THE RAGING DEBATE of 2021 is whether the inflation we’ve been experiencing this year will be transitory or more permanent. The Federal Reserve’s official stance is that the spike in inflation is a perfect storm of pent-up demand, supply-chain disruptions and year-over-year comparisons that are “inflated” relative to 2020’s pandemic-induced deflation, and eventually will revert to more normal levels.
Recent hotter than expected inflation data—including the consumer price index (CPI), producer price index (PPI), U.S. import and export prices and the Fed’s preferred measure, personal consumption expenditures (PCE)—have thrown a monkey wrench into the Fed’s transitory thesis. Even the Fed seems to be having doubts.
Over the past 12 months, consumer prices rose 5.4%. You have to go back nearly 40 years, to 1982, to find sustained levels of CPI of more than 5%. Core CPI (CPI minus volatile food and energy prices) is up 4.5% over the past year. It’s been 25 years since it was last above 3%. In other words, few economists today remember a time when inflation was a serious threat.
Is it possible that expectations for inflation have been powerfully biased to the downside by the past four decades of calm and waning inflation? Fed Chair Jerome Powell, who is age 68, didn’t begin his career in finance until 1984. Just as some people make investment decisions through a rearview mirror, isn’t it possible that economists are susceptible to the same ailment?
Last November, I expressed concern that inflation was a greater risk than ever before, at least in my (short) investing career. My fear stemmed from the teachings of the late economist Milton Friedman, who said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
To understand why, consider the board game Monopoly. At the beginning of the game, a set amount of money is distributed to each player. The object of the game is to amass the greatest amount of money by buying up properties and charging fellow players rent when they land on your property. Imagine the rules were modified so that everyone received twice as much cash as usual at the start of the game, and also received $400 instead of $200 when passing “Go.” Furthermore, let’s assume that properties were sold to the highest bidder. It doesn’t require a PhD in economics to realize that property prices would soar. That is, inflation would take hold.
To the surprise of many, years of quantitative easing—the Fed’s moves to lower interest rates and encourage economic activity—failed to move the needle on inflation. Putting massive quantities of money in circulation failed to stoke inflation on Main Street, although it likely led to inflated asset prices on Wall Street. Theories abound for why this occurred. But to me, the most convincing explanation is that the excess cash failed to circulate in the real economy—what economists refer to as money velocity. Going back to our Monopoly analogy, it would be like printing more money but keeping it at the bank rather than in players’ hands.
This dynamic changed once “helicopter money” rained down from the sky in the form of stimulus checks and other fiscal largess. Money supply as measured by M1—the sum of currency, checking accounts and demand deposits—has quintupled since the beginning of the pandemic, pushing prices higher.
Won’t inflation subside once these extreme monetary and fiscal measures are withdrawn? Perhaps. But like many things in finance, psychology and behavior play a role, too. Should inflation expectations be anchored higher, inflation could become a self-fulfilling prophecy. When people begin to expect higher prices, they make purchases sooner rather than later, which drives up demand and fuels even more inflation. Once such an inflationary mindset takes hold, this dynamic can be difficult to break.
A great deal hangs in the balance in the inflation debate. Inflation is a silent thief, confiscating people’s purchasing power over time. Ronald Reagan was more direct, calling inflation “as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” Inflation also is the great enemy of bonds and other fixed-income investments. With the exception of TIPS, or Treasury inflation-protected securities, inflation can wreak havoc on returns.
Stocks aren’t necessarily immune to higher inflation. All else being equal, higher interest rates make bonds more attractive than stocks, depressing share prices. Higher interest rates resulting from a robustly growing economy are one thing. But when inflation is stoked by monetary and fiscal policies aimed at reviving moribund growth, the real danger for stocks is stagflation—low growth and high inflation. This would be an especially toxic brew for U.S. stocks, which are currently priced for perfection.
John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.
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Two minor quibbles:
M1 has exploded largely due to a simple accounting change post covid: savings accounts which used to only be included in M2 are are now counted in M1, driving that number way up regardless of fiscal policy. That in itself cannot “push prices higher”.
”Extreme” monetary measures are then quoted as being one of the two factors for driving inflation but the previous Monopoly section rightly showed that monetary policy has not been able to cause inflation as the Fed’s money printing, namely reserves generated by QE. has not and cannot get into consumers’ hands. It stays completely in the inter-banking system.
Inflation now is fiscal policy all the way down.
I’m confused, in your 7/22/21 peice you wrote:
As I argued recently, expected returns from U.S. stocks are abysmal. Based on valuations and the tendency for asset classes to mean revert, the coming decade may be another “lost decade” for U.S. stocks. By any number of metrics, the U.S. stock market is in bubble territory. Ratio of total market capitalization to GDP? That would be 200%, the highest in recorded history. What about the cyclically adjusted price-earnings (CAPE) ratio? It’s at 38, a level only once surpassed, at the height of the tech bubble in 2000.
Yet 2 weeks earlier you claim prices with (CAPE)-P/Es ratios now over 40 you state:
This would be an especially toxic brew for U.S. stocks, which are currently priced for perfection.
Priced for perfection, or bubble territory?
Good luck & Best wishes.
An excellent article. I wish my ECON 101 instructor had explained inflation this well (Sorry, Mr. Thomas!).
If compounding is the eighth wonder of the world – then inflation a wonder too – without any “wonderful”.
Inflation is particularly pernicious because it also compounds. The inflation rate in any given year builds upon the inflated price level from the previous year.