The Big Explainer
What is inflation?
This week Roger Hirst is joined by multiple guests to help explain the controversial topic of inflation. It's very difficult to pigeonhole something that impacts different people in different ways. Even a simple calculation of inflation, such as CPI, is fraught with controversy. Inflation, however, still needs to have a standardized definition.
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Why inflation is such a difficult thing to get our head around is because there are so many different facets to it. There's so many different moving parts.
That's sort of hard to keep track of and try to work out what's going happen globally then regionally and then even further down domestically.
Welcome to The Big Explainer.
Inflation is one of the most controversial topics within economics, but it's very difficult to pigeonhole something that impacts different people in different ways. Even a simple calculation of inflation, such as CPI, is fraught with controversy. Inflation, however, still needs to have a standardized definition.
We think of inflation as a general rise in the price level for a given country. We measure that using an index, the most popular one is the consumer price index. Most countries have a CPI, in the United States we also use something called the Personal Consumption Expenditures Index, particularly the Fed focuses on what we strip out as the volatile items of food and energy. So take your pick of which inflation measure you choose. There we start to think about what is deflation or what is disinflation. So disinflation would be a slowing in the increase of the absolute price level. Deflation would be a decrease in the absolute price level. Inflation, disinflation, deflation, all have implications for investors, for central banks, for treasuries.
As well as inflation, deflation and disinflation, we also hear about hyperinflation, which is inflation that's run wild, such as we recently saw in Venezuela. Stagflation is where economic growth stalls whilst prices rise, which we saw in the 1970s. Reflation is where inflation is part of a general increase in growth that might be associated with a rebounding economy. Furthermore, timeframe matters, inflation may quickly follow a period of deflation and vice versa.
We're seeing a sweet spot right now where growth has been decimated by the Covid pandemic. And so with that cut in aggregate demand, we're seeing disinflation and in some cases, outright deflation. Where to from here however? I would say that as government borrowing continues to grow apace, that the price level is destined to rise and could rise quite sharply.
Milton Friedman, one of the most famed economists of the last century, said that 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. Actually, inflation is better described as a sustained rise in the general price of goods. But there are many factors that can influence prices, not just an increase in the money supply. Problems in supply chains can create inflationary bottlenecks, as we saw with Chinese pork prices last year. Demographics and automation can influence prices in both directions. There are many influences on inflation and deflation.
I think one of the biggest drivers of inflation normally, traditionally has been wage inflation. So what do people earn? And the more that people earn, the more they're able to spend, the more they spend, the more economic activity there is, economic growth leads to higher prices. And of course, that can actually be absorbed in their economy where people are earning more and more. So their disposable income is actually such that they're able to spend more while still saving. So I think that is the big one. It has always been wage inflation. Another key factor feeding into inflation has always been the level of economic activity, the higher your economic activity, the more healthy your economy, the more likely they were to be inflationary pressures. Now people are worried about the state of the economy. They're worried about their jobs, the job security that they have, especially in the last 50 years. So I think that that's actually becoming more of a consideration as well. The shale industry in the United States has rather revolutionized the energy sector in that we are no longer dependent solely on the members of the OPEC countries. We now have other sources of oil to rely on. So, of course, there's downward pressure on oil prices and that through that mechanism of the sort of logistics transport industry purely based on carbon, on carbon fuels, we see there's not that much inflationary pressure there anymore.
If we look at the demographic side of things and we use Japan as an example, as a case study. For the last three decades the Japanese have basically aggressively been following loose monetary policies in order to ignite economic growth. And for three decades they have basically failed. There's two reasons there: one of course, is that they, after their crash sort of in the late 80s, early 90s, they had a couple of companies that they didn't want to let go, don't want to let them go to the wall. So you've got these zombie companies that are potentially taking up a lot of valuable resources within the domestic economy. But I think what's the key point there more likely is, is the demographic picture. So Japan I think, is the country with the largest percentage of its population over the age of 65.
Even when the monetary authorities are stuffing the channels with support and stimulus, the type of inflation that this can create can vary. Over the last decade and even more clearly during the Covid crash, monetary support has fed into asset prices at a faster pace than it has fed into other types of inflation.
