Weekend Reading: Inflation Nation

Mar 15, 2021 | Sharon Forbes


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Hi everybody,

 

          The topic of inflation has become pretty popular. The prevailing opinion is certainly that yes, it is here or its coming or “hold on to your hats it’s going to destroy us all!”. Maybe, maybe not, but that is not what this week’s email is about. No, this week’s email is about answering the question what IS inflation. How does it work, how do we tell if it’s here or not here, and is it a good thing or a bad thing…or both? To acknowledge any bias up front, I do believe we are headed for higher inflation…I am not a believer in hyperinflation at the moment, but I also believe the real rate of inflation is higher currently than the statistics suggest. On the chicken wings rating scale, my current opinion would be we will have “medium spicy” inflation…. Above salt and pepper or mild, but below hot and “sign this waiver before eating”. Before we can even talk about what I think or why I think it, we need to understand what inflation is in the first place. Luckily, it’s quite simple…

Inflation is the change in  magnitude of the velocity of the M2 money supply as measured by the year over year change in the consumer price index…. *snooze button*.

A lot of very smart people use very smart definitions of inflation and how to predict or measure it but the problem seems to be that a lot of them have been wrong for a long period of time. Their models predicted inflation and then none showed up. They have very smart reasons for why their very smart models were wrong, but I don’t think an understanding of those technical aspect of the financial markets is needed to “get” how inflation works. I think we really can do it in a simple fashion.

Inflation is too much money chasing not enough goods.

You can measure the money and the goods in different ways, and when you do you get different readings and different predictions, but at the end of the day when there is substantially more money than things to spend it on you get inflation. So the next logical question is, how do you “get” too much money?

All fiat currency comes from, and is controlled by, the central bank of a country. That bank (the Fed, in the States) usually has “control of inflation” as one of its stated purposes, and it does so via what we call monetary policy. It usually sets that monetary policy alongside the Federal government’s policies of spending and taxation, which are called fiscal policy. Together, monetary and fiscal policy control the amount of money that is in the system, and by doing so they can control inflation, among other things.

To illustrate this point and a later point I would like to make, let’s think about the Great Financial Crisis (GFC) of 08’-09’ and the Covid recession of last year. In the GFC banks failed, or were on the verge of failure, due to poor lending practices. In response, the government created the TARP (Troubled Asset Relief Program) whereby they authorized $700 billion USD to be used to buy bad assets from the banks. Doing so gave the banks money, took the bad assets off their books, and re-capitalized them. Think of it like your house burning down while you have a big mortgage and no insurance, and then the government just buys your non-existent house for the value of your mortgage or a little more and now you’re ok. The central bank just printed the money, lent it to the government, and they “bought” the toxic and worthless assets from the banks because the banks going bust was more damaging than the government carrying a bunch of debt. The phrase “too big to fail” was coined, and the banks now had cash to lend instead of worthless assets.

So $700 billion of cash was created, but at this point it was all just sitting at the banks. Some at the time called for massive inflation, but remember our definition above. Let’s just agree for now that $700 billion was “too much money” (sounds rather small now, doesn’t it?), but while it sat in the bank it was not “chasing” any goods. So how does the government get it out on the hunt? They lower interest rates.

When you lower rates you make money cheap. Three things happen when you do that…

1)   the bank doesn’t want to hold as much of it, because they don’t make very much to do so. By lending it out they can charge rates higher than the overnight deposit rate, and so they see lending as a better course of action than holding cash.

2)   consumers want to borrow it, so that they can, well, consume. The less it costs for you to borrow money the more you can earn on whatever you borrow it for, or the cheaper the purchase of a depreciating asset becomes. If you wanted to buy a car, the new low rates make buying a car cheaper and so you are more likely to buy one, and maybe even a more expensive one. If you wanted to start a business or invest, the lower cost of money means there is more of the investment return left for you, so you start more businesses or make more investments.

