Jul 6, 2021
Welcome to Finance and Fury - The big question on many investors minds at the moment is if inflation is going to be transitionary, or something that is going to set into the economic framework for the long haul – maybe not for the next decade, but for the next few years at least – if you listen to Central Bankers, the inflation within the economy is transitionary i.e. going to last a few quarters then revert back to normal, if you listen to investment pundits, it is something that could set into the economy for the long haul – i.e. the next few years – so who is right?
In this episode – we will look at inflation – an often-misunderstood concept – because when talking about higher inflation it is important to focus on what type of inflation is occurring – as well as what is important to the economy – so we will look at the core concept and types of inflation, the current causes of inflationary pressures and try to see if this is something that is just going to be a momentary shock to the economy and your purchasing power, or if it is going to be persistent for the next few years and something that could really affect not only your own wallet – but also financial markets due to an increase in interest rates, and potentially a dramatic one at that if central banks need to combat inflationary effects similar to that of the 1980s.
To start with - It is important to define inflation – as many people have different definitions of inflation and what price increases are actually important to them – I talk to many people about this, it is interesting as people see inflation as something different
- Now - the very definition of inflation as per the government’s
measurement of statistics is based around price increases of a
basket of goods and services – measured by the consumer price index
(CPI) – IMO this is not a great representation – the collection of
these statistics can be very biased, based on what is included in
the basket and how it is collected – there are 10 baskets in
Australia - food, alcohol & tobacco, furnishings, health,
transport, recreation, insurance & financial services, housing,
education and communication – each of these go through trimming
(normalising outliers) as well as hedonics (adjusting for quality
increases) – so it is a pure measurement of a price increase and is
often an underrepresentation to the actual price increases seen
- An important point is that housing doesn’t represent the costs of your mortgage or the price of buying a home – we will come back to this later – but as an example, the CPI for housing is a negative 0.9% over the past quarter – whilst the price of timber and construction has increase massively over this time period – so take this with a grain of salt
- What are these price increases, being measured by CPI representing? Goods and services we buy from private companies – which aim to be competitive – a company in a competitive environment won’t increase their prices just because money supply has increased – if they do, they will lose business to other competitors – assuming the market is competitive
- But what creates price increases? Does a company want to charge as much as possible and make a profit? Sure – but what creates a situation where this is not possible? Competition – the more supply on the market allows for competition between distributors, so monopolistic prices cannot be charged (which are always higher than that of a free market economy)
- Market prices of supply and demand – Particularly at the
moment, looking back over the past 18 months – coming from Supply
shortages –
- What have we seen over the past 18 months – small business being shut down – small business has always provided some form of competition in supply – remove this you are left with only an oligopoly of suppliers, especially in the distribution services – on top of this there has also been the issue of direct suppliers, those producing the goods, like farms which have seen shut down – this creates a situation where less competition is present in both the production of goods as well as the supply chains which distribute these goods
- Also, you have Increase cost to businesses – labour costs of employment have been a major point of contention over the past year since government unemployment benefits kicked in – the best example of this I have seen has been in the US where there is no federally mandated minimum wage – Unemployment benefits equate to around $15USD per hour – so if a business is going to hire someone for $15USD to fill a role, would you take this role if you had to work 9-5, 5 days per week? Do nothing or work full time for the same salary? This brings up the economic cost of your time – say a role was advertising for $17 per hour, would you then work for a benefit of $2 per hour? When compared to not working - probably not – it is the equivalent of trading your time for $2 per hour – a business would need to offer well above market rates to employ people to get the people they need to operate a business – this increases the cost to the business – which leads to an increase in prices being passed through – I have seen some stories from the US where hospitality services like MacDonald’s cannot find anyone to work – so they need to offer higher salaries – which results in higher prices of goods provided
- This beings up the concept of Productivity – for every dollar invested, what is the return in business – if you are spending $1 then as a business owner you hope to see at least $1.01 in return – however with additional costs of labour over the current economic cycle, this reduced this capacity for business owners to turn a profit – due to a situation where businesses were shut down for large chunks of the year, hurting their supply potential, but then when they are allowed to re-open, they are now competing with the government in the form of unemployment benefits – this further compounds the effects of a restricted supply – so assuming demand stays the same, this allows those remaining companies to increases their prices – not only to compensate for the loss of revenues (if they have had any, because large companies have not seen this) – but also to account for the increase costs to the business -
- On the other hand – you have monetary theory of inflation -
which states that the increase in the money supply will lead to an
increase in inflation through reducing the purchasing power – the
more money there is, the less valuable each dollar is
- This is true –when the money supply has a limiting factor, such as under the gold standard – i.e. where the increase in the gold supply would lead to inflation through a reduction in the purchasing power of the population directly – as you used to be able to convert your paper money for gold – but also when the monetary supply increase is distributed equally to the population
