by David Robertson, CFA
March 2018
Periods of much higher inflation, such as those in the 1970s and early 1980s, tend to have a debilitating, almost visceral effect. Ronald Reagan gave voice to what many people felt in 1978 when he said, "Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man."
Times have changed since then and inflation no longer conjures up such violent images. Quite the opposite actually. It's almost as if investors are in a daze on the subject. Partly this seems to reflect complacency on the part of investors unfamiliar with the risks. Partly it seems to reflect a wide degree of confusion on the subject. Either way, it's a good time for investors to bone up on the subject because status quo continuation of low and steady inflation is one of the least likely scenarios over the next several years.
Opinions about inflation are all over the map and part of the reason is that there are many preconceptions and misunderstandings about it. In order to establish a working understanding of inflation, Chris Martenson provides a quick and effective tutorial [here]. He notes, for example, "Inflation is not caused by rising prices. Rising prices are a symptom of inflation. Inflation is caused by the presence of too much money in relation to things we want to buy." As a result, "What we experience is things going up in price, but in fact inflation is really the value of our money going down, simply because there’s too much of it around."
Another reason there are so many opinions on inflation is that there several relevant perspectives as to what constitutes “too much money” and “things we want to buy”. Too often, strong opinions are formed on the basis of overly simplified views. In order to develop a more complete understanding then, it makes sense to consider some of the more important perspectives.
One of those is economic growth. This is important because longer term trends in economic growth serve as a good proxy of demand for the "things we want to buy". A very solid and systematic analysis of such trends by Lacy Hunt can be found [here].
Hunt starts with a basic tenet of economics: "Consumer spending is funded either by income growth, more debt or some other reduction in saving. Recent trends in each of these categories ... do not bode well for this critical sector of the U.S. economy." He goes on to highlight, "Consumer credit over the past year has risen by $208 billion, or 5.9%. Interestingly, without the drawdown in the saving rate, real consumer spending over the past two years would have been reduced by more than half." He summarizes, "Considering the slow and declining rate of growth in income as well as the low saving rate, it appears that the current spending level cannot be sustained."
He adds that downward pressures on growth are "being reinforced by the problems of poor demographics and productivity. Population growth in 2016 was the slowest since 1936-37 - roughly half of the post-war average - and the fertility rate in 2016 was the lowest on record." Based on his thorough consideration of longer term economic drivers Hunt concludes, “Inflationary expectations will ratchet downward in this environment.”
Insights into the trajectory of economic growth, as important as they are, are not always the most important consideration in regards to inflation, however. As John Cochrane highlights [here], "But the Fed’s view that inflation happens only during booms is too narrow, based on just one interpretation of America’s exceptional post-war experience. It overlooks, for instance, the stagflation of the 1970s, when inflation broke out despite 'resource slack' and the apparent 'stability' of expectations." Cochrane proclaims, "Most analysts today — even those who do worry about inflation — ignore the direct link between debt, looming deficits, and inflation."
That "direct link" calls to attention the notion that "Inflation is a form of sovereign default" and helps explain why "serious inflation often accompanies serious economic difficulties". He continues, "Paying off bonds with currency that is worth half as much as it used to be is like defaulting on half of the debt. And sovereign default happens not in boom times but when economies and governments are in trouble."
The mechanism of inflation as a form of sovereign default works like this: "If people become convinced that our government will end up printing money to cover intractable deficits, they will see inflation in the future and so will try to get rid of dollars today — driving up the prices of goods, services, and eventually wages across the entire economy. This would amount to a 'run' on the dollar. As with a bank run, we would not be able to tell ahead of time when such an event would occur. But our economy will be primed for it as long as our fiscal trajectory is unsustainable."
To create some perspective on this point, Cochrane provides an instructive historical example: "In 1947, everyone understood that war expenditures had been temporary, that huge deficits would end, and that the United States had the power to pay off and grow out of its debt. None of these conditions holds today."
