A Rough Overview on Inflation

Est. Reading Time: 15-18 Minutes

Now that the Federal Reserve has dropped the word “transitory” from their vocabulary, inflation is once again a variable to consider both in business and in everyday life.

 To begin, a simple definition…

Inflation (financially speaking) - a general increase in prices and the fall in the purchasing value of money.

 

From a calculation perspective, this would be shown by taking the price of one good, say a dozen eggs, in one time period and comparing the price of that same good in a future time period.

If the prices have increased, inflation. If the prices have decrease, deflation.

This is a pared down example to highlight the point and clearly not useable in day-to-day life as the price for any one good can fluctuate for a wide array of reasons. For instance, let’s say you live in a small village with two vendors for eggs and one falls ill and does not make it to the morning market. The competing vendor now has pricing power, but this is not inflation.

To put it into useable macro terms that might apply to a large percentage of the population, it would be more useful to take a VERY large basket of goods and run the same analysis. Which is exactly what the Bureau of Labor Statistics does to calculate the Consumer Price Index (CPI).

But before looking into the CPI, a primer on what inflation actually IS might be a bit more useful given we haven’t had to consider its implications or its source for more than forty years.

Revisiting Econ 101

While potentially controversial among modern economists, I contend that the Austrian School of Economics, as opposed to the Modern Monetary Theory, holds the correct view of inflation and how it manifests itself within the economy.

The current popular belief of Modern Monetary Theory asserts that an increase in the money supply is the primary cause of inflation. As the increase in supply will cause an increase in demand it will subsequently cause a one for one increase in inflation, all else being equal.

This is a simple application of the Supply and Demand curves most are familiar with from their introductory Economics courses.

Additionally, it holds that interest rates should be set through the control of this supply of money by a central authority. In this way inflation can be controlled and directed based on the current state of the economy.

Given this is a more recent experiment, it is worth noting that it seems the only approach that causes interest rates to drop to zero and sometimes below across varying economies/countries, which is a uniquely modern phenomenon and an inherent Achilles Heel.

The risk here is a mathematical one. Let’s say rates were at 15.0%, and inflation was creeping up towards that number. Should a central authority want to slow the inflation down, a 3.0% bump up to 18.0% might be sufficient to stop it in its tracks. That 20.0% increase in the cost of capital (3.0% / 15.0%) might be painful to business, but likely not insurmountable. Especially if it is a good business.

Now, let’s say we have the same issue, but we are starting with rates closer to what we have been experiencing lately at 1.0% and we need a bump to 2.0% to stop inflation. That is now a 100% (1.0% / 1.0%) increase in the cost of capital. This makes forecasting in business exceptionally difficult and why in our current environment Federal Reserve meetings have turned into must watch television. As rates approach zero, this balancing act becomes more and more difficult as smaller incremental changes have greater proportional effects.

The Austrian School of Economics rejects these Supply and Demand notions and instead holds that rates should be determined by the preferences of borrowers and lenders directly and not by a central authority. That is, that the rate one can borrow at (the cost of capital) is directly related to the opinions of the lender and the borrower at the point of transaction. If allowed to operate this way, money will flow towards uses that are productive because productive needs are those that will be sufficiently able to cover the cost of that capital and rates will reflect a natural balance between productive uses and acceptable risk.

To put this into a real-world example, anyone who has tried to get a business loan understands this firsthand. While the bank is influenced by the Federal Funds Rate, the discussion is primarily on the business needing the loan and the likelihood it will have the ability to cover its debts. A company’s, or individual’s, ability to cover their debt is directly related to the ability to generate necessary cash flow. Cash flow, in aggregate, typically flows from those products or services that provide value or tackle a need.

Through this lens, any increase in the money supply above and beyond what is needed for productive growth leads to an increase in prices as money finds its way to uses or projects that would not fit the criteria of productive (malinvestment) distorting the price discovery process.

However, the existence of excess capital on its own does not cause inflation.

