An Inflation MasterClass

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Introduction

The ability to predict whether inflation lies ahead is probably one of the most important things to get right when structuring your investment portfolio. No wonder that since the start of 2021, whether we are in for a period of prolonged inflation or not has turned out to be the most heated debate among investors, economists and policymakers.

Over recent years, there have been several natural deflationary forces at play which have been aggressively counteracted by policy intervention in response to the pandemic. The possibility that people and businesses alter their spending behaviour once the dust settles imposes an additional level of complexity for those attempting to predict inflation.

In this Master Class, and in the series of articles which will be published over the next few weeks, we aim to provide you with the essentials you require to formulate an opinion of whether inflation will emerge and whether it is here /to stay. The content we produce will be supplemented with strategic decision-making visuals to help you structure your portfolio accordingly.

In this Master Class you will learn:

You can also access a visual summary of the article here.

What is inflation and where does it show up?

Inflation describes a rise prices in goods, services or assets, either due to higher demand, higher costs of production or limited supply. Inflation also occurs when money becomes less valuable relative to everything else because its scarcity property is violated, resulting in a decline in the currency's purchasing power.

The mention of inflation is generally made in the context of an increase in prices of goods and services. However, inflation can also happen in assets like houses, bonds and stocks. The following section delves deeper into the different categories in which inflation may occur.

Goods and Services Inflation

Goods and services prices may increase due to a number of factors, including:

higher production costs incurred by producers, such as raw materials and wages. To preserve their profit margins
Profit margin is profit as a percentage of sales
, producers charge higher prices. For instance, the reshoring of production from a less developed economy to a wealthier economy can lead to higher prices as workers in the developed economy demand a higher wage than workers in the less developed economy. This type of inflation is called cost-push inflation. Cost push inflation may also result from supply chain disruptions. For instance, a hurricane whirling close to an oil drilling area can lead to disruptions in oil production, which may cause oil prices to increase.
higher demand for goods and services. This is called demand-pull inflation, which occurs when higher demand outpaces the available supply of goods and services, hence causing supply shortages. During a recession
Economists define a recession as two consecutive quarters of negative GDP growth
, producers typically adjust their production downwards due to lower demand. However, when the economy starts to recover, supply may take time to respond sufficiently to surges in demand, so upward price pressures ensue.
exchange rate depreciation relative to other currencies. A depreciation of the exchange rate means that the domestic currency loses value relative to other foreign currencies. When this happens, imported foreign goods and services become more expensive. For example, following the outcome of the Brexit vote, the pound depreciated significantly against the currencies of its main trading partners, meaning that it became more expensive for Brits to import from Europe and the US. When these higher import costs feed into the prices of domestic products and services imported inflation occurs.

How is goods and services inflation measured?

The official measure of goods and services inflation is the Consumer Price Index (CPI), which is also known as the Retail Price Index (RPI). In Europe, the Harmonised Index of Consumer Prices (HICP) is used as the standard measure of inflation, while the US Federal Reserve (FED)
The Central Bank of the United States
bases its monetary policy decisions on the Personal Consumption Expenditure (PCE) inflation rate.

The prices of some components included in the CPI like energy and food are volatile, meaning that they can change wildly from time to time. That is why these components are sometimes stripped from the overall CPI measure to give what is known as the Core CPI.

Is goods and services inflation good or bad?

Goods and services inflation is generally looked upon negatively by consumers, since they end up paying higher prices for the goods and services they wish to purchase. However, inflation is less damaging to individuals whose income increase at a faster rate than the increases in prices and are able to afford the higher prices. Inflation is desirable for borrowers because future debt repayments are made in money with a lower value, but it penalizes savers because it dilutes stored wealth.

A mild level of inflation is beneficial for an economy. If we expect prices to continue rising, we will be discouraged from postponing our purchases. Think about it - if you know that the price of fuel will increase next month, you will ensure that your fuel tank is full by the end of the month. The anticipation of price increases encourages us to spend today instead of deferring consumption. In response to higher spending, firms increase production and employment. More employment means that more people are able to spend, and this generates further rounds of consumption and the economy grows.