All that money that's been pumped out by the other central banks doesn't make its way down through to the real economy, but that money has to go somewhere. So it finds itself going through to the financial markets. So you'll see asset inflation take place in stocks, bonds, futures and options, certainly you'll see it there. I think then leading on from there, you know, if we I just mentioned the financial inflation that asset inflation that could take place, commodities obviously is a big one. So you will find that money goes into commodities and that you will see prices become more expensive there.
One of the reasons why, despite the poor outlook for companies that stock prices, or stock valuations continue to rise is because there's there is no alternative. We call it TINA 'there is no alternative'. And others will say, just buy the dip. Bond prices are at record highs, stock prices are at record highs, gold is near a record high. So the more that countries are borrowing, the more that investors are putting into that market, those prices continue to rise. I don't think that's a sustainable model.
Money printing should also be inflationary because of the dilution of the domestic currency, making imports more expensive by weakening exchange rates.
When you have a loose monetary policy, you find that those those countries where they've got near zero interest rates, there is a price pressure down on their currency, on the exchange rate of a currency. So they find that maybe the purchasing power of the currency isn't what it once used to be. A good example for those of us in the United Kingdom is we have seen a series of shocks over the last couple of years on the, on the pound exchange rate. And we know that that actually has made certain items more expensive.
But if every country is printing money to devalue their own currency, then no one's currency will fall. During the last two or three years FX volatility has generally remained subdued, while central banks have missed their inflation targets and asset prices have soared. Technological advances have also had an impact, which should be deflationary.
Basically what it does is it brings prices down. There's never been I think, an example of a technological advance in manufacturing that's led to increased prices over a period of 5 to 10 years. Initially there might be because of something brand new and there's a novelty factor and the marketing machine will kick in and people will be keen to get hold of this new, let's say, mobile phone, tablet, but the reality is, if you look at if you look at those technological advancements, all I've ever done is cause prices to go down.
Now to further complicate the picture, we have absolute or nominal inflation on the one hand versus real inflation on the other.
When you talk about nominal deflation is inflation is like, we talk about wages for example right, so I tell you that, as you've said, I've had a five percent increase, you know, but your actual inflation rate is six per cent. So your nominal wage inflation is five per cent, but your real wage inflation is actually minus one per cent, because you were lagging behind the actual price increase level, the level of price increases in your country. So what we had is that people are getting small increases, but the measurement of inflation that those increases are being pegged to is by definition not a true picture. So there is I believe, people are finding themselves constantly behind, they are not earning enough to match the price increases in the economy.
We also need to add into the mix the potential of combining monetary and fiscal policy. Monetary policy is quantitative easing and adjusting interest rates. Fiscal policy is government spending. Over the last few months monetary policy on its own has created specific areas of inflation, but it has failed to lift inflation in its broadest measure.
For all of the money that's been pumped into the economy by the QE, by QE programs across the world, most of it doesn't get to the real economy in the first place. So, you know, people are unlikely to change their spending patterns, which might lead to that sort of across the board price increase that you need for proper inflation pressures to come up.
Now, however, we have the prospect of modern monetary theory, which combines the potential for unlimited government spending with unconstrained central bank buying of government debt. If this is effectively infinite in potential, then future inflation risks do rise sharply. Currently investors are not concerned with hyperinflation, but they are trying to hedge for a pickup in generally rising prices.
Investors are seeking hedges, in some cases in the form of precious metals, which would be a traditional hedge gold, silver, platinum, but they're also seeking inflation compensation through the US and the UK in particular have treasury inflation protected securities or linked bonds, inflation linked bonds. And so there's been quite a bit of investment recently in these linkers, you call them in the UK or in the US we call them TIPS. So investors are seeking compensation for the risk of inflation and we're seeing a tremendous amount of demand for those securities right now.
So inflation versus deflation will remain a thorny issue. The Covid crisis and its response has created enormous potential in both directions. Monetary and fiscal policy could combine to create runaway inflation, whilst debt, demographics and automation could create runaway deflation. Some people will experience inflation, whilst others will experience deflation at the same time. Both the inflation and the deflation camps may be correct. It may just be a matter of timeframe. One thing is certain, the inflation deflation debate will rumble on throughout our investing careers.