Commonly, headlines on the subject focused solely on the “too much money” portion and miss the other side of the coin. This is perhaps the reason why our discussion on whether we were experiencing sticky or transitory inflation was so divisive during the period following the COVID induced government stimulus.

Taking the Austrian School’s view, the excess capital must be allocated improperly towards malinvestment. That is, the money needs to start changing hands.  

If the Federal Reserve wanted to create a two trillion-dollar coin, they could have one minted and then put it in a desk drawer and never do anything with it. This would not cause inflation, even though the money supply has indeed increased (roughly 9%). This coin would need to find its way into the system.

So, it needs to be the excess supply of money AND the velocity of money. The faster it changes hands the quicker and more aggressively you’ll see inflation.

Going back to the start of the pandemic, the money supply went through the roof. A common remark of the time was that almost half of all dollars in circulation were printed since the beginning of 2020. But, at the same time, the velocity of money has been running at about 72% of the pre-pandemic level. And roughly 50% of the level before the Great Financial Crisis, the last surge of money creation.

M2 Money Supply (includes cash, checking deposits and easily convertible near money)

Velocity of Money (the rate at which money changes hands)

So, absent that velocity, the money supply as a stand alone is necessary, but not sufficient to cause inflation. This is worthwhile to keep in mind when taking the M2 money creation figure into account.

In our complex economic landscape, it clearly is not a one for one ratio between M2 Money Supply and Prices. While any excess capital beyond what is required for sustained growth will likely help to distort prices to some degree, the real catalyst to get the velocity portion of the inflation equation moving is artificially low rates to accompany excess capital.

Even if there was excess capital, if rates were say 8.0%, a project that was only able to support a 3% interest rate on required debt wouldn’t get funded. But, if rates were 1.0%, all the sudden the case can be made that it is a suitable return on capital. It can support 3x the debt service after all. However, this mathematical shift says nothing of the underlying quality of the cash flows the business can generate and it is a similar dilemma mentioned earlier where smaller proportional changes carry increasing larger effects as you approach zero.

The logical response would be “what happens if that velocity ticks back up,” and that is a valid question in trying to determine if the probabilities are stacked towards an increase or decrease in our current rate of inflation. Suppose there were actually useful endeavors to allocate all the capital that was created in the last few years, and it has found its way into the system safely. So, there is no threat that we’ll see any kind of uptick now that the money printing has abated.

While the global economy is far too complex to confirm or negate that statement with any kind of granularity, we can look at a few larger scale passive or barely productive “heat sinks” of capital to approximate an answer to the question.

Going back to the “drawer” the Fed put that hypothetical two trillion-dollar coin into, it would seem the Overnight Reverse Repurchase Market has served as a suitable drawer for the banking system to stash at least that much capital into when in prior years this market’s value was measured on the order of a few to several billion rather than a couple trillion.

Since this market is purely for passing capital back and forth to make razor thin margins when the banks have nowhere else to allocate the funds, it would seem safe to say that not every dollar is finding its way to a productive use lately.

Overnight Reverse Repurchase Agreements

Buyer Beware…Back to the CPI

Returning to the large basket goods that was alluded to prior, this is the method used by the Bureau of Labor Statistics to arrive at the Consumer Price Index (CPI), or our best attempt to quantify the inflation experienced by the average American.

Each month, a basket of 80,000 goods that represents what Americans buy in their everyday lives is compared to what that basket cost in the previous month and year(s).

But we need to take this measurement with a grain of salt. To try and keep the CPI relevant across a long timeline (years/decades) it is routinely adjusted for quality differences as products innovate. The idea being that certain goods may be far more versatile or effective than they were previously. For instance, the phone in your pocket bears no resemblance to the phones twenty years ago. So, it’s argued, that the benefits of those improvements should be captured in the price indexes so that price increases due to quality can be teased out from those that are rising due to inflation.

This can lead to distortion in the way the numbers are presented.  

On one hand, you might say that the price of a phone going up is acceptable because it can now do so much more. Where before you may have needed to purchase a phone and a set of maps, now you get both in the same expense. You might even be reading this on a phone. So, per unit of value or utility, it may actually be cheaper.