While inflation encourages consumption, savers do not view inflation favourably. In fact, inflation is commonly referred to as an invisible tax on wealth. Consider the following example:

If I have £100 in a bank account and annual the interest rate on bank deposits was 1.5% while CPI was 1.0%, inflation shaves off 1.0% from the 1.5% interest earned. In this case, I beat inflation by 0.5 percentage points. While the total value of the £100 at the end of the year will be £101.5, the actual purchasing power of the initial £100 will be £100.50. Had the CPI for the year been 2%, then I would have lost purchasing power. The value of the £100 at the end of the year would still be £101.50, but the purchasing power of this amount would be £99.50.

It follows that individuals who earn a fixed or slow-increasing income such as pensioners or blue-collar workers suffer the most in the presence of goods and services inflation. The spending of these individuals is more inclined towards essential items such as food, energy and rent, rather than luxury items which are not afforded by the majority. These essential components are price inelastic

, meaning that inflation barely affects the demand for these goods. The strain on finances of low-income earners following an increase in the price of food or an increase in rent prices is much larger than what it would otherwise have been had the price of yachts gone up, since their earnings are generally unable to outweigh price increases.

The following chart shows how prices of different components of inflation in the US.

From 2010 to 2020, rent increased by 38.3%, the cost of education increased by 39.2% and the price of food and beverages increased by 20.3%, while the weighted price of all items increased by 20.3%. The overall inflation rate is based on the weighted spending of the average consumer, which may differ from your personal inflation rate.

Asset Price Inflation

Asset price inflation describes an appreciation in the price of assets like stocks, bonds, real estate, gold, art, watches, fine wine and other assets which have value. An increase in price of these assets does not imply a concomitant rise in their intrinsic value
What an asset is truly worth
. This is because an increase in price can be simply driven by more money which can be spent on these assets.

On the other hand, a higher intrinsic value should be backed by structural fundamentals, including:

scarce, or otherwise deteriorating supply of tangible assets like land, art, fine wine or precious metals
strong company performance in the case of intangible assets like equities and corporate bonds.
strong country performance in the case of Government bonds
network effects and widespread adoption in the case of cryptocurrencies

When asset valuations are not backed by fundamentals, price bubbles may emerge, whereby surges in demand are driven by a combination of too much money in the hands of irrationally exuberant

investors' and Fear-Of-Missing-Out (FOMO) .

How is asset inflation measured?

The CPI, PCE and other goods and services inflation measures do not capture rising asset prices. This is because the CPI is constructed to capture price changes in items which are bought by the majority of the population on a recurring basis. Assets are only owned by those who can afford them, and the frequency and size of purchases vary.

To measure asset price inflation, analysts use several metrics for different assets:

To value the equity market as a whole, common benchmarks used are the Shiller P/E Ratio, the Market Capitalization relative to GDP, the Dividend Yield and Earnings Yield. If these metrics show that the market exceeds historical averages without fundamental backing, then asset prices may be inflated.
To value individual equities, the Discounted Cash Flow technique is one of the methods used. Equity valuations which exceed the intrinsic value are overvalued. Other valuation techniques include multiples analysis and regression analysis.
Real estate is valued using the Discounted Cash Flow and Net Present Value techniques, and using metrics such as the House to Rental Price ratio.
Bonds
A loan provided by an investor to a borrower for a fixed term which guarantees a stream of fixed income payments for the investor
are usually the best expression of fundamental macroeconomic trends. There are several classes of bonds, ranging from the safest form of debt like Government bonds to investment-grade bonds
Loans of businesses which have solid financial positions and are less at risk of default. These companies are able to pay a lower yield to lenders when borrowing
and Junk Bonds
Loans of businesses which are not investment grade. Because of a higher risk of default, these businesses need to pay a higher yield to borrow
. Central Bank intervention affects the yields on short maturity bonds
Bonds which need to be repaid in the short term, usually within a few months to a year
, while the longer dated bonds are determined by demand and supply. Investors pay close attention to the shape of the yield curve
A chart showing the maturity of several bonds issued by the same entity on the horizontal axis against the yield on the vertical axis
, any notable changes in yields, the rate at which yields change and the spreads between yields of different bond classes.
To ascertain whether precious metals like gold and silver are excessively valued or not, investors use the real interest rate
The difference between the nominal interest rate and expected inflation
, stock to flow models as well as metrics such as the gold to silver ratio and the gold to money supply ratio.
Cryptocurrencies are valued by their stock to flow as well as network effects.

