Against Cassandras: Inflation
The spectre of inflation raising its ugly head is one that is haunting us investors all the time. And while I think there is indeed a possibility of runaway and persistently high inflation in coming years, this is by no means a done deal. In fact, I find Cassandras who claim inflation is inevitably going to remain high make these forecasts based on an outdated and flawed understanding of the link between monetary policy and increases in consumer prices.
Originally, I thought I could just put these Cassandra calls to bed by linking to my many posts in the past where I have shown the data that refutes the argument of inflation Cassandras, but I fear I have to write yet another overly long explanation why I think inflation is more likely to calm down than stay high or increase.
So, here we go…
The key argument is that printing money leads to inflation. The good old monetarist argument. Well, I have shown that the link between inflation and money printing has broken down since the 1990s in this post.
My opinion is that the link between money printing and inflation has broken down because of two reasons. First, we no longer live in a world where once a central bank prints money the money stays in the same country. The financial world is global, and money printed in one country does not necessarily stay there but goes anywhere in the world where the best investment opportunities are.
Second, we no longer have to invest money in the real economy to generate profits. In the good old days, when central banks created money, commercial banks would lend that money to real businesses and consumers who in turn spent that money on consumer and capital goods. Today, when a central bank creates money, a bank doesn’t have to lend it to businesses and consumers and neither do businesses and consumers have to spend that money in the real economy. We are perfectly happy to invest it in paper like US Treasuries and other bonds, stocks, or indeed any kind of financial derivatives we fancy.
The money created by the central bank never actually reaches the real economy but remains in the secondary market creating higher valuations and investment bubbles but no inflation. This tendency for banks to not lend money in the real economy is stronger the more costly it becomes for banks to lend, i.e. the lower interest rates are and the more capital they have to hold against loans they hand out. Furthermore, if the opportunity costs to lend money are high because the bank can make a decent return by just investing in government bonds or holding central bank deposits, the less a bank is willing to lend.
Adding to that, consumers and businesses are less willing to invest or spend their money if they think they can make more money in financial markets or if they have to invest their savings for their retirement. The more precarious their retirement situation looks the more consumers will save and the more money there is sloshing around in capital markets.
Theoretically, higher savings imply higher investments (most have learned at university that I = S is an accounting truism) but in an economy with both a real sector and a financial market, the investments never have to end up in the real economy as long as the financial market offers sufficient opportunities.
In essence, what we have seen in the decade between 2010 and 2020 is what you expect to see in a low interest rate environment with global financial markets and no capital restrictions. You create high-flying financial assets and persistently high valuations that look nothing like the valuations we were used to in the past.
So, blame free markets and free capital flows as well as the 2009 invention of paying interest on central bank reserves for the asset ‘bubbles’ and the breakdown of monetarist inflation theories if you like but as long as we don’t go back to the 1960s and 1970s with their closed economies and capital flow restrictions I have doubts we will see monetarist theories of inflation rise from the dead.
A more sophisticated version of the same argument is that the velocity of money is low and that is why inflation remains subdued. This is essentially the same thing as saying that the money ‘printed’ by central banks does not end up in the real economy, which is my point entirely. I have discussed this argument extensively in two successive posts here and here. The velocity of money has been on a steadily declining trend and even the 2022 increase in velocity as seen in the chart below has not broken that trend. In fact, outside the US, the velocity of money has hardly increased to begin with even as inflation has reached double-digits indicating that recent inflation is not a result of an increase in the velocity of money or money printing.
Velocity of money
On that note, please don’t argue with me that the inflation of 2022 is proof that money printing leads to inflation. If that were the case, why did we start printing money in 2009 and inflation only increased in 2022? Why did the Bank of Japan start printing money in the 1990s and it has not seen inflation rise to this day? Japan’s inflation currently remains lower than that of the US, the UK or the Eurozone, yet the Bank of Japan has ‘printed’ more money than any other central bank anywhere.
No, the inflation spike of 2022 was triggered predominantly by the supply shock in energy commodities triggered by the Russian invasion of Ukraine and the supply shock from global supply chain disruptions in 2021. There was a small component of demand-driven inflation, but that explains less than a third of the overall inflation spike. In essence, 2022 was a repeat of the 1974 OPEC oil shock or the 1990 oil shock after Iraq invaded Kuwait.
And this brings me to my view about how this may play out in the coming years. Arguably, inflation is declining already in most countries, and I would expect it to decline slowly but steadily throughout 2023 and 2024. However, inflation has become entrenched to some extent which is why I expect inflation to decline only slowly. Eventually, the interest rate hikes by central banks will reduce demand to such an extent that inflation will decline toward 3% or less.
But – and this is the key risk I see for the coming 12 months – in the 1970s in reaction to the OPEC oil shock, central banks cut interest rates too soon when inflation was declining but still well above normal levels. These cuts in interest rates then created more demand and about a year later, inflation started to rise again. Central banks were forced to reverse course once again and hike rates but starting from much higher levels than in the first round. This is what triggered the loop of higher and higher rates and inflation and the state of permanently low growth (i.e. stagflation).
And this is the tightrope central banks must walk in the next one to two years. If the Fed or other central banks cut rates too early, they risk creating runaway inflation like in the 1970s (and no doubt the inflation Cassandras will perform their victory dance). If the Fed or other central banks keep rates too high for too long, they risk a deeper and deeper recession. I have argued in a previous instalment of this series, high interest rates cannot last for a long time before businesses will feel the pinch and have to curtail investment activity. But now, with inflation so high, central banks will have to inflict some of that pain. I am not a central banker but if you ask me the right balance between the two challenges would be to keep policy rates at current levels throughout all of this year (maybe you can cut by a symbolic amount) and then slowly reduce rates throughout 2024 even though the economy is not growing fast. But in my view cutting rates too fast or too much is a bigger risk right now than prolonging a recession.
All of this is to say that whether inflation will remain high or not in the next couple of years is not set in stone, yet. It will crucially depend on monetary policy actions over the next one to two years. And none of the inflation Cassandras would agree with this statement. In their view, high inflation is inevitable and that, I think is just not correct and simply not supported by the facts.