This article will serve to unpack some of the concepts related to inflation. It serves to supplement some of my earlier posts as follows ICYMI:
Magic Markets – Ep9: MMT and inflation
Yield Breakout and ‘Shadow rates’
An unprecedented time
If you haven’t read these or are unfamiliar with concepts like MMT and the Yield Curve, I would urge you to read these articles first before commencing this one. Given the global focus of some of these concepts I will restrict this discussion to US data , but bear in mind that many of the concepts are easily relatable and transposable the most global economies.
To reemphasize some points, we are currently in an unprecedented time with large volumes of unconventional stimulus being pumped into the global economy. At the forefront of this battle is the US Federal Reserve [FED] and US Treasury.
But they are not alone. All major global central banks as well as the governments of most developed and developing countries are in the middle of the largest monetary and fiscal experiment of our times.
These unconventional policy and stimulus measures, coupled with asset prices and financial markets and all-time records, have given rise to concerns of bubbles as well as the potential that policy makers and central bankers will be behind the inflation curve.
This fear is well grounded in economic theory. Bear with me as I address Eco’s 101. The formula below represents the relationship between money supply and the velocity of money on one side of the equation and overall price and output levels on the other side of the equation.
MV=PQ
M (Money Supply) * V (Velocity of Money) = P (Prices) * Q (Overall Output)
This identity suggests that any increase in money supply with all other variables staying the same may result in a commensurate increase in prices in order to balance the equation.
It’s also probably important to explain velocity of money. This concept put simply is how many times a unit of currency is spent or used within a year. It is representative of whether money is being used or spent in the system or rather being hoarded in assets or savings.
Inflation rears its head
With all the stimulus in the system, it stands to reason that we should start seeing some increase in inflation.
The most recent headline CPI number out of the US saw inflation rising by around 2.6% year on year as shown in the chart above. When viewed in the context of a long-term 2% inflation target by the Fed , this number may seem alarming, although the Fed is willing to tolerate a transient spike in inflation. The long-term chart above also shows how current levels are fair from most pre or post GFC peaks.
Let’s unpack this further and look at the relationship between money supply and inflation to see if this is in fact the driving force for the rise in the short term. From the chart above we can see that the relationship is anything but clear. So let’s go back to that equation of MV = PQ.
Potentially the reason we haven’t seen an outsized increase in inflation (relative to the amount of stimulus provided) is that over the course of the last year the velocity of money has collapsed, and this has largely offset the increase in money supply.
So what’s driven the near term inflation spike?
Lastly if we delve into the detail behind the most recent CPI number out of the US, we can see that a large proportion of the inflationary bump was related to energy prices. Bear in mind that a lot of economic data around the world for the month of March and April will likely be comparing to sharp declines in most prices and indices for the same period last year.
As such year on year comparisons may appear outsized but as the base effects are slowly worked into the data the volatility in these year in your comparisons should abate.
Put simply, low prices from last year this time will mean that year on year comparisons of inflation may be really high. However in order for the inflation rate to remain persistently high, we would need to see sustained increases in prices from current levels.
What about all the Stimmy?
Let’s look at one last dimension inflation dynamics which is related to the consumers ability as well as willingness to spend. When we look at the personal savings rates in the US, we can see at they spiked to levels of around 34% and are currently sitting at levels of around 14%. This high savings rate is also mirrored by a commensurate decline in consumption expenditures. Retail sales data suggests that consumers are starting to unleash is high savings entire consumption more recently.
This is a trend which I would like to watch a lot more closely. Bear in mind that there is still a substantial amount of fiscal stimulus by way of ‘stimmy’ checks being distributed in the system. In order for consumption expenditures to remain supported, not only will consumers be drawing down on their savings, but it will also largely be contingent on continued stimulus programs.
Marginal propensity to save vs. propensity to spend
So what’s the bottom line?
I think that we’re now seeing a confluence of massive stimulus as well as an increase in the velocity of money as consumers unleash pent up demand and drawdown on savings accumulated over the course of the last year. Given the economic equation of MV = PQ , this is likely to result in higher prices as well as a rebound in overall output.
The question from a policy makers standpoint is whether any bump up an inflation is transient or sustained. It’s too early to tell and for now, the policy standpoint will likely remain easy but with a hint of caution over the medium to longer term.
From an investment standpoint, inflation generally tends to support cyclical industries and commodities. Whether the old tried and tested relationships hold still needs to be seen. If indeed policy makers and central bankers are behind the curve and the recent bump in inflation proves to be more transient, this will likely necessitate tighter policy, with ramifications on stock valuations.
The market seems to be digesting this relatively well and the yield on the US 10Y has now corrected to around 1.5% from levels of around 1.8% a few weeks ago. While my overall stance to my own investments has been a cautious one , specifically because of a number of risk flags as referenced in this piece, Risky Business , my longer term view is one of an inflation spike in the in the short term which proves transient.
Any subsequent normalization will likely see policy remain accommodative over the medium term. In this context I believe that there are still opportunities to pursue in the equity space but from an overall asset allocation perspective I maintain caution with an adequate cash buffer to ensure that I sleep easy and that I stick toward my own definition of risk tolerance and strategy, despite some inflation consternation.
As I always say: “Investing is a marathon not a Sprint”.
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