Is asset inflation good or bad?

Asset inflation is good for those who have assets. That is ultimately why investors invest in assets - to benefit from asset price inflation or to earn a stream of income. It is for this reason that asset price inflation is looked upon less negatively than goods and services inflation (at least by those who own these assets).

Asset inflation is driven by increased demand for the asset which may, or may not be complemented with a reduction in supply of the asset, the latter making it more scarce. When the fundamentals of the asset improve, then it makes sense that its valuation should also improve relative to other assets. But when the asset price inflation has no unfounded fundamental backing, but simply increases because investors have more capital to deploy, then the asset price is artificially driven.

Besides the artificial increase in prices and bubble-emerging risks associated with monetary-driven asset inflation, the wealth divide between asset holders (a.k.a. the haves) and non-asset holders (a.k.a. the have nots) is exacerbated. Those who afford ownership of appreciable assets benefit from asset price inflation and become wealthier than they already are, while the rest are left behind. This may eventually lead to social tensions and civil unrest.

Monetary Inflation

Monetary inflation is the increase in the total supply of money in the economy. The premise behind monetary inflation is that the total supply of money multiplied by the frequency at which a unit of the currency circulates in the economy over a given time period should be equal to Gross Domestic Product (GDP)
The value of total output of an economy within a given period, which is equal to total expenditure by households, firms, government on domestic output minus expenditure by these parties on foreign output, plus expenditure by foreigners on domestic output within a given period, which is also equivalent to the total value of incomes and profits within a given period
.
$$ M V = P Q $$ where M: Money Supply, V: Money Velocity, P: Price, Q: Quantity

Presuming that the velocity of money

remains constant over time, an increase in the money supply should yield a higher nominal GDP. This increase in GDP will be a combination of increases in actual output (real GDP) and higher price (inflation).

How is monetary inflation measured?

The measure which captures monetary inflation is money supply growth. The money supply is classified as broad money, comprising money in circulation, instantly demandable deposits, savings deposits and money market mutual funds

. Growth in the money supply is determined by the willingness of commercial banks to lend and, as witnessed recently, direct transfers of money initiated by Government.

How this money is created warrants a basic understanding of Central Bank operations and balance sheets of financial system operators.

Central Banks liabilities include the money in circulation and reserves, which are collectively known as the monetary base. The currency in circulation is already in the economy and exchanges hands on a daily basis. Reserves are distributed among commercial banks and banks use these reserves to grant loans. Banks are penalized for holding too much reserves on their balance sheets.

In what was once a normal financial system, Central Banks used to simply adjust the target interest rates they charge commercial banks on the reserves they hold at the Central Bank to influence lending conditions. When lending was not occurring and the economy was slowing, the Central Bank reduced the interest rate to encourage borrowing. Contrarily, the interest rate increased when excessive lending was occurring. However, the Great Financial Crisis of 2008 made Central Banks realize that conventional manipulation interest rate was insufficient to counteract the negative shock, particularly because of the already low starting position of interest rates and the excessively leveraged financial system.

Therefore, Central Banks resorted to unconventional monetary policy via Quantitative Easing (QE)

, whereby Central Banks inflated their balance sheets by purchasing Government bonds and asset-backed securities from commercial banks, pension funds, insurance funds and other major institutions. In return, the Central Bank swapped these financial institutions' assets with reserves, which was supposed to give them the necessary leeway to increase their lending. The following graphic is a simplified illustration of how QE works.

how-quantitative-easing-works

Now it is important to understand that while Central Banks can in theory create money by increasing the amount of reserves at commercial banks, they cannot ensure that these reserves are transformed into loans. Ultimately, commercial banks are the creators of new money, and not the Central Bank.

In fact, Central Banks soon discovered that QE was not having its desired stimulative effects. Despite the increase in the monetary base

due increased reserves, the money supply did not follow suit. Since banks preferred to use the reserves initiated by the Central Bank to repair their damaged balance sheets following the Financial Crisis, lending growth remained muted and the money supply did not grow as much as the monetary base.

In fact, an almost perfectly inverted symmetric relationship can be observed between the size of the FED's Balance Sheet and the money multiplier, which is the ratio of the money supply in the economy to the base money created by the Central Bank.

