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Understanding Inflation: The Good, The Bad, and The Ugly

By DrugsandFIRE | Seeking FI | 17 Apr 2020


Mid March, the Federal Reserve announced that they'd be cutting overnight interest rates back down to zero percent and that they'd officially start their quantitative easing (QE) program back up.  Initially, QE was going to be limited to ONLY $700 billion.  That was until the stock market (and perhaps more importantly, the corporate/municipal bond market) continued to sell off despite the Fed announcement.  In response, Chairman Powell channeling his inner Doom Slayer, decided to fire up his version of the BFG-9000 and announced that the Fed would expand its QE program to other assets such as corporate bonds and do so without limit to support the markets.  So called "QE infinity."  With this announcement that the Fed would be essentially "printing" trillions of dollars in order to prop up markets, an important question (which was asked before when QE first became a thing) needs to get asked.

What about inflation?

At face value, it should shouldn't it?  The central bank is "printing" (I put that in quotes because it's technically not correct) trillions of dollars so that should cause inflation right?  Any one who learned about the concept of inflation back in grade school could tell you that.  Inflation is just a consequence of more money being present in the economy, it's that simple.  Or is it?

As it turns out, inflation is a much more nuanced concept than most people realize; and how it plays out in the economy depends a great deal on its root cause.  What seems like a simple input/output to the economy is actually much more complex and in the absence of understanding, you get a lot of misunderstanding or outright fear mongering.  Neither of which serves us as investors. 

So to help everyone understand what's going on with this, I thought it would be good to write about these root causes.  Hopefully by the end of the post, you'll have a better grasp on the concept of inflation and be able to filter out some of the noise that'll be coming at you in the future.

 

Good Inflation: Demand Pull Inflation

 

Inflation happens in good times and in bad, but if we were to choose an inflation to have, it would be inflation caused by an increased demand for goods and services.  With this cause of inflation, known as demand pull, an increased demand for goods and services leads to higher prices due to the relative scarcity of those goods and services.  The good news though, is that because of increased demand, businesses experience an increase in earnings and workers (at least in a properly functioning economy) can demand higher wages.

This is the type of inflation that happens when times are good.  What's more, because inflation in this sense usually translates into higher wages, it's the best type of inflation for the consumer.  Demand pull inflation is simply the byproduct of sunshine and rainbows.  But honestly, it's not worth talking about much more.

 

Bad Inflation: Supply Push Inflation

 

Sometimes prices just go up; and when this happens, it's usually because costs increase somewhere in the supply chain.  Scarcity of one thing that other things depend on can lead to higher prices for end products in a process known as supply push inflation.  And over the past century, scarcity of one thing in particular has led to this type of inflation: oil.

Inflation caused by an increase in costs sucks for a number of reasons.  First and foremost, regular people feel the pinch with this type of inflation more than anyone.  When the price of gas suddenly spikes, all sorts of essential expenses just go up.  Food, heat, fuel, you name it, stuff just costs more.  But unlike demand push inflation, people aren't making any more money.  Those increased costs on your essentials simply eat away at your budget for other things.  What's more, you might even get laid off because those increased costs aren't translating into increased profits (at least immediately) for businesses.  Fun stuff.

Secondly, inflation of this type is typically triggered by politics.  In the case of the 1973 oil crisis, an oil embargo was placed on the US by Arab nations in retaliation for support of Israel during the 1973 Arab-Israeli War.  This embargo led to a widespread increase in the price of oil and gas which rippled across every sector of the economy resulting in widespread inflation.  And as the decade went on, this sort of inflation suppressed the growth of US businesses and led to a scenario that became dubbed "stagflation."  To give you a better idea how people felt about the economy back then, the situation led to the creation of a new economic metric known as the "misery index" which measured unemployment against inflation.  Spoiler alert, it was miserable.

 

Ugly Inflation: Monetary Inflation

 

Now we get to the really timely lever on inflation: monetary inflation.  Monetary inflation doesn't come from the success of an economy or the decision by some other country to cut off the supply of some resource.  No.  This type of inflation happens when a currency weakens as a store of value as a result of overprinting of money and it's most definitely the most concerning type of inflation that exists.  It's the type of inflation that, if uncontrolled, leads to the kind of nation-killing episodes of hyperinflation that dot history such as what happened during the 1920's in Weimar Germany.  There, inflation got so bad that it was literally cheaper to heat your home by burning Deustchmarks than to buy coal!

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Weimar Germany, Where the Good Boys and Girls got Coal for Christmas!(Source)

However, monetary inflation is also the most widely misunderstood type of inflation and I think that's mostly because its effects hinge on the variables of an equation most people forgot from Econ 101.  The equation I'm talking about is Fisher's Law of Exchange.  The formula goes like this:

M*V=P*Q

M= Money Supply; V = Velocity; P = Price; Q = Quantity

Or, since we're interested in inflation here, you can rewrite the equation this way:

M*V/Q = P

Now, as I mentioned before, everyone knows that when you increase the supply of money, money becomes less scarce, and therefore worth less right?  The Fed has created a massive amount of new money through QE so obviously it's going to result in inflation.  Well...not necessarily.  The part of the equation that gets left out in that line of thinking is the velocity of the money stock.  Inflation is a function of both money stock and velocity.  Without velocity, you don't get inflation (at least in terms of metrics such as CPI).