An important conclusion that Cochrane reaches is that this form of inflation is ultimately uncontrollable. The reason is that a "run" on the dollar would be a function of behavior: "Neither the cause of nor the solution to a run on the dollar, and its consequent inflation, would therefore be a matter of monetary policy that the Fed could do much about. Our problem is a fiscal problem — the challenge of out-of-control deficits and ballooning debt. Today’s debate about inflation largely misses that problem, and therefore fails to contend with the greatest inflation danger we face."
Yet another aspect of the inflation equation that often gets overlooked and/or confused is its global reach. The growth in China's economy and monetary base, for example, mean it can cause noticeable effects outside of its country borders and it has. And if inflationary pressures are hard to gauge in the US, arguably they are even more difficult in a country like China.
As Diana Choyleva reports in the FT [here], "On the face of it, China does not have much inflation to export. Consumer prices rose 1.7 per cent in the year to November." But she also reports that "CPI is a flawed measure" in China and other measures indicate much higher inflation. For example, "The GDP deflator, which measures prices across the economy, was 4.5 per cent higher in the third quarter than a year earlier, according to the NBS. By Enodo's calculations, it was up 6.4 per cent." Further, she expects the liberalization of energy prices by 2020 to induce upward pressures on inflation.
So China similarly presents a mix of conflicting signals on inflation. On one hand, "It is true that many investors are braced for a debt crisis in China that will lead to it exporting deflation to the rest of the world." But if and until that happens, "Chinese inflation is much more likely to be the surprise that financial markets are not pricing in."
Such a confluence of mixed inflationary signals in the context of loose monetary policy might cause one to give up trying to understand if not for the fact that it has actually happened before. As Jim Grant highlights in the February 23, 2018 edition of Grants Interest Rate Observer, "Twenty-first century central bankers are many things. What they are not is original. QE, financial repression and other post-2007 radical monetary interventions got a fair trial in France exactly 300 years ago."
He goes on to recount the story of John Law in early 18th century France. As it happened, Law's notion of loose monetary policy "resonated in France at the time since the kingdom, heavily indebted and impoverished by the wars of Louis XIV, was forced to borrow at 8% or so." Law had an idea to extract the country from its troubles: "His plan was to start a national bank, replace gold with paper money, and print as much of the stuff as the economy required." In other words, the circumstances were, in important respects, remarkably similar to today's.
While a contemporary banker acknowledged "In the short-term ... a central bank could force interest rates down by printing bank notes to purchase government bonds," he also recognized the longer term consequences. He noted, "[B]ecause they [printed bank notes] are used for the buying and selling of stock, they do not serve for household expenses and are not changed for silver." Following the logic through leaves the conclusion: "But once those excess notes escaped into the economy at large, consumer prices would soar."
At very least, we can now start synthesizing these insights into a more informed and cohesive view on inflation. First, credible evidence and analysis suggests that concerns about the economy heating are overstated. Second, the focus on economic growth as a key driver of inflation is too narrow; debt and projected deficits must also be considered. Third, in today's globalized economy, attention must extend beyond local markets because "too much money" can go anywhere.
We can actually do a fair amount more, though, and better understand the process of inflation. It starts with "too much money" which, in our current environment, originated with ultra-loose monetary policy. And, just as Grants depicted, the first stop for the excess money was financial assets like stocks and bonds: "As in Law's day, the initial impact of QE was largely confined to the financial markets ..."
A really key point though, is that there is no good reason why the excess money should stay in financial assets, especially when asset prices imply terrible future returns to the money that stays put. Rather, such excess money will be nervously looking for the next best, or least worst, place to go. As Grants describes, "The danger now comes from those excess money balances seeping into the deeper economy and producing a great consumer-price inflation."