The monetary stimulus initiated by the Central Banks was not passed on to the people and firms in need of the money, because it got caught up in the financial system. And that is why goods and services inflation remained muted following the Financial Crisis. Those who thought that QE was going to be inflationary were clearly wrong. Instead, monetary inflation transfigured itself into asset price inflation, and those who held assets got richer.

However, the effects of the pandemic-induced crisis which hit the global economy in 2020 were not limited to the banking system. The pandemic directly shattered economy, causing lost jobs and corporate insolvencies

Interest rates were already at low levels and QE was proved unsuccessful in transmitting the required stimulus from the Central Bank to the real economy. So Governments got creative. They found a way to directly channel funds through the real economy by directly providing the money to people and businesses themselves.

They raised money by issuing bonds which were indirectly financed by the Central Banks. In this way, Governments funded their accounts sufficiently to be able to pass on the money to the economy when they wanted and to whom they wanted. This time, policymakers were able to increase the money supply.

Having received this money, consumers and firms are able to spend and regenerate economic growth. Theoretically, if this money is spent on goods and services, demand-pull inflation should follow. But will it? This is the multi-million dollar question. We develop a framework for thinking about whether monetary inflation will cause consumer price inflation in our next article. Sign up to immediately get notified when it is released!

In a nutshell, there is a distinction between money printing by the Central Bank and money creation by commercial banks and Government. While monetary inflation is always initiated by the Central Bank, the extent to which it happens is a function of whether commercial banks are willing to lend and/or Government's transmission of the money to those in need of the money.

Is monetary inflation good or bad?

An inherent characteristic of the credit-based fiat monetary system

we use is that, assuming that the velocity of money is fixed, a mild increase in the money supply is required for economic growth to occur. This suggests that some money supply growth per year is essential, but if monetary inflation outpaces economic growth, there is risk that the currency loses its value relative to goods and services, relative to stronger currencies and/or relative to stores of value.

A fundamental property of money is that it must be scarce. Monetary inflation makes the currency less scarce relative to other currencies and dilutes the currency's value relative to scarcer assets. A weaker currency can discourage foreign investors from parking their capital in the economy as foreign currency denominated assets become expensive.

During non-crisis periods, monetary inflation hovered around 5.2% annually in the US, 5.4% in the Euro Area and 7.1% in the UK. But during 2020, global Central Banks responded to the pandemic by increasing the monetary base by around four times average in the US and around double the average in the Euro Area and the UK. Following major Central Banks' announcements in late March 2020 that they will continue to print money for as long as needed, the S&P 500 increased by 60.7% through the end of the year. Bitcoin was up by 500% over the same period; House prices in the US increased by 4.2% while those in Europe and the UK both increased by 2.1%. The gains in these assets continued strongly throughout the first few months of 2021 as people's wealth was boosted by direct monetary transfers provided by Government.

But are these fundamentals-driven increase in asset prices?

As a case study, consider the 2020 bull run in Apple (ticker: AAPL). During 2020, Apple's earnings grew by nearly 4.0%, while free cash flow increased by 24.5%, without any ground-breaking technological breakthrough. Yet the equity price accelerated 78.2%. Gains of this magnitude had no substantive backing. Apple simply turned out to be the usual outperformer it has always been. The insane increase in its price is not backed by an increase in value of the same extent. It is entirely driven by monetary inflation.

On an alternative note, monetary inflation is beneficial for debtors who have fixed debt repayments.

If I borrow £100,000 today with a 20-year repayment term, by the end of the repayment term I am obliged to repay the original £100,000 plus interest. The £100,000 remains fixed and is thus unaffected by inflation. Since excessive monetary growth dilutes the purchasing power of currency, future debt repayments will be made using in a weaker currency. The presence of inflation thus reduces the opportunity cost of borrowing, but increases the opportunity cost of lending.

In fact, inflation may be an attractive way for policymakers to reduce the real cost of the debt they have issued. If the inflation rate is greater than the interest rate on debt, borrowers benefit from repaying the debt with less-valuable money.

However, the risks of excessive debt are high when the low interest, easy money environment causes the economy to overheat. Higher output and employment may generate transitory upward price pressures. If long term interest rates rise in response to expected inflation, this will not bode well for indebted firms. And when nominal interest rates reach a strenuous level for highly indebted firms, a credit event occurs, which ultimately leads to deleveraging

and a series of deflationary shocks. When the dust settles, this marks the start of a new economic cycle.

