In this blog I attempt to decipher what actually matters with regards to inflation. If I attend my cardiac surgeon pre-surgery, I am less interested in the precise definition of the ailment and more concerned with the expected outcome. Expectations matter! The old adage of “buy the rumour, sell the news” is relevant when discussing inflation expectations. We have known for some time that the lived experience of inflationary pressures is subjective. Retiree’s for example, living on a fixed income may experience much higher “relative” inflation comparable to younger households. There are many variables driving this phenomenon most notably rising food costs, healthcare, travel costs and energy bills. Historically low interest rates have suppressed [for now!] inflationary forces on younger homeowners. Perhaps the most famous quote attached to the inflationary debate is assigned to Economics Nobel laureate Milton Friedman:
”Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”
Friedman argued that if the money supply rises faster than the rate of growth of national income, then the inevitable consequence is inflation. The question we have to ask ourselves is whether inflation is better measured as the increase in the price we pay for goods and services versus a decline in the purchasing power of our money. These are not the same thing. Defining inflation is a complex matter which central banks continue to falter at. For instance, over what period are we studying these price movements and how are we evaluating the distinction between relative inflation and decreases in inflation [or disinflation]. If defining inflation seems like a challenge, then forecasting the future price movements of goods and services looks like an impossible task.
Inflation segmentation is key
We should have gathered by now that inflation is not a simple concept and is difficult to model. An appreciation of this granularity allows investors to segment inflation expectations according to its anticipated duration and levels. How we quantify inflation is important and the economic environment should inform the analysis. For instance, how might wage inflation counteract the negative impacts of rising goods and service prices?
Why does Inflation matter?
There are obvious answers available to this question. One immediately considers the requirements for price stability, debt-management, standard of living expectations, consumer & market confidence and government policy responses. From an investment portfolio perspective, increased inflation means that the “real” value of your fixed income coupons will decline and the policy response is likely to lead to raised interest rates. This inevitably reduces the value of both your bond and equity holdings as rising interest rates means heavier debt servicing costs and a re-pricing of existing bond prices. Asset price inflation has been the predominant feature of the post-Great Financial Recession period. If asset prices become divorced from the fundamental reality [slowing earnings & corporate profits] then a substantial correction becomes inevitable.
CPI, PCE, PPI and whatever you are having yourself!!
Consensus on Cause?
We can grasp the concept of rising prices when studying the practical implications of inflation. Things start to get re-complicated again however when deciding upon the medium of analysis. Whilst most consumers use the consumer price index [CPI] as their measure of inflation, powerful government agencies including the US Federal reserve utilise personal consumption expenditure [PCE]. Why would the US government not use CPI? Perhaps the answer lies somewhere in the transitory nature of the CPI metric. There has been prolonged criticism of the relevance of CPI given our inability to compare the numbers over longer periods and the acquisitions relating to government manipulation. Commodities are one of the inputs into many measures of inflation and the main inputs by producers determining the Producer Price Index [PPI].
The debate around the implications of quantitiave easing has been heated and continuous. A group of 23 leading economists penned an open letter to Fed Chair Ben Bernanke in 2010. Notable signatories included Michael J Boskin, economics professor at Stanford University, and David Malpass, deputy assistant treasury secretary under Ronald Reagan. It was also signed by Harvard University professor Niall Ferguson, and Geoffrey Wood of the Cass Business School in London.
”We believe the Federal Reserve’s large-scale asset purchase plan (so-called “quantitative easing”) should be reconsidered and discontinued. We do not believe such a plan is necessary or advisable under current circumstances. The planned asset purchases risk currency debasement and inflation, and we do not think they will achieve the Fed’s objective of promoting employment”
To address Friedman’s theory of inflation related to money supply, we need to delve a little deeper into the implications of the various QE programmes. A by-product of these programmes was massive expansion of the bank’s balance sheets. However Central Banks do not actually print money. The Federal Reserve has the ability to create reserves against which the banks can lend. However the key ingredients for inflationary pressures are a bank that is willing to lend and customers eager disposed to borrowing. Neither of these two forces appeared particularly fluid during the QE programmes. Using simple maths and the mechanics of universal supply & demand, an over-supply of a currency assuming a fixed demand should devalue a currency. Simply put, if more fiat currency is chasing fewer goods then the price of those goods should rise. However the theory struggles against a back-drop of universal currency debasement leading to an equalization of sorts.
How can we use inflation expectations?
We need to be aware of how Mr. Market views the world. The academic evidence confirms that inflation expectations are enough to move asset prices without inflation actually occurring at all. We have most recently [Q1’2021] noticed how commodities like Lumber & oil prices have pre-run significant inflation prints.
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