3) Savers invest. By lowering what they earn on cash, you entice them to move that cash into other investments, thereby financing economic activity.

So savers and banks want to lend more, and consumers and business want to borrow more. The first savers/banks to take the risk and invest make a good return, and so that entices more savers/banks to look for investment. The first borrowers also have a good experience, as the economy is picking up, and so that entices more people to borrow for investment or business, and here we have the beginning of a feedback cycle of borrowing and consumption. As all the new cheap money chases goods and services you can expect inflation, but if that was true why did none show up after the GFC? Here is where how and what you measure matters.

After the GFC a lot of the money went into financial assets aka the stock market. Cheap money spurred a fury of investment, but not a fury of general consumption. The rate at which people bought goods and services increased, but so did the number of businesses that were supplying them. When goods can keep up with money you don’t get inflation (sort of, more on this in a minute.) A lot of inflation measures follow a basket of goods, and it can get kind of funny when you look at the details. For example, some measures of inflation don’t include food and energy…the two things literally everyone uses every day in north America, and most parts of the globe. It’s a bit like thinking about your health while ignoring anything to do with your heart or lungs. So after the GFC we didn’t get CPI inflation, but we certainly got asset price inflation…just look at the stock markets, and bonds, and real estate since then. Too much money chased not enough public stocks, and we had a massive bull market for over a decade, but we don’t include the DOW level in our inflation measurements so we had “no inflation”.

Then, a lowly bat brought it all back down on our heads around this time last year and the government dusted off the GFC playbook, but this time with a different spin…

COVID didn’t hit the banks at the top of the financial pyramid, it hit the consumers at the bottom. They couldn’t go out to earn money, or spend it, and so the world ground to a halt. Interestingly, this created a period of deflation, which is the opposite of inflation… not enough money chasing too many goods and services. An easy example…did any of you venture out at all this time last year and notice the price of gas? The price at the pump plummeted and the price in the markets actually went negative for a brief moment. If the only item in the world to buy was oil and gas, the money you had was getting more and more valuable because each dollar could buy more and more gas as time went on. Technically, when it had a negative price, you had infinite money as priced in oil.

Back to the 2020 recession…

The bond market started to seize up and so the government in the US signed another bailout package, this time worth $2 trillion (ahh finally, we are talking about real money). Some of this money went to buy bonds from the banks so that the market wouldn’t close up and topple the financial system, and as with the GFC they slashed rates to encourage lending. But in 2020 the banks were solvent. It was the citizens who were in trouble, and so a bunch of the funds, as well as some relief programs, went direct to consumers. Cheques to their bank accounts, rent relief, debt extensions, moratoriums on evictions and defaults. All of these saved the consumer and allowed them to stay at home in an attempt to stop the spread, or bailed them out if they had lost their job, but for many this amounted to some free money. The rates were low, your debt was deferred, and you had a few thousand dollars in your bank. This time, that money did begin to chase goods and services, but again it was focused on Covid friendly spending. Bikes, RVs, trampolines, home fitness equipment, for some reason toilet paper… these things flew off the shelves and, in some cases, you still have a hard time finding them to this day. But that wasn’t all Covid brought to the party… it also destroyed the supply chain.

A few paragraphs ago I said you don’t get inflation when the amount of goods can keep up with the amount of money, but the truth of that can depend on your POV. Inflation can show up in two ways, “cost push” and “demand pull”. So far, we have been thinking about demand pull… too much money demanding not enough goods, and so the price of those goods can be raised by sellers as people are willing to pay more for a scarce resource. That dynamic can also be true for the raw materials required to make the goods, which is “cost push” inflation. If you want to buy a wooden chair and there is not a huge demand for chairs, but there is not enough wood in general, the cost of your chair will go up. That is still inflation, but it is caused by the input cost of making the chair. Perhaps the wood is scarce from destruction of the resource, or the demand for lumber for homes or some other thing made of wood, but in the end all that matters is what it cost the builder to make the chair. The more it costs them, the more you have to pay to get them to make it, even if you are the only person on earth looking for a wooden chair. From the manufacturers perspective it is still too much money looking for not enough goods (in this case the chair maker’s money looking for lumber) but we talk and think about inflation from the consumers POV, so this is considered “cost push” inflation. If wood was plentiful but chairs were in extreme demand, the price of the chair would rise and this would be demand pull. Same outcome, different path.