Velocity is an odd concept.  By definition, it refers to the rate at which money is exchanged in an economy.  In theory, when an economy is booming, velocity should be high since there's more economic activity going on.  But that definition isn't too practical when it comes to understanding what's going on today.  To better explain the concept, let's look at what velocity is doing right now.

By many accounts, the economy was supposedly booming before the coronavirus came onto the scene.  But at the same time, velocity had fallen to the lowest levels in over 60 years.

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Velocity of US M2 Money Stock 1959-2020 (Source)

So what gives?  The truth is, as I alluded to in a previous post about negative interest rates, the economy wasn't really booming and the fall in velocity can actually highlight a more practical way of looking at velocity.  When a central bank engages in QE, what they're doing is exchanging longer term bonds off the books of banks in exchange for short term reserves.  In other words, they buy their bonds and give them cash.  However, in order for that cash to get into the real economy, that cash needs to be lent out through the banks.  When banks are reluctant to lend, like when interest rates have been suppressed to the point where taking on credit risk no longer makes sense, they just keep the cash as excess reserves or invest it elsewhere.  What results, is the weird scenario we see today.  A massive expansion of the money supply coupled with falling velocity that doesn't result in much (if any) inflation.

In this sense, we can look at velocity for what it really is: the rate of credit creation by banks in the economy.  In effect, the Fed can print all the money it wants, but if that money isn't getting transmitted into the real economy by the banks through lending, you don't get any inflation.  In other words, if the money supply is like water trying to move through a hose then velocity is the valve that controls its flow into the real economy, and therefore inflation.  And, with QE, central banks can create a scenario where they can theoretically have their cake and eat it too (up to a point).  This is because the manner in which money is created also creates a disincentive for banks to lend, suppressing velocity.  How?

When new money is created, it has to go somewhere, even if that somewhere isn't Main Street.  As soon as a central bank creates money as part of QE, that money goes immediately into financial assets and, most of the time, those assets are fixed income instruments such as treasuries, mortgage backed securities (MBS), and corporate bonds (so far the Bank of Japan is the only central bank buying stocks).  In turn, these large scale purchases inflate the prices of those financial assets.  When the price of those assets gets high enough, they get sold, but usually for something else that promises a better risk adjusted return.  This leads to newly created money moving first from risk free assets such as treasuries, then onto other bonds such as MBS and corporates, and finally into the equity markets boosting stock prices.  And, since all this happens presumably with a weak economic backdrop, actions that get money into the hands of people such as consumer lending and mortgages are suppressed because the risk-reward equation makes such lending less attractive.  Lending to people like you or me might even be so unattractive that a bank is more willing to park their money in a long term bond with a negative yield than give you a mortgage!

Now, obviously, a central bank can't just pump an infinite amount of money into the system without it blowing up at some point.  The hose eventually has to burst (or leak at the very least) right?  Well, that's the multi-trillion dollar question.  When does that happen?  As of right now, the point of that critical mass is unknown, at least for the major economies of the world.  The worry, of course, is hyperinflation.  But history shows that's not much of a concern for us.  In his book Principles for Navigating Big Debt Crises, Ray Dalio (the founder of the world's largest hedge fund) shows that hyperinflation only occurs when there's massive money printing and the following two conditions are met:

  • The currency is pegged to some external source of value such as gold, a commodity, or a foreign currency
  • The national debt is denominated in a foreign currency or payable only in a certain commodity or gold

With the developed nations of the world engaging in QE, neither of those two conditions are met.  Here in the US for example, the USD is a pure fiat currency and our debt is all denominated (and thus payable) in USD.  In other words, the argument that the US won't be able to pay its debts is stupid because it can just make more USD to pay the debt. 

The question then for such a nation, in terms of the end effects of inflating the money supply, is really how the currency compares to other stores of value.  However, while a currency such as the USD might devalue in terms of something more immutable such gold or even bitcoin, it might not move much in relation to other currencies like the euro or yen; especially if the issuers of those currencies are doing the same thing.  In that case, there can also be no perceptible inflation in the real economy despite all the money printing.  This is because at the end of the day, actual commerce is conducted in terms of national currencies (the USD in particular) and not alternative stores of value.  What really determines the end result of monetary inflation is value of your currency relative to its peers.

So to sum up monetary inflation, when you're dealing with a country that has full control of their currency and their debt, an increase in the supply of money will most definitely cause inflation in asset prices.  But, unless there's a corresponding uptick in velocity, it's unlikely that prices in the real economy will inflate.  In the case of QE style money "printing" you can even get less inflation (disinflation) or even outright deflation in the economy if QE causes the risk-reward relationship to disincentivize lending, and thus suppress velocity.  In addition, if "everyone is doing it" so to speak, the value of a currency might not drop that much in relation to its peers and therefore not result in perceptible inflation.

 

Conclusion

 

I hope though this post I've been able to give you a better idea how inflation works.  In the coming years, I think it's going to be incredibly important that we all understand the concept of inflation, what causes it, and how monetary policy should play out when implemented.  This is all the more important given the current environment and being able to sort what's fact from what's BS is essential.

Thanks for reading

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DrugsandFIRE
DrugsandFIRE

I'm a pharmacist pursuing financial independence, hence drugs and FIRE.


Seeking FI
Seeking FI

A blog dedicated to the things I've found interesting on the path to financial independence and my thoughts

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