Tabular Summary

The following table extracts the main points from the above discussion.

Types of Inflation	Goods & Services Inflation	Asset Inflation	Monetary Inflation
What is it?	Increase in price of consumables;	Increase in price of assets;	Increase in Money Supply; Devaluation of currency;
How is it created?	Demand Driven; Cost Push Inflation; Imported Inflation;	Scarcity; Demand Driven; Liquidity Driven Network Effect;	Policy (Monetary and Fiscal); Bank Lending;
How is it measured?	Consumer Price Index; Personal Consumption Expenditure Index; Harmonised Index of Consumer Prices	Discounted Cash Flow; Stock Flow; Ratio Analysis; Multiples Analysis	Monetary Base (M0); Money Supply (M2,M3); Central Bank Balance Sheet;
Who/What does it positively affect?	Economic Growth	Asset holders; Borrowers;	Holders of stores of wealth like gold or Bitcoin
Who does it negatively affect?	Consumers; Fixed income Earners Low Income Earners	Lenders; Those who do not hold assets;	Users of debasing fiat currency

Next, we will present the salient trends and short term drivers goods and services inflation so that you can conceptualize for yourself whether inflation is up ahead.

Can consumer price inflation be predicted?

In the near term, inflation is a function of the amount of money in the system, who holds this money, the number of people in employment, production input costs and exchange rate dynamics. Over a longer time period, inflation is conditional upon secular trends like demographics, debt, globalisation, geopolitics and technological improvements. Therefore, inflation can be predicted to a certain extent, as long as any short term price pressures are transitory and policymakers do not intervene sufficiently to distort inflation expectations.

Asset price inflation clearly dominated the past decade following the Great Financial Crisis, fueled by strong corporate profits, share buybacks

and the undesired outcomes of unconventional monetary policies such as QE. A decade of low interest rates also encouraged borrowing and leverage , which further propelled asset prices. However, the seemingly dormant CPI inflation amidst such aggressive asset and monetary inflation over the past decade has invoked skepticism in policymakers’ ability to bring back goods and services price inflation.

The COVID-19 pandemic continued to exacerbate downward price pressures, as job losses and the widespread lockdowns prevented people from maintaining their pre-pandemic spending patterns. This reduced the velocity of money, which correlates well with the CPI, to an all time low. But is low goods and services inflation here to stay? Are policymakers putting undue emphasis on the CPI which disguises other form of inflation?

To answer this question, it is pertinent to distinguish between the secular drivers and cyclical drivers of goods and services inflation.

What are secular drivers of inflation?

Secular drivers of inflation determine whether the long-term trend in prices is upwards or downwards. Demographics, geopolitics and its effect on globalisation, technological developments, and debt are amongst the salient drivers of secular inflation. A decelerating rate of inflation is called 'disinflation', while a declining rate of inflation is called 'deflation'.

Demographics

Demographics are a fundamental determinant of inflation because different age cohorts have different spending behaviour. The baby boomer generation

is by far the largest generation which has ever roamed the planet. When these baby boomers joined the labour force (1960s to 1980s), they brought about a surge in economic growth due to first-time purchases of cars, houses, furniture and capital goods. This surge in demand was one of the key contributors to the inflation witnessed throughout the 1970s.

Throughout the 1980s, fertility rates

across the globe started declining. Baby boomers were having less kids, and this resulted in smaller succeeding generations. This means that the number of individuals engaging in first-time purchases is notably lower than it was in the 1970s, making demand-pull inflation difficult to reignite.

Moreover, medical advances contributed to improvements in life expectancy, implying that the baby boomers are ageing at a slower rate. This leads to another behavioural shift, since when baby boomers realize that the state pension is insufficient to maintain their pre-retirement living standards and get them through their now longer retirement, they will less inclined to spend.

These demographic developments are reflected in the velocity of money

, which has exhibited a declining trend since the 1980s. This coincides with a downward trend in the labour force participation rate in the US, which measures how many people are willing and able to work. Looking ahead, a relatively lower number of working age individuals will be able to support the relatively larger retirement cohort.

It is no coincidence that velocity of money mirrors the disinflationary trend in prices.