- The trouble is that this monetarist theory goes back to
monetary systems like the gold standard – where monetary increases
which were backed by something decreased the relative value of each
dollar, or even ounce of gold – and the financial system wasn’t the
major recipient of any increase in the monetary supply – then an
increase in the money supply would represent a reduction in the
purchasing power of the population –
- take Spain as an example after the gold rush that occurred after looting the Aztecs (and other tribes of south America) – they say that due to their over supply of gold, that prices of things started to increase – well this was due to this gold being distributed amongst the population eventually, first through repayments of debt that the Spanish crown had – which was then siphoned through the hands of the monarch, to nobles to the everyday individuals – so due to the abundance of gold in Spain, the purchasing power of one ounce was now lower – so it did lower their purchasing power – however when looking at today, most of the money supply increase does not end up in our hands and due to the fiat nature of the financial system, an increase in the monetary supply doesn’t correlate to an increase inflation rate as it did in the past – especially due to the way it is measured by monetary officials
- To look at this point further – there has been a massive increase in the money supply occurring since the 1970s – but this got ramped up to a new level from 2009 onwards – the introduction of un-conventual monetary policies like QE increase the base money supply – US saw an increase of their monetary base by 10.58% p.a. for the decade from 2010 to 2020 – did inflation rise by this level the way it is measured? No, it averaged 2% p.a.
- This shows that the inflation effects were contained through
the nature of credit growth – i.e. the increase in lending
increasing the price of property and other assets, such as shares
- This brings up another major point – in particular when it comes to Australia - If inflation is considered to be the reduction in purchasing power of your dollar – then no area of the economy is more prevalent then the property market
- If you could buy a property 20 years ago for $100,000 and today the same property is selling for over $600,000 with no improvements or renovations – then this is an average inflation rate of 9.4% p.a. over this time period
- The government statistics do no consider the effects of the
monetary expansion through credit growth on inflation of asset
prices – this has really hurt the Australia dream – owning a
property to get into the game and start to see some equity growth
- Hence – the inflation to reach this dream has been eroded by almost 9.5% per annum, well beyond the average household’s capacity to save – which due to the current ZIRP environment is actually a disincentive to save – i.e. you get 0% interest whilst seeing inflation eat away the real value, let alone the fact that you potentially need to save a further 9.5% p.a. each year for a deposit that you wait
- If people are looking for correlation of anything when it comes to monetary expansion and increases of prices, it isn’t CPI, but credit growth and hence property price increases which have been the most correlated
- This brings up the biggest question of all – what inflation
really matters to you and how is this created?
- is inflation caused by the money supply increase, devaluing your purchasing power?
- is inflation the measurement of prices charged by businesses on goods and services, caused by supply and demand?
- or it is the price increase of assets – essentially devaluing your purchasing power over time?
- the truth is, that it is a muddied version of all three when it comes to what is important to you and I – they all matter
- Inflation caused by the money supply increase is seen where
this money goes – which over the past 20-30 years has been asset
pricing – particularly property but also shares to a lesser extent
- This has been great if you have been in the game for the past 10-20 years – but if you a new entrant, then you are buying in at the top of the markets in the hope that the same monetary policies continue - but in essence this has created a large barrier to entry – especially for housing
- But over the past 20 years - Inflation from business price
changes have been seen as both deflationary and inflationary –
- Sectors that have seen less direct government involvement have seen deflation in prices – electronics – but only from non-monopolistic supplies – TVs, fridges, and other electronic goods, clothing, cars – all seen in real terms lower prices – think about buying any of these goods 50 years ago – it was very expensive and you got a worse product – today you get a great product for less in real terms
- Other sectors that are highly regulated – energy, health, education, housing, insurances – have seen a large increase in prices – but the two have managed to offset each other – so CPI in the way the government measures it hasn’t been particularly noticeable
- In this essence – inflation – the way it is measured and what monetary officials focus on hasn’t come from the massive flood of the monetary expansion – the CPI measurements we have seen have come from issues with supply chains – when compared to demand
- This is why I think the major issue with inflation at the
moment has come from supply issues –
- Many companies being shut down over the past 18 months and not allowed to operate – labour costs increasing – so this needs to be passed on to consumers through price increases
- Therefore – if lockdowns and the limiting of supply continues –
then prices definitely have the capacity to increase further,
increasing the inflation measurements – In addition, if
governmental support payments like unemployment benefits continue
to be generous o the point they are anticompetitive to the free
market with other businesses – this will also lead to an increase
in the costs of goods due to increased costs of labour – being
passed on in the form of an increased price of a good or service –
if the world returns back to normal – not the new normal – then the
inflation currently seen should subside – even if it does have the
capacity to still increase costs in the long term
- As an example - one high year of inflation is still bad – it is due to the compounding nature of returns – Start with $1 – if inflation is 2.5% p.a – that good will cost $1.28
- Now say that inflation of 10% for 1 year leads to that good costing $1.10 – then it reverts back to 2.5% p.a. – in 10 years’ time it costs $1.37, which is a reduction of purchasing power by 33% in 10 years’ time when compared to inflation just going up by 2.5% p.a.
