demand for credit. In the context of weak economic growth the last several years, there has been little demand to finance business expansions. As a result, excess reserves do not get lent out and do not enter the economy.
In the absence of a convenient path to the real economy, money typically finds its way into financial assets. Through leveraged transactions, securitizations, and various forms of arbitrage, banks and non-bank financial institutions can earn a return on money in an environment of low rates and low economic opportunity.
At the end of the day, the key thing monetary policy cannot accomplish is the one thing most needed - the creation of demand. Indeed, many aspects of monetary policy are more revealing for what they are not than for what they are.
For example, the efficacy of monetary interventions was always contingent on the coordination of monetary policy with fiscal policy. It was clear from the start that monetary policy on its own could accomplish very little. Despite this, monetary interventions persisted in almost complete absence of fiscal policy coordination and with no evident effort made to ensure coordination.
Perhaps the most damning aspect of these measures is the degree to which they sacrifice long-term stability for short-term benefits. The failure to coordinate monetary and fiscal policy reduces benefits and increases risks. While monetary policy has been broad, ample, and persistent by one measure, it has been short-sighted, misdirected, and reckless by another.
This raises a couple of possibilities in regard to the effect of monetary policy on the inflationary environment. One is the environmental conditions are just too deflationary for monetary policy to overcome, and I think there is some truth to this. Another is whether by lack of intent or by lack of competence, the Fed has not created policy interventions that are effective.
Either way, things would have to change in order to believe in the potential for monetary policy to create higher inflation. As it stands, monetary policy appears more desperate than effective in its objectives of maximizing employment and hitting its inflation target.
One of the more important elements of the inflation equation is that of expectations. The tradeoff between prices and demand are ultimately set by economic participants making transactions and those decisions involve expectations. If consumers expect prices to rise, they are more likely to pull consumption forward. Conversely, if consumers expect prices to fall, there is an incentive, on the margin, to defer consumption.
Expectations are difficult to model because they are based on psychology and beliefs. Even assessments of current conditions almost always include assumptions and simplifications that are influenced by psychology.
The role of expectations extends beyond specific microeconomic considerations such as making a purchase. Expectations also involve broad assessments like determining the overall level of uncertainty in the economy. For example, uncoordinated or capricious public policy is hard to evaluate and can create a great deal of uncertainty.
Expectations are also tricky to model because they can change in a nonlinear fashion. Since expectations are also influenced by the expectations of others, positive feedback loops can form. When this happens, overall expectations can adjust dramatically. This is one of the most important and also most difficult aspects of inflation to manage.
e. Tradeoffs and offsets
One of the greatest considerations in the inflation debate is the degree to which inflationary and deflationary forces offset one another. It is all too easy to oversimplify the discussion by focusing on just one or the other.
In practice, tradeoffs of opposing forces manifest in many ways. High growth of money supply can be offset by a decline in the velocity of money. The effects of fiscal policy can offset effects of monetary policy if they are not coordinated. The relative strength of opposing forces must also be assessed in order to determine the net effect.
The exercise of determining tradeoffs becomes massively more complicated when considering the higher order effects that are generated from complex and dynamic feedback loops. Imposing initial conditions can spawn corrective policy. New policy measures can then affect economic behavior in other ways.
Another factor to watch closely is the reaction of people to the economic and policy environment. For example, it is clear that in response to lockdowns and substantially higher unemployment, people have paid down debt and saved more. Have these actions been taken as emergency measures or do they represent a more permanent behavioral change toward building a financial cushion? The answer has important implications for economic growth.
The reaction to other policy measures will be important to follow as well. After receiving $1200 stimulus checks, will people begin demanding more handouts? Now that extended unemployment benefits have expired, will there be demand for more? How will people handle the forbearance of rent and mortgage payments? Will they simply pick up where they left off or have these policies just forestalled bankruptcies and other displacements?
As uncertain as the ultimate effects of policy measures are, the effects of policy measures that have not yet been implemented are even more uncertain. Is it possible the Fed will implement yield curve control? How will investors react to that possibility? In this sense, it is important to consider not just the "disease", but also the "cure".
Finally, the inflationary environment is also affected by conditions outside of US borders. If China decided to allow its currency to weaken significantly, the deflationary force would sweep through the economies of every country that imported Chinese goods. Likewise, high levels of debt in many emerging markets is constraining demand and putting pressure on those currencies.
a. Evaluation: Inflation or deflation?
In assessing whether the environment leans more toward inflation or more toward deflation, a key consideration is defining the time frame. Are we talking about what is likely to happen over the next several months or what is setting up to happen a few years out? Many arguments fail to do this and can be misleading as a result. This is especially so since different investors operate with different time horizons.
It is also important to keep in mind that conditions are always changing. A big economic impact here or a big policy initiative there can completely change the dynamics. As a result, it is difficult to make an aggressive case either for or against inflation; each one is imbued with caveats. That said, there are some ways to think about the inflation debate that can tease out useful insights.
For starters, current environmental conditions point almost uniformly to disinflation/deflation. Weak demand, high unemployment and structurally soft demand factors present substantial obstacles for inflation. Any change from this state of affairs will most likely require forceful policy changes that are able to change expectations meaningfully.
Sooner or later, it is fair to expect forceful policy changes will come. Since the only practical ways to mitigate high debt levels are to reduce debt through austerity or to create inflation, the path of least resistance points to inflation. Although short-term conditions point to deflation/disinflation, longer-term conditions point to inflation.
This implies that the expected timing of inflation is an important consideration for investment strategy. Such timing will be an ongoing function of economic conditions, policy responses, individual actions, and expectations, and will also be affected by policymakers' incentives to disguise economic reality throughout.
b. Implications for investment strategy
The whole point of gaining a better understanding of inflation is for the purpose of improving investment results, not least of which involves preserving one’s wealth.
One point is that inflation tends to run in long cycles, it pays to prepare ahead of time. Once inflation sets in, it can persist for many years.
Another point is that the uncertainty of timing in regard to inflation presents a real challenge. There are costs to deploying inflation protection too early and too late.
When inflation does start to bite it is important to be aware that different assets work in that environment than a deflationary one. For example, real assets such as real estate, commodities and gold retain their value relatively well whereas financial assets do not. Cash, which provides a valuable option to buy cheap assets in a deflationary environment, becomes a depreciating asset in an inflationary one.
Stocks perform better than bonds under moderate inflation but also suffer under high inflation. Expected returns for both need to be revised down in light of the prospects for inflation. Asset light business models perform well under disinflation and businesses with high fixed assets do better under inflation.
In the extreme case of financial repression, when fixed income yields are capped while inflation runs higher, investing in financial assets is penalized instead of rewarded. Such a policy redistributes wealth from investors in financial assets to the rest of the population. In doing so it turns the entire proposition of investing upside down.
Finally, the impact of each of these factors depends on any individual investor’s unique circumstances. Investment horizon, asset allocation, income sources, income needs and other factors all shape the effects of inflation in any particular case.
Understanding inflation and calibrating for it in one’s investment portfolio is one of the most important preparations investors can be making right now. Unfortunately, it can be extremely difficult to disentangle useful insights from less relevant or even outright misleading claims. This report should go a long way toward helping investors identify both the shortcomings of various inflation arguments as well as the valid arguments that can expand one’s understanding. In stark contrast to the last forty years, investors will need every tool available to preserve and expand their wealth over the next forty.
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