Any number of things could figuratively fire off the starting gun on the exit of excess money from financial assets. It could be as simple as the momentum stopping. Absent price momentum, money could stop flowing into index funds - which would remove an important marginal buyer. It could be that baby boomers start selling off portfolios to fund their retirement. It could be that increased concerns about inflation itself, for whatever reason, could cause investors to flee the types of assets that would suffer most.
Ben Hunt proffered an interesting hypothesis [here]. "The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world ... Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback? Why in the world would management take the risk — and it’s definitely a risk — of investing for GAAP earnings when they are so awash in easy money that they can hit their pro forma narrative guidance by simply buying profitless revenue?"
Hunt conjectures: "As the Fed slowly raises rates, as the barge slowly chugs down the tightening river, it will force companies to play it less safe. It will force companies to take on more risk. It will force companies to invest more in plant and equipment and technology. It will force companies to pay up for the skilled workers they need." He summarizes by saying, "My view: as the tide of QE goes out, the tide of inflation comes in. And the more that the QE tide recedes, the more inflation comes in."
This raises yet another key point: the way in which inflation gets manifested is a policy decision. Once a system if flooded with excess money, policymakers eventually must make a difficult choice between deflating markets and accepting all of the negative consequences that goes with it, or triggering significant inflation when excess money migrates from financial assets into the real economy. The challenge for investors (and central bankers!) is that there is almost no middle ground; the odds are stacked to extreme outcomes. Further, there is no reliable formula to determine how individual central bankers will react when push comes to shove.
Finally, the subject of inflation is a confusing one and belies simple explanations. Confusion and complacency are two elements that contribute to the "daze". Nonetheless, a few things are reasonably clear. One is that inflation poses and ominous risk to financial assets [as previously noted here] and therefore should be taken seriously. Another is that inflation can manifest itself in many ways. Better understanding the process of how excess money finds a home helps in the effort to identify good warning signals. Finally, and importantly, once a significant imbalance in money supply occurs, outcomes become extremely unpredictable because they involve the interplay between the behavioral responses of investors and the decision making of policymakers.
March 2018
Periods of much higher inflation, such as those in the 1970s and early 1980s, tend to have a debilitating, almost visceral effect. Ronald Reagan gave voice to what many people felt in 1978 when he said, "Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man."
Times have changed since then and inflation no longer conjures up such violent images. Quite the opposite actually. It's almost as if investors are in a daze on the subject. Partly this seems to reflect complacency on the part of investors unfamiliar with the risks. Partly it seems to reflect a wide degree of confusion on the subject. Either way, it's a good time for investors to bone up on the subject because status quo continuation of low and steady inflation is one of the least likely scenarios over the next several years.
Opinions about inflation are all over the map and part of the reason is that there are many preconceptions and misunderstandings about it. In order to establish a working understanding of inflation, Chris Martenson provides a quick and effective tutorial [here]. He notes, for example, "Inflation is not caused by rising prices. Rising prices are a symptom of inflation. Inflation is caused by the presence of too much money in relation to things we want to buy." As a result, "What we experience is things going up in price, but in fact inflation is really the value of our money going down, simply because there’s too much of it around."
Another reason there are so many opinions on inflation is that there several relevant perspectives as to what constitutes “too much money” and “things we want to buy”. Too often, strong opinions are formed on the basis of overly simplified views. In order to develop a more complete understanding then, it makes sense to consider some of the more important perspectives.
One of those is economic growth. This is important because longer term trends in economic growth serve as a good proxy of demand for the "things we want to buy". A very solid and systematic analysis of such trends by Lacy Hunt can be found [here].
Hunt starts with a basic tenet of economics: "Consumer spending is funded either by income growth, more debt or some other reduction in saving. Recent trends in each of these categories ... do not bode well for this critical sector of the U.S. economy." He goes on to highlight, "Consumer credit over the past year has risen by $208 billion, or 5.9%. Interestingly, without the drawdown in the saving rate, real consumer spending over the past two years would have been reduced by more than half." He summarizes, "Considering the slow and declining rate of growth in income as well as the low saving rate, it appears that the current spending level cannot be sustained."