An opposing argument suggests that since economies are faced with a smaller cohort of new workers entering the labour force is creating a shortage of workers. Labour shortages increase the bargaining power of workers and unions to negotiate better wages. And economists claim that inflation is a by-product of wage growth.

The significant monetary handouts provided by governments is worrisome because those earning the stimulus may become complacent and choose to drop out of the labour force. By providing social assistance, there is no incentive for people to work. To attract workers, employers may need to offer significantly higher wages, which not all employers may be able to afford. This may indeed lead to some short term inflationary pressure, however, for wage growth to be sustained, the rate of productivity

gains must rise by at least an equivalent amount. Otherwise, employers will find it hard to make ends meet and will have to wind down production.

Geopolitics and Globalisation

Globalisation

has been the engine of global growth since the beginning of the 21st century. The ability to easily move capital around the globe allowed firms to locate production in economies where labour costs were cheap, and this allowed them to reduce their production costs. By combining lower production costs with lean process management systems, firms were able to reduce costs.

However, ever since Trump was elected President of the US in 2016, developed nation leaders started voicing their concerns that the offshoring

of production was proving to be detrimental for local labour markets. This political stance was reinforced by the pandemic, as certain nations found themselves short of medical supplies when they were needed the most.

But reshoring production in developed economies is more expensive because workers demand a higher wage. Firms then have to decide whether they will reflect the higher production costs in prices to maintain their profit margins. If they do so, then inflation is likely to emerge.

If firms face higher production costs but are unable to pass these higher costs onto the consumer, then inflation may remain muted.[^1] But because of the lower profits, firms may be less willing to employ new labour or invest to compensate for the lower profit margins and this will eventually be a headwind to sustained inflation.

Therefore, a stronger political stance in favour of deglobalisation may lead to higher goods and services prices only if reshoring firms are able to pass on higher production costs to consumers.

Technology

Technological progress allows for increased efficiency, innovation and productivity. Recent developments in software and artificial intelligence, such as speech recognition, machine learning and driverless cars have hastened the move to automation and threatened the jobs of some workers. Since machines are cheaper to employ than actual workers, a shift towards automation is deflationary.

The following chart shows price declines in certain technology components of CPI since 2010.

Furthermore, the fear-inducing narrative that several jobs may be at risk of becoming obsolete could damage both consumer and producer confidence, which may cause spending restraints and a reluctance to hire. This cause further downward price pressures.

Debt

Debt is the accumulation of credit, which essentially is the act of borrowing to satisfy current consumption at the expense of future consumption. While the ability to borrow allows for higher spending in the present, debt repayment obligations are likely to restrain future spending. Besides, when repaying debt, money is being taken out of circulation, so the money supply is reduced. This means that excessive debt causes downward pressure on prices.

In fact, economist Ray Dalio pioneered the long term debt cycle, which is a 75-100 year cycle illustrating the progressive loosening of financial conditions as debt compounds within shorter term business cycles. The long term debt cycle prior to the one we are currently in ended following the Great Depression of the 1930s. Private debt was at record highs at the time, as shown by the following chart of private debt in USA, UK and Australia, with peaks reached during the Great Depression in the early 1930s.

private-debt-to-gdp

To make it easy to afford the high debt, policymakers reduced interest rates to record lows and money printing similar to what we are witnessing today transpired.

long-term-debt-cycle

When debt levels get too high, the productivity generated by additional debt-financed investments decline, because the cost of paying the interest on debt becomes too high relative to the cash inflows. Therefore, excessive debt causes downward pressure on prices.

Besides, it is yet to deciphered what permanent effects will emerge in the aftermath of the pandemic following policymakers' strong intervention to prevent the deflationary shock which would have otherwise materialized. In doing so however, supply in some countries has remained artificially elevated. The extent to which consumers' behaviours change following the pandemic has yet to be seen. If people realize that they can do without certain expenditures by working from home or engaging into less recreational expenditure, then the oversupply must eventually adjust to the lower demand. If so, debt defaults and business closures may emerge which are by nature deflationary.

What are cyclical drivers of inflation?

Cyclical drivers of inflation bring about changes in prices over the short-term business cycle. Drivers of short-term inflation include increases in money supply adequately channeled to those who need it, their willingness to spend the money, strong employment and wage dynamics, commodity supply constraints, and currency weakness.

