Guest Contributions

The Mystery Of Inflation

James Athey breaks down inflation and relates it to the COVID-19 pandemic.

As part of their attempts to prop up economies during the COVID-19 pandemic, central banks injected new money into the system through asset purchase schemes, relief programs, and other methods. These policies, combined with expectations of a massive uptick in consumer spending post-lockdown, have incited fears of inflation at a rate we haven’t seen in more than 40 years. In order to truly understand the problem at hand, we need to understand inflation – a controversial concept.

Inflation and Consumer Price Indices

Inflation refers to a general rise in the level of prices or a reduction in the purchasing power of money (these are two sides of the same coin… more on that later). Most central banks target some form of consumer price index (CPI), which is an attempt to measure the change in price of every single consumer good and service over a given period. Those changes are weighted according to their significance in the average consumer’s consumption ‘basket’. In other words, the things that we spend more on each month will carry a greater weight in the CPI than those which we consume infrequently or at a minor cost. See the example of the U.S. CPI below for the year ending May 2021.

Source: U.S. Bureau of Labor Statistics

However, consumer price indices are inherently flawed and subject to all manner of assumptions, errors, and statistical flaws. Indeed, to name one problem, the methodology for calculating CPI has changed throughout time, such that if we were to apply the method of the 1980s today, we would discover a CPI inflation rate of 10% as opposed to the current 5%. Another problem is that of data collection – imagine trying to track like-for-like price changes across a country as large as the U.S. or a fragmented group such as the Eurozone on a monthly basis! Besides these issues, which are certainly not marginal, we need to consider the fact that statisticians keep tabs on how the quality of goods has changed over time and attempt to integrate this into the CPI metrics through the use of ‘hedonic adjustments’. For example, if the price of a good such as a TV does not change from year-to-year but the latter has a better screen and more features, consumers are receiving more for their money and thus the price has theoretically fallen.

Whilst the rationale behind making hedonic adjustments seems logical, it is actually limited. Firstly, from the consumer’s point of view, the price of the TV has not actually changed year-to-year and so there is no effective increase in purchasing power unless wages have risen. Secondly, statisticians do not account for the changing life-span of goods over time. Technology has undoubtedly improved the performance of consumer goods dramatically over the last century. However, as many of us could attest to, the build quality and thus life-span of such goods has fallen commensurately and we are forced to replace them more often. This is partly because of planned obsolescence, whereby products such as smartphones are intentionally designed to last only a certain time with the explicit aim of increasing purchase frequency. The effect of this is that many of these goods will have contributed deflation (falling prices) to consumer price indices although the money being spent on these goods in aggregate has increased over time, resulting in a metaphorical tug-of-war between these two forces. Consequently, a chasm exists between our experience of actual inflation in our everyday, year-to-year lives and statistical inflation.

Consumer price indices also fail to include important ‘goods’ that individuals could spend their hard-earned money on, such as houses. As the largest and most significant purchase of most people’s lives, I find this omission to be glaring and laughable. It’s no coincidence that, while global central banks have been narrowly and irresponsibly focusing their experimental monetary policies on the flawed CPI and its refusal to move from 1.8% to 2% over the last decade or more, we have seen house prices in major global cities rocket higher, making home ownership an impossible dream for a growing proportion of society. Certain asset classes are also excluded from consumer price indices – ranging from financial assets such as stocks and bonds to alternatives like fine art and vintage wine – despite their significant price increases in recent times. To illustrate, the first graph below exhibits the hypothetical growth of a $10,000 investment in the MSCI World UCITS ETF June 2011 to June 2021, which represents worldwide stocks. The second graph shows nominal (not inflation-adjusted) house price increases in the U.S. and Germany between Q2 2011 and mid-April 2021.

Source: iShares by BlackRock
Source: The Economist, OECD
Theories of Inflation

Let’s return to the two-sided definition of inflation given at the beginning, which speaks of prices on the one side and money on the other. Effectively, they are saying the same thing, but choosing either says something about how the theoretician in question thinks about the world. Modern central bankers are enrolled in the same economic schools of thought. In their dynamic stochastic general equilibrium models of the world (don’t ask), neither money nor the financial system exists, but gross simplifications do. These sorts of eco-thinkers view the world through the lens of supply and demand for goods and services. To them, inflation is caused by a mismatch of aggregate supply and aggregate demand, where demand is simply greater than supply. Specifically, their models suggest that when the economy operates below capacity, we will see prices either remain stable or fall. Vice-versa, if the economy operates above capacity, prices rise. To save us from falling down this rabbit hole, let’s ignore the fact that nobody has a clue how to measure an entire economy’s capacity at a given moment in time. Indeed, economists assume that historical trends can be extrapolated into the future – a catastrophically inept assumption.

An alternative economic school of thought which has fallen out of favour in recent times is that of monetarism, which revolves entirely around money. In this economic model, inflation is caused by an increase in the supply of money and nothing else. Although ‘too much money chasing too few goods’ would theoretically result in inflation, this relationship is not proportional: if there was 10% more money in circulation, this would not necessarily lead to a general price increase of the same magnitude. Monetarist theory supports the notion that unproductive money-printing (quantitative easing) as we have witnessed central banks engage in during the pandemic, will inevitably bring about inflation regardless of capacity changes. The graph below depicts the U.S. M2 money supply. Notice the 25% leap during 2020 on the far right.