He adds that downward pressures on growth are "being reinforced by the problems of poor demographics and productivity. Population growth in 2016 was the slowest since 1936-37 - roughly half of the post-war average - and the fertility rate in 2016 was the lowest on record." Based on his thorough consideration of longer term economic drivers Hunt concludes, “Inflationary expectations will ratchet downward in this environment.”
Insights into the trajectory of economic growth, as important as they are, are not always the most important consideration in regards to inflation, however. As John Cochrane highlights [here], "But the Fed’s view that inflation happens only during booms is too narrow, based on just one interpretation of America’s exceptional post-war experience. It overlooks, for instance, the stagflation of the 1970s, when inflation broke out despite 'resource slack' and the apparent 'stability' of expectations." Cochrane proclaims, "Most analysts today — even those who do worry about inflation — ignore the direct link between debt, looming deficits, and inflation."
That "direct link" calls to attention the notion that "Inflation is a form of sovereign default" and helps explain why "serious inflation often accompanies serious economic difficulties". He continues, "Paying off bonds with currency that is worth half as much as it used to be is like defaulting on half of the debt. And sovereign default happens not in boom times but when economies and governments are in trouble."
The mechanism of inflation as a form of sovereign default works like this: "If people become convinced that our government will end up printing money to cover intractable deficits, they will see inflation in the future and so will try to get rid of dollars today — driving up the prices of goods, services, and eventually wages across the entire economy. This would amount to a 'run' on the dollar. As with a bank run, we would not be able to tell ahead of time when such an event would occur. But our economy will be primed for it as long as our fiscal trajectory is unsustainable."
To create some perspective on this point, Cochrane provides an instructive historical example: "In 1947, everyone understood that war expenditures had been temporary, that huge deficits would end, and that the United States had the power to pay off and grow out of its debt. None of these conditions holds today."
An important conclusion that Cochrane reaches is that this form of inflation is ultimately uncontrollable. The reason is that a "run" on the dollar would be a function of behavior: "Neither the cause of nor the solution to a run on the dollar, and its consequent inflation, would therefore be a matter of monetary policy that the Fed could do much about. Our problem is a fiscal problem — the challenge of out-of-control deficits and ballooning debt. Today’s debate about inflation largely misses that problem, and therefore fails to contend with the greatest inflation danger we face."
Yet another aspect of the inflation equation that often gets overlooked and/or confused is its global reach. The growth in China's economy and monetary base, for example, mean it can cause noticeable effects outside of its country borders and it has. And if inflationary pressures are hard to gauge in the US, arguably they are even more difficult in a country like China.
As Diana Choyleva reports in the FT [here], "On the face of it, China does not have much inflation to export. Consumer prices rose 1.7 per cent in the year to November." But she also reports that "CPI is a flawed measure" in China and other measures indicate much higher inflation. For example, "The GDP deflator, which measures prices across the economy, was 4.5 per cent higher in the third quarter than a year earlier, according to the NBS. By Enodo's calculations, it was up 6.4 per cent." Further, she expects the liberalization of energy prices by 2020 to induce upward pressures on inflation.
So China similarly presents a mix of conflicting signals on inflation. On one hand, "It is true that many investors are braced for a debt crisis in China that will lead to it exporting deflation to the rest of the world." But if and until that happens, "Chinese inflation is much more likely to be the surprise that financial markets are not pricing in."
Such a confluence of mixed inflationary signals in the context of loose monetary policy might cause one to give up trying to understand if not for the fact that it has actually happened before. As Jim Grant highlights in the February 23, 2018 edition of Grants Interest Rate Observer, "Twenty-first century central bankers are many things. What they are not is original. QE, financial repression and other post-2007 radical monetary interventions got a fair trial in France exactly 300 years ago."