The amount of money in the system, who receives it and what they do with it

We have discussed monetary inflation extensively in the preceding sections. The only way an increase in the monetary base can be inflationary is if the money supply also increases, i.e. if banks lend or if Government directly transmits money to those in need.

In fact, that is why inflation did not emerge following the QE process initiated by Central Banks in response to the Financial Crisis. The QE process is essentially a bond-for-reserve asset swap which the Central Bank initiates with financial institutions to increase their excess reserves and give them more leeway to make loans.

But if commercial banks keep these excess reserves on their balance sheet or use these excess reserves to purchase assets with higher yield rather than granting loans, then the money supply will not increase. The following chart shows the different response of the M2 money stock to an increase in the monetary base in the 2008 Financial Crisis and in the 2020 pandemic.

In fact, the money multiplier series correlates very well with velocity of money, the latter being a key indicator of the prospects for demand-pull inflation.

The problem with monetary policy is that the widespread reduction in interest rates or Quantitative Easing did not trickle down to those who actually need the stimulus. Instead, money was diverted into assets, which inflated asset demand and made the wealthy wealthier.

However, the policy response to mitigate the disruption caused by the COVID-19 pandemic was different in two respects:

The growth in money supply dwarfed the corresponding surges witnessed during the Financial Crisis.
Central Banks indirectly financed Government deficits.

The latter allowed Governments to have full control of how much of these funds get transmitted into the real economy, and who receives the funds.

If these funds are disbursed to those who direly need them - such as small businesses and low to middle class consumers - then the likelihood of a pick up in goods and services inflation increases. Otherwise, if the money ends up in the hands of the wealthy, then the marginal effects of the stimulus are minimal.

However, although this time round money was indeed provided to those who need it the most, it does not mean that goods and services inflation will emerge. This is for a number of reasons:

Individuals and firms may be more willing to pay off their debt with the money they receive. This means that goods and services spending may be limited in the case of individuals. Also, productive investment which can produce jobs may be subdued.
Individuals may be more inclined to hold the savings on their balance sheet for precautionary purposes, in case they lose their job. Firms may also choose to retain earnings as a buffer against future black swan events.
Individuals may be more informed on the benefits of investing and investing fees have been reduced profoundly. Therefore, the money received may be invested instead of spent.

Therefore, the extent to which goods and services inflation will emerge depends on the behaviour of the recipients of the stimulus. We will delve further into these reasons in our next article.

In sum, an increase in money supply is inflationary if and only if it is channeled to those who actually need it, AND the recipients of the money choose to spend it than to save or invest.

Employment, Wages and Competition

A fundamental concept in economics is Okun’s law, which suggests that there exists a negative relationship between an economy's production levels and the unemployment rate.

In a growing economy, firms are likely to employ more people to meet production requirements. When this happens, demand pull inflation is likely to occur, since a larger number of workers are now earning a spendable income. As the labour market tightens and it becomes increasingly difficult for employers to fill vacancies, unions gain bargaining power and can negotiate better wage contracts.

If employers reflect these higher wage costs in their selling prices to preserve their profit margins, then cost push inflation will occur. This cyclical inflation is generally observed towards the start of the business cycle.

Another potential determinant of inflation is market competition. When big players acquire smaller competitors or drive them out of business, there are less job opportunities for workers. The smaller number of opportunities diminish workers' bargaining power and thus keeps a lid on cost push inflation.

Commodity demand and supply

Commodities are natural resources which are extracted to be used for production (like oil, copper, iron-ore, silver and uranium) or for store of wealth (like gold and silver).

Because of their direct use production as primary inputs, commodity prices movements are a leading indicator of inflation. When observing commodity price inflation, we should always query whether the price movement is being derived by an in aggregate demand, production constraints and/or currency devaluation caused by monetary inflation.

For instance, improved environmental awareness should fundamentally explain why demand for commodities like lithium and uranium are likely to increase over time. This will lead to demand-driven inflation in prices of goods using these commodities and ancillary services.

Contrarily, a supply side driven increase in commodity prices may be driven by a production-disrupting event or by a rapid surge in demand which is unable to be instantaneously met.