But, on the other hand, there is a certain number of good categories that are needed given the physical place in the world or profession you may occupy. For instance, similar to the phone example, the average car is far more technologically advanced than a car from the 1970s. From safety features, connectivity, reliability, etc. But, if you lived in a place where you need a car in the 1970s and you still need a car today, regardless of whether it is qualitatively nicer you still need that one car. If that is now eating up a larger proportional chunk of your income, then the quality increase doesn’t count for as much when measuring how you are feeling inflation.

Beyond this quality adjustment (warranted or not), another thing to keep in mind is that often what is reported is the so-called Core CPI. This is the change of prices excluding food and energy prices, since these tend to be volatile.

The rationale here is that because the prices of these two categories can contain a lot of noise, removing them gives a better indicator of the underlying pace of price changes. This is somewhat similar to smoothing the progress of say a stock price by charting the moving average rather than the day-to-day oscillations.

While argued in both directions, in my opinion, it makes little sense in practice as I know of no business or individual that exists without the use of energy and/or food.

Finally, it is worth noting that these numbers will be reported in aggregate as compared to say the previous year but also as the rate of change.

This became very relevant earlier this year when in August a zero rate of change was reported for the month of July. Behind the scenes what had happened is certain categories like gasoline had changed, but the overall wholistic number was the same.

The Government took this as an opportunity to advertise zero inflation. While it’s not possible to say whether it is purposely misleading, it is misleading none-the-less. Inflation had a zero percent change from the 30-days prior but had not gone to zero.

This would be akin to saying you’ve been trapped in a sauna that has been going up in temperature every hour for the last 12-hours and is now at an uncomfortable 145-degrees. If you wait another hour and it is still at 145-degress it has stopped going up, but you are no more comfortable than you were an hour ago.

There’s Nothing New Under the Sun, We’ve Been Here Before

Unless you are over sixty-four years of age, from a professional standpoint you have not had to operate under the influence of inflation above the Federal Reserve’s mandate.

Let that sink in.

The vast majority of the professional world is (relatively speaking) in uncharted waters. This author included. Thankfully, history tends to rhyme.

So, is there anything in the past we can look to, in order to assess what we might be headed for now?

The 1970s was the most recent bout of sustained inflation and it famously took Paul Volker, then the Chair of the Federal Reserve, to raise rates to a high of 20% and cause two recessions to get it under control.

This period was marked by higher volatility in not only overall prices but also the financial markets. In fact, had you invested in a balanced market portfolio in 1972, your investment (adjusted for inflation and reinvesting dividends) would not have broken even in real terms until about 1984. A full twelve years of zero overall real growth.

Specific investment approaches and pockets of the economy were making money, but the overall market saw poor investment endeavors wallow and those generating true cash flow raising in rank.

The takeaway is that during this time the typical business cycle became unreliable. It was an era of knee-jerk back and forth trying to reel in inflation and not quite getting it right.

It ultimately became a period of stagflation, or rising prices plus decreasing demand, which is the worst possible outcome from an economic perspective. 

However, wages have been increasing which makes the current environment also look like post-WWII inflation. This was a period where inflation was much shorter lived as American households were able to spend away the inflationary pressures thanks to America’s rise as a producer. As well as having a similar labor market, borrowing rates were very close to recent levels. However, there was arguably a higher proportion of productive spending during this period as America was a net exporter, which it is currently far from being.

As of late, consumer spending has remained strong during the short period of time that has occurred since direct stimulus was ended by the Federal Reserve. However, some cracks have begun to show with indications of shifting consumer behavior and reduced investment by some of America’s largest companies. For instance, in June of this year, Walmart indicated that consumer spending at their stores had shifted more towards food and less on discretionary items such as electronics in response to inflationary pressures.

While macro predictions tend to be a waste of time, it is prudent to take note of how the past has transpired as rough guide rather than a prediction.

That being the case, some forward thought on the subject and how to operate within it, should it come to pass or not, is advisable.