December 28, 2020
What will inflation be in the years to come?

Inflation is an idea well worth thinking about if you are an investor because it plays an important role in the level and distribution of returns across asset classes.

For example, if you expect inflation to rise, you are more likely to buy the stocks of companies which can raise their prices than to buy bonds whose fixed coupons are worth less every year. And among stocks, you are more likely to gravitate to sectors such as gold, energy, and commodities, which have historically done well during inflationary periods, than for example utilities, banks, and real estate, which have tended to do better when inflation was falling.

The last time we saw serious dollar inflation was in the 1970’s. The ‘80s and ‘90s were a period of disinflation (falling but not negative inflation). The 21st century was expected by many to be a period of mean reversion back to inflation, particularly since the financial crisis of 2008, which introduced levels of money creation by central banks on a scale never seen before. But inflation seems not to have appeared, so what’s the story? Is inflation dead or is it going to return?

To answer this question, we are going to need to begin with a definition of what inflation is. And right there is where this subject starts to become murky.

Most people think of inflation as meaning an increase in the price of goods and services generally. Economists generally use the term instead to refer to an increase in the supply of money. For now, let’s refer to these things respectively as price inflation and money inflation. You would expect the two to be related. As the economist Milton Friedman once put it, if you drop a bunch of money from helicopters over an island society with a relatively fixed supply of goods and services on offer, you would expect the suddenly wealthy residents to go on a buying binge which would eventually bring the balance of goods and money back into balance via rising prices. In other words, monetary inflation should lead eventually to price inflation.

Thus it was confusing to people after 2008 when so much money was created, that we did not see subsequent price inflation. So the question is why did we not?

There are several possible answers to this question. The one commonly brought up first is the notion of a falling level of monetary velocity. Money velocity is defined as the ratio of nominal GDP to the quantity of money. And as you can see from the chart below, it’s been falling for years.

m2 money diagram inflation blog for pynk community

There are a host of simplicities embedded in this measure. For starters, GDP does not measure all of the activity in the economy and perhaps more importantly M2 is not the only or the full measure of what money is. But the idea is simple enough: if the money velocity is 1.5 for example, it suggests that every dollar of money in the economy is circulating on average 1.5 times during the year. Here is a simple illustration from Wikipedia.

“If, for example, in a very small economy, a farmer and a mechanic, with just $50 between them, buy new goods and services from each other in just three transactions over the course of a year

  • Farmer spends $50 on tractor
  • Mechanic buys $40 of corn
  • Mechanic spends $10 on barn cats

then $100 changed hands in the course of a year, even though there is only $50 in this little economy. That $100 level is possible because each dollar was spent on new goods and services an average of twice a year, which is to say that the velocity was

Note that if the farmer bought a used tractor from the mechanic or made a gift to the mechanic, it would not go into the numerator of velocity because that transaction would not be part of this tiny economy’s gross domestic product.

Macro-oriented economists will tell you that as velocity has fallen, it has suppressed inflation despite the rising quantity of money. Which only begs the question, why has it been falling? They may then go on to tell you that it has fallen because the quantitative easing of the past dozen years has been executed via the banks in a manner that led to increased bank reserves and asset prices rather than showing up in the economy and getting spent. Some of them believe that this will all be remedied as governments worldwide have learned during the pandemic to increase money by directly providing it to consumers. And when this happens, they expect inflation to come roaring back. Maybe.

Austrian school economists will tell you that the velocity of money is merely a term defined by an economic identity, it has no use as an explanation for anything. If you want to know why prices rise or fall you have to look more closely at the way individuals value goods relative to money, which will likely be affected by their perception of government and central bank behaviour. The velocity of circulation is not a cause of anything, more likely a consequence. At a macro level, you may as well say that wet sidewalks cause rain.

Disclaimer: This information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.

In any case, without a very clear model as to what will drive velocity up or down, it isn’t clear how much use this notion of velocity is. What is clear though is that governments worldwide seem determined to increase the supply of money at an increasing rate and without limit and eventually, give or take velocity, this will lead to increasing debasement.

As can be seen in the chart below, the price inflation index has been rising in tandem with the quantity of money, although it has yet to fully reflect the increased rate of money creation since 2008 and especially since the onset of the pandemic. In other words, the blue line may start to turn upward just as the green line has already.

M2 money stock graph pynk community inflation blog

But up to now we have been talking about statistical abstractions as presented by governments. Let’s get back to basics.