- So even transitionary, or one or two years of inflation can be damaging – especially as monetary policy is trying to combat deflationary environments through having low interest rates
So, in conclusion - Is inflation transitionary? – there are indications that broad-based inflation indicators are rising, but nothing is conclusive at this stage if this is going to be anything more than a transitionary effect – but this could always change in the coming months
- The case for looking at inflation being a long-term trend is usually based around a broad-based phenomenon – where the price of everything is increasing across the board – It is not just one or two sectors of the basket are going up in price – but that the whole economic environment shows a general price increase
- Think about inflationary episodes in economies around the world in the past and present – Weimar Germany always comes to mind – where the cost of everything was elevated – or today with Venezuela and other south American countries, like Argentina which have struggled with inflation for years – most of this occurred in a different economic environment but also with extreme government controls on supply
- I would go out on a limb and say that we won’t end up in this sort of situation if the economy is allowed to go back to work – the only thing that could lead to this is a massive shock to supply due to further lockdowns or restrictions of business, as well as extensions of the above market rate unemployment benefits
- Looking at what happened in 2020 - For the first time in
decades central banks actually increased money supply well above
demand – due to the forced shutdown of economic activity - the
economy did not collapse due to lack of liquidity or a credit
crunch, but due to the lockdowns and restrictions of supply – this
created the major area of inflation we are seeing playing out now:
- a disproportionate amount of money flowing to risky assets joined by more flows to take overweight positions in scarce assets – in other words - the excess money made investors move from being underweight in commodities to overweight, as commodities are scares resources – creating an abrupt rally
- So what is the risk? - The history of the economy points to a
similar pattern playing out - when money is aggressively printed
and with this comes the excuse that there is no inflation – then
when inflation rises, central banks and governments tell us that it
is transitionary and to not worry – then this transitionary
inflationary inflation turns out to be a longer term trend – then
government/central banks present themselves as the solution to the
problem –
- From the Government perspective – this involved imposing price controls and restrictive measures on exports – this would be the worst-case scenario – as it would further compound supply shortages due to prices being capped below the costs of production and sale
- The risk has always been the government responses – a free market can see inflation for periods of time, but this if often corrected as additional supply comes onto the market to soak up the demand
- But the real risks to markets – Central Bank policy – If
inflation is overly persistent in the way that central banks
measure this – will they then increase interest rates?
- This has massive flow throughs to the economy – not only in financial markets by reducing the present value of cash flow valuations of equities – but also increasing the financing costs of property, reducing the price capacity of credit growth, and with this price increases
- So the major question is: Will central banks tighten policy when government deficits are soaring and even a small increase in sovereign yields can generate a debt crisis?
- In summary - My thoughts are that inflation, the way it is
measured by the government and what influences CB policy responses
- shough only be temporary if things are allowed to go back to
normal economic activity – but this is the real issue – many small
businesses may not come back – which does increase the risk of
inflation running away –
- Inflation in the context of asset price increases through credit growth is likely to continue – but then at some point if interest rates do go back up – it would slow
- This doesn’t mean that the areas that see the monetary
expansion effects should be ignored – for example - property has
been inflationary –this isn’t measured by statisticians and is
hence ignored by monetary officials – whilst it is ignored by them,
it is still important to you
- The issue with this is that CBs will let CPI run wild beyond
the point of control before responding – but CPI will only run wild
if government continue their absolute control over the economy
through further economic shutdowns and reduction productivity
through unemployment benefits
- The irony of this is if we actually viewed inflation as the increase of credit growth – rather than the increase of prices selectively edited by central banks – there would have been an increase in interest rates –
- Due to the largest spending components of most households being property, this could then lead to deflationary pressures as less people are willing to spend in the economy
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