For instance, oil extracting facilities are often experience extreme weather events in their vicinity and are forced to cease operations. This unprecedented decline in supply relative to the unchanged demand causing oil prices to increase.
Another case in point is the commodity price surge following the reopening of economies and resumption of global trade once the pandemic was brought under control. Consumers were unable to spend their income on recreational services during lockdown, so a surge in demand for housing goods took place. With several workers in commodity-extraction firms facing quarantine and social distancing measures, supply fell back and prices like lumbar and steel surged. The following chart shows surge in commodity prices since the start of 2020.

commodity-returns-2020

The exchange rate

Exchange rate movements are relative a function of interest rates, money supply and growth prospects.

When an economy's interest rate is reduced, when its money supply increases following easy fiscal and/or monetary policy or when it faces less optimistic growth prospects, the currency tends to lose value relative to other economies' currencies. A weaker currency makes imports invoiced in foreign currencies more expensive, and can thus generate imported inflation.

Following the preceding section on commodities, commodity price movements, particularly those in precious metals like gold and silver, can also be currency driven. This is because commodity prices are generally priced and traded using the world’s reserve currency, which is (at the time of writing) the US dollar.

When excessive monetary inflation weakens the dollar, commodities priced in dollars increase in value and thus come with a higher price tag per dollar. The dollar becomes less scarce relative to the commodity, so each unit of currency is capable of purchasing less commodities. The opposite occurs when the dollar strengthens.

Therefore, extreme monetary inflation can instill a loss of confidence in the currency, which can lead to less desirability to hold the currency.

Inflation expectations: Can they be self-fulfilling?

I bet that by now you're scratching your head on whether you're in the deflationary camp or in the inflationary camp. In truth, there are compelling arguments for both and as odd as it seems, expectations of inflation may influence the actual outcome.

Indeed, both firms and households discount future inflation when making daily economic decisions. Expected inflation captures the markets' perception of what inflation will be some time in the future. Beliefs that inflation may rise in the future can become self-fulfilling. If people expect producers to increase prices in the future, then producers will want to raise prices. This anticipated price increase would intensify workers' and worker unions' salary negotiating efforts, a concept known as the wage price spiral.

To avoid expectations to manifest into market disruptions, Central Banks periodically provide forward guidance on the economic outlook and how they intend to adjust their policy to reach their employment and inflation targets. The market digests this news and reassesses what inflation is expected to be in the future, even if the actual policies communicated by Central Bank were only announced, not implemented.

However, market expectations may not always be right.

The market thought that Quantitative Easing implemented following the Great Financial crisis would bring about goods and services inflation. But the market was wrong.
Central Banks repeated their unconventional monetary policy intervention on a larger scale when the 2020 pandemic exposed a global liquidity crunch. But this monetary support was complemented by an astounding fiscal stimulus, which the market thought would be the catalyst for future inflation. In response, US Government bonds, which tend to be less desirable during inflationary periods, recorded a 13.8% decline in 2021, while commodity prices soared. The market seems to be priced for inflation, but will it be wrong this time?

Bottom Line

Ultimately, when predicting inflation, it all comes down to the time horizon under consideration. An important distinction should be made between cyclical drivers, which may be transitory and secular drivers, which are not easily counteracted.

For those of you who are curious about my view: At the time of writing (April 2021) I believe that some short term CPI inflation is undeniable, especially in light of the low base from a year prior. However, I still believe that over the long term disinflationary and possibly deflationary pressures will come back to haunt, especially if this monetary support is all transitory. Think about it, if you are given a one time €1000 cheque to spend, you may increase your purchases imminently, but holding all else fixed, next year you will be €1000 poorer.

The question is whether money printing will actually result in sustained goods and services inflation? We will provide a flowchart which will help frame your decision in our next article. Sign up to be sure not to miss it!

[^1]: Unable to pass on the costs to consumers means that consumers reject higher prices and lower their demand in response, meaning that producers will be forced to reduce prices again.

Visual Summary

All you need to know about inflation part1

All you need to know about inflation part2

References

Content

Mishkin, F. S., & Serletis, A. (2011). The economics of money, banking and financial markets.

Dalio (2020), The Changing World Order: Why Nations Succeed and Fail

Charts & Formatting

https://fred.stlouisfed.org/

https://www.debtdeflation.com/blogs/

https://imgbb.com/

https://www.canva.com/

https://www.koyfin.com/index