It turns out that price inflation may not be as low as reported by the government. The graph below shows what they’ve been saying about inflation

m2 money stock inflation graph for pynk community 3

And in the next chart below, you can see what ShadowStats has to say about how reported inflation (red line) compares with actual inflation (blue line). ShadowStats is an independent outfit that has recreated what the inflation rate would be if they measured inflation today the way they used to measure it in 1980.

consumer inflation graph for pynk community inflation blog

As ShadowStats points out, there have been a number of changes to the way inflation is measured over the past forty years. Among them are a number of changes that have systematically reduced the reported level of inflation. One change involves what are called hedonic adjustments, where the Bureau of Labor Statistics (BLS) says, for example, that the computer you can buy this year may cost more than the same model last year, but it’s faster and has better screen resolution and so forth, and therefore, adjusted for the improvement in quality, the price has actually dropped. Of course, the truth is that computers are more expensive than last year but that is no longer captured in the inflation measure. Another change involves substitution: the BLS reasons that if chicken prices fall relative to beef, consumers may buy more chicken than they used to so they increase the weight of chicken in the index. Systematically increasing the weighting of items that are falling in price will naturally lead to a lower measure of reported inflation. And there is plenty more legerdemain going on at the BLS to suppress measured inflation.

In sum, price inflation was always supposed to measure the change in the cost of a fixed basket of goods and services, but as constructed today, it no longer measures that. Consider that Chapwood Index.

chapwood index image for pynk community inflation blog

Chapwood measures directly the change in price each year of the 500 most commonly purchased goods and services in 50 cities around the U.S.

Both Chapwood and ShadowStats reveal that the actual increase in prices in the U.S. over the last decade has been nearer to 10% than the 2% which the BLS reports. You might wonder why smart people at the BLS are deliberately misleading everyone. Well, they have a pretty big incentive. Firstly, among the costliest items in the U.S. federal budget are the social security and medical entitlement programs, which thanks to a 1970’s era act of congress are adjusted by reported price inflation each year (a cost of living adjustment). Secondly, real GDP as reported is found by subtracting reported inflation from nominal GDP as measured. A higher rate of inflation would imply lower economic growth. Not a pretty picture if they are understating inflation. But at the root, of course, the government finances itself by three means: taxes, borrowing from the public, and money printing. Every dollar they print is a dollar for them to spend and a proportionate reduction in the value of all other dollars already in circulation and held by savers. Price inflation is an on-purpose source of funding and it works as long as it isn’t widely seen as such. And most people don’t think price inflation is a deliberate act by the government, if anything they think it is a deliberate act by companies raising prices.

In 2020, money printing was the single largest source of funding supporting the federal budget. If that continues, it will not be long before it is clear to everyone what is going on. And unfortunately, it is probable that it will continue. The newly printed money is used to buy government bonds and as that debt rises, the government’s ability to service the interest on that debt remains possible only at low-interest rates, which can only stay low as long as the central bank keeps buying more government bonds to suppress rates. They have painted themselves into a corner.

So back to the question we asked at the outset: is inflation dead or is it going to return?

Well perhaps it isn’t dead at all and it has been with us all along. It is certainly consistent (looking back at the very first chart above) that the money supply more or less doubled between around 2012 and 2019 (an annual rate of 10% compounded) and that ShadowStats and Chapwood have objectively measured a similar rate of price inflation over the same period.

In the end, there are two opposing forces at work here. The natural forces of a weak economy and large amounts of debt are highly deflationary. Historically they led to bankruptcy and debt default and since debt and money are two sides of the same coin, monetary deflation followed by price deflation. Opposing these natural forces are the governments of the world printing money to finance themselves and hoping to whittle away at the inflation-adjusted value of their massive debt loads. Which is the stronger? Well here’s a little thought experiment. Imagine the government were to actually drop sackfuls of hundred dollar bills over every neighbourhood in the country. Would those dollar bills still have the same purchasing power as before the drop? That seems to be the plan.

Either way, since the U.S. among major governments seems to be among the most intent on debasement, the dollar may continue its recent drop.

US dollar debasement chart for Pynk community inflation blog

And since all major commodities are traded in dollars, the companies that produce those commodities and the economies in which they are produced (many emerging markets) are likely to be beneficiaries of any inflation coming our way. N.B. emerging markets also benefit from a falling dollar because they must use dollars to make imports and consequently they have dollar debt.

The price of copper, approaching seven year highs, suggests that markets may be beginning to discount the possibility of the inflationary scenario.

copper price chart for pynk community inflation blog

If you expect inflation, it may be worth owning some commodities, some precious metals, some energy stocks and some emerging market securities. It doesn’t hurt that these things have been out of favor and are only just recovering, suggesting some early investors are preparing for inflation. As they say, good things happen to cheap stocks.

Disclaimer: This information does not constitute any form of advice or recommendation by Pynk One Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision. When investing, your capital is at risk and you may recover less than the initial investment.

Written by
Mark Borwick
View all my posts →
Pynk is a registered trademark and copyright of Crowdsense Ltd. Crowdsense Ltd is a company registered in England and Wales (No. 11339494) with the registered office at 20-22 Wenlock Road, London, England, N1 7GU.

Crowdsense Ltd is an unregulated firm and the information contained herein does not constitute investment advice or investment research and should not be relied upon to make any investment decisions.

Investing involves risk to your capital. Past performance is not an indication of future results. The value of your investments can go down as well as up, and you may get back less than you originally invested. References to specific assets or securities are included for illustrative purposes and should not be understood as an endorsement or a recommendation to engage in investment activities.

Please invest aware.