Source: St. Louis Federal Reserve

Although both modern and classical/monetarist theories of inflation certainly capture some macro-economic realities, they are both incomplete. This is due to a myriad of influences, including but not limited to: menu-cost pricing, which refers to the reluctance of firms to introduce price changes due to the cost of ‘reprinting menus’; microeconomic reality, for example, firms in low-competition industries have an enhanced ability to maintain profit margins and raise prices; commodity prices, which are set globally, not driven by domestic factors, and influence prices greatly in the form of input costs; and foreign exchange rates, which produce greater price volatility in economies which import many of their goods as opposed to those which are more self-sufficient, such as Brazil or the U.S.A. Furthermore, globalisation has a deflationary influence that is not incorporated by these theories. Indeed, the outsourcing of production to developing economies allows corporations to reduce their expenses (lower wages, cheaper raw materials), in turn lowering the prices of goods and services. The same deflationary pressure has been brought about by technological advancements, which have increased efficiency. None of the above elements have anything to do with the money supply or the supply-demand relationship, illustrating the limited scope of both modern and monetarist theories of inflation.

Another central tenet of traditional economic theory is that inflation depends in part on the expectations of economic actors and can therefore be argued to be a self-fulfilling prophecy. For example, if prices are rising today, consumers will demand higher wages tomorrow, boosting demand and thereby increasing the probability of future price rises. Once more, this proposal is detached from reality – workers may wish for higher wages but that doesn’t mean they will get them. In the past 50 years, most developed economies have largely de-unionised – in the 1950s, 35% of US workers were unionised and that figure stands at around 10% today – thereby significantly reducing the bargaining power of large swathes of the labour force. The labour force has also become global, making effective replacement workers more available and thus further eroding the negotiating power of unskilled, low-skilled, and semi-skilled workers. A measurement issue exists too since average wage data ignores the composition of the workforce. To demonstrate: if unemployment is falling because more low-skilled workers are getting jobs, the average wage will fall too, telling us nothing about like-for-like wage changes i.e., what was a waiter paid last year compared to this year?

An Arbitrary Target

One might rationally infer from the actions of central banks over the last several decades that higher inflation is a good thing and conversely disinflation or deflation are the devil. The reality is that things are not as clear cut. No-one will argue that extremely high, self-fulfilling and out of control hyperinflation is a terrible development. Indeed, despite the rarity of these episodes, they are at least incredibly damaging and at worst fatal for the country and currency involved – Weimar Germany and Zimbabwe being perfect examples. On the other hand, falling prices, which are partly brought about by deflationary pressures such as globalisation and technology, are a boon to consumers because they can afford more for less. However, the economic babblers running the global economy today fail to distinguish between good and bad deflation. They assert that, if prices are falling, consumers will reduce demand today in order to buy more cheaply tomorrow (maximising their purchasing power). This could theoretically result in a positive feedback loop whereby demand continues to evaporate, creating a deflationary depression. This is realistically improbable on a large and widespread scale – not least because most consumers buy things they need over things they want. You can’t forego eating or paying your electricity bills just because you think these expenses will be lower next month! If hyperinflation is undoubtedly catastrophic and central bankers tell us that deflation is undesirable, where do we stand? Central banks in developed economies have settled on a rate of 2% inflation as some sort of virtuous ‘goal’. In truth, it is a completely arbitrary number that lies above zero and below ‘high’, with no theoretical or empirical justification for it. It seems convenient that historic inflation in the Eurozone (‘All-items’) has neatly settled into this range.

Source: Eurostat
What Now?

Inflation has become the most critical economic statistic for central policy making the world over. Regardless, it seems that inflation is both misunderstood, ‘misdiagnosed’, and therefore impossible to model or forecast. Our measurements are substandard and there is conflict and confusion about whether inflation is a ‘good’ or ‘bad’ thing under various circumstances and conditions. We can still say a few things with certainty. If prices are rising faster than wages, we will be able to afford less and will feel poorer. This is a headwind to growth and a ‘bad’ thing. Extremely high inflation accompanied by rapidly rising wages (which increase at least as fast as prices), can feed off one another to form an economic wrecking ball that can collapse currencies and economies if left unchecked. This is without question the most dangerous scenario and it must be avoided at all costs. Historically low and stable inflation has become a monetary experiment that has created a fragile financial market prone to booms and busts – ironically, the latter is always resolved with more of the same monetary largesse that created the problem in the first place. We are reaching a culmination of this high-stakes experimentation. The COVID-19 pandemic induced unprecedented economic volatility. This, paired with massive monetary and fiscal (relating to government spending and taxes) interventions by central banks, is a key cause of prices rising faster than at any point in recent history. What happens next is impossible to know for sure. If prices keep rising as fast as they are today it will eventually necessitate a monetary tightening. In a world over-burdened with debt and with a financial system sustained largely by the ongoing provision of free money, this could become another financial crisis in the making. Whatever happens – it is high time we completely rethink the role of inflation in central bank mandates.

James Athey – 26/06/21 – Fixed Rates Investment Director at Aberdeen Standard Investments

Edited by Johan Lunau – 26/06/21

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