Now, this week they passed another $1.9 trillion stimulus package in the states, and they likely will do another $2 trillion in infrastructure packages later this year. Around the globe more money is yet to be printed, rates are at essentially 0, and in most cases the printing includes some funds being sent direct to consumer’s savings accounts, which some consider a form of UBI. Along with that we have supply chains that are still in disarray from COVID closures and rules. We have chip shortages. We have low rates causing a housing boom that is creating massive demand for lumber which has resulted in a record high price for the commodity. We have milk that was dumped and potatoes that were left to rot last year now missing from our supplies this year as restaurants prepare to reopen thanks to vaccines. We have base metals and oil in demand as manufacturing picks up, but mines and drill rigs were entirely closed to protect workers from Covid. We have a heck of a lot more money being created than in 2009, we have it being given direct to consumers in some fashion, we have money that is closer to free than anyone alive has ever seen, and we have fewer goods available to meet that demand because of shut downs and supply chain disruptions. We have a recipe for demand pull AND cost push inflation. We want more chairs AND there isn’t enough wood. Inflation, this time, seems inevitable in more “measurable” items beyond financial assets. Many of you can see it already…just look at the pump price and your grocery or takeout bill compared to a year ago.

So let’s wrap this up with a discussion of if this is good or bad. The answer is, it depends. Here’s why.

Imagine you are the government, and you are printing (aka borrowing from the Fed) oh, I don’t know, lets pick a random number…. $1.9 trillion dollars. How are you going to pay that debt off? Well, there are 3 ways… taxes, inflation, or default.

Default – this is not the plan. Save the tinfoil hats for another email.

Taxes – they call it economic growth, but taxes are the only government revenue source, so what they mean is they will raise taxes to take a bigger slice of the current pie and then hope the pie gets bigger so that the same tax rate gets them larger slices of a growing pie into the future. All that pie feeds the Fed, who they owe pie to. Great….now I’m angry about future tax hikes AND hungry for pie.

Inflation – the government is infinite. They can carry the debt for eternity, it doesn’t need to be paid off by the end of someone’s term and, in fact, is often looked at as a problem for someone else later. Because of this, the government can lower rates, lend themselves cheap money, and then plan to pay it back in the future with cheaper dollars thanks to inflation. To grasp this, imagine your grandfather made a deal to borrow money for a stamp and the lender agreed that his grandchild (you) could pay the debt back in 2021. Your grandfather borrowed something like 7 cents, a princely sum back then. You now owe that 7 cents, which you can probably find in your couch. You have paid the debt back with cheaper dollars. If the interest rate over that time was small, then your grandfather made out like a bandit. This is also why bond holders and savers are hurt by inflation… you have a fixed rate of income, say 3%, and those dollars will buy less and less goods into the future. If the rate of inflation is above your fixed rate of return, you actually lost purchasing power, which is the same as losing money.

So for the government inflation is good when they have a lot of debt. This is why I think we will get inflation, and why they have said that they want it. They will hold rates low while they create a huge debt, and then ideally wait for inflation to pay a bunch of it back for them while tax revenue services the cost of the cheap money. For savers and anyone receiving a fixed income inflation is bad, because your fixed amount of dollars buys you progressively less stuff. For anyone with inflation adjusted assets or pensions, it’s somewhat inconsequential because you have protection against the erosion of the purchasing power of your money, as long as your inflation adjustment is tied to the correct inflation measurement. If you have payments adjusted for the price of food and energy you are probably ok. If they are adjusted based off the price of shoelaces and scotch tape, you could be in trouble.