He goes on to recount the story of John Law in early 18th century France. As it happened, Law's notion of loose monetary policy "resonated in France at the time since the kingdom, heavily indebted and impoverished by the wars of Louis XIV, was forced to borrow at 8% or so." Law had an idea to extract the country from its troubles: "His plan was to start a national bank, replace gold with paper money, and print as much of the stuff as the economy required." In other words, the circumstances were, in important respects, remarkably similar to today's.
While a contemporary banker acknowledged "In the short-term ... a central bank could force interest rates down by printing bank notes to purchase government bonds," he also recognized the longer term consequences. He noted, "[B]ecause they [printed bank notes] are used for the buying and selling of stock, they do not serve for household expenses and are not changed for silver." Following the logic through leaves the conclusion: "But once those excess notes escaped into the economy at large, consumer prices would soar."
At very least, we can now start synthesizing these insights into a more informed and cohesive view on inflation. First, credible evidence and analysis suggests that concerns about the economy heating are overstated. Second, the focus on economic growth as a key driver of inflation is too narrow; debt and projected deficits must also be considered. Third, in today's globalized economy, attention must extend beyond local markets because "too much money" can go anywhere.
We can actually do a fair amount more, though, and better understand the process of inflation. It starts with "too much money" which, in our current environment, originated with ultra-loose monetary policy. And, just as Grants depicted, the first stop for the excess money was financial assets like stocks and bonds: "As in Law's day, the initial impact of QE was largely confined to the financial markets ..."
A really key point though, is that there is no good reason why the excess money should stay in financial assets, especially when asset prices imply terrible future returns to the money that stays put. Rather, such excess money will be nervously looking for the next best, or least worst, place to go. As Grants describes, "The danger now comes from those excess money balances seeping into the deeper economy and producing a great consumer-price inflation."
Any number of things could figuratively fire off the starting gun on the exit of excess money from financial assets. It could be as simple as the momentum stopping. Absent price momentum, money could stop flowing into index funds - which would remove an important marginal buyer. It could be that baby boomers start selling off portfolios to fund their retirement. It could be that increased concerns about inflation itself, for whatever reason, could cause investors to flee the types of assets that would suffer most.
Ben Hunt proffered an interesting hypothesis [here]. "The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world ... Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback? Why in the world would management take the risk — and it’s definitely a risk — of investing for GAAP earnings when they are so awash in easy money that they can hit their pro forma narrative guidance by simply buying profitless revenue?"
Hunt conjectures: "As the Fed slowly raises rates, as the barge slowly chugs down the tightening river, it will force companies to play it less safe. It will force companies to take on more risk. It will force companies to invest more in plant and equipment and technology. It will force companies to pay up for the skilled workers they need." He summarizes by saying, "My view: as the tide of QE goes out, the tide of inflation comes in. And the more that the QE tide recedes, the more inflation comes in."
This raises yet another key point: the way in which inflation gets manifested is a policy decision. Once a system if flooded with excess money, policymakers eventually must make a difficult choice between deflating markets and accepting all of the negative consequences that goes with it, or triggering significant inflation when excess money migrates from financial assets into the real economy. The challenge for investors (and central bankers!) is that there is almost no middle ground; the odds are stacked to extreme outcomes. Further, there is no reliable formula to determine how individual central bankers will react when push comes to shove.
Finally, the subject of inflation is a confusing one and belies simple explanations. Confusion and complacency are two elements that contribute to the "daze". Nonetheless, a few things are reasonably clear. One is that inflation poses and ominous risk to financial assets [as previously noted here] and therefore should be taken seriously. Another is that inflation can manifest itself in many ways. Better understanding the process of how excess money finds a home helps in the effort to identify good warning signals. Finally, and importantly, once a significant imbalance in money supply occurs, outcomes become extremely unpredictable because they involve the interplay between the behavioral responses of investors and the decision making of policymakers.
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