In one case, inflation can be bad for everyone. And that is hyperinflation, which is just a negative feedback loop of money chasing goods and services too fast. I’ll give you a real world example of hyperinflation and deflation, and then consider this topic closed.

In an inflationary environment you see the price of the goods you want going up. If its minor that’s ok, but if starts to go to fast you get worried and you begin to stockpile. Say your grocery store plans on everyone in your town buying 1 loaf of bread per week, and that is what they bring in. Normally this is fine, but say you go in and see the price of bread is up 10%. Maybe you buy one loaf and are a bit unhappy, but next week it’s up another 10%. The shelf seems more empty than normal but you still buy one loaf and head home. The third week it’s up another 10%...ok, that’s concerning, you better buy 2 loaves this week because it may be 10% more again next week…but uh oh, seems everyone did that and now they are sold out of bread. In week 4 the price is up 15%, because of demand from week 3, and everyone is trying to buy 2 or 3 loaves out of concern about week 5 prices and beyond. The price rising too fast has created its own demand and thereby caused it to rise even faster. In general, when prices rise to quick you will buy more now if you can, because you are worried that your money will be worth less in the future. You would rather have the goods than hold onto the depreciating money. If that cycle continues and gets faster and faster you have hyperinflation, to the point where a loaf of bread is $1 million dollars and you have a wheelbarrow of all your money and are willing to spend it, because you think it will be worthless the next day or week. If inflation gets too high people lose trust in money as a store of wealth and purchasing power, so they try to spend it all now while it’s still worth something, and you end up in a hyperinflation loop.

Reverse this and you have deflation. Say you are buying 3 loaves of bread per week and the price is dropping 10% per week. If you believe that will continue why would you buy 3 loaves now, instead of one now and 2 for 10% less later. You will consume the bare minimum because the amount you spend on bread today may be enough to buy both bread and milk next week. In other words, your money is gaining purchasing power, so it makes sense to hoard money, not goods, if you believe doing so will allow you to get more goods for the same money later. In our bread example you will reach a minimum purchase amount…you need some amount of bread per week to eat… but on other goods you will delay purchase all together. Consider a car, a much larger purchase than bread. If the price of a car falls 10% that’s a lot more dollars saved than 10% cheaper bread offers. If your current car runs you don’t NEED a car, so you will delay a car purchase all together, believing that you will be able to buy one later for much less. If prices fall to fast (value of money rises) then non-essential purchases are delayed or cancelled altogether, and you have a crash in the economy as consumption drops to zero on some items, and to its minimum on others.

In both cases, the system is trying to correct itself. Higher prices create more incentive to make that good, and a subsequent increase in supply (abundance) puts downward pressure on prices. Lower prices create less incentive to create the good, and so reduced supply (scarcity) puts pressure on prices to rise. Inflation and deflation are natural in any single market, but broadly they can be dangerous if the cycle gets out of control. One of the reasons the US went off the gold standard was so that they could control this better…they could create money without needing to buy gold, which is a finite resource.  This is also why things like gold and commodities are a hedge against inflation… you are owning the good that consumers want to purchase, so as inflation increases your physical good is increasing in price along with it. If the value of a dollar drops in half, your gold bar will be worth twice the dollars and hold its value, if we oversimplify the process.

Imagine a world where the Fed couldn’t print another dollar. A finite money supply would drive the value of money up, causing people to hoard dollars as their purchasing power increased. If that went too far and business suffered, the Fed would be powerless to help, as it couldn’t print any money to re-capitalize failing parts of the market. It would be the invisible hand of the free markets, and only destruction of certain capital would lead to eventual equilibrium. Lower rates and higher taxes would be the only option to attempt to entice people to spend their share of the finite resource rather than hoard it.

Our fiat currency can be printed and manipulated…

…but there are only 21 million Bitcoins. Therefor Bitcoin can never be an effective replacement for our currency. Thanks for coming to my Ted Talk.

Have a great weekend everybody!

-Andrew