Inflation and the 1%

There is an increasing number of investors who are afraid of rising inflation in the aftermath of the current economic crisis. The arguments are eerily similar to the ones made after the financial crisis of 2008 when investors expected an increase in inflation because all that new government debt had to be financed with freshly printed money. I was one of them, but have come to change my mind 180 degrees. Yet, in 2020, we are doing exactly the same thing as we did in 2008 and 2009 and these investors expect a different outcome than last time.

In any case, if we get to see inflation, what will that do inequality? It is well-known that higher inflation tends to hurt the working class and the poor because their wages or their welfare benefits tend to grow at best with inflation but often less than that. And due to a lack of other income, higher inflation typically means declining living standards for the poor and working class.

It is generally assumed that higher inflation benefits the rich since they own businesses and stocks, both of which are real assets that should appreciate in value if inflation rises.

Unfortunately, that is not quite true. A study of 12 developed countries from 1920 to 2016 shows that high inflation hurts the rich more than it hurts the poor. Yes, it is true that the rich own stocks and businesses that appreciate in value if inflation rises. But what sometimes gets forgotten in these calculations is that higher inflation also leads to rising interest rates. And rising interest rates mean higher discount rates for future cash flows. A simple analysis of the cyclically-adjusted PE-ratio as a long-term measure of valuation shows that there is a critical tipping point. Once inflation in the United States climbs above 4% to 5%, valuations of stocks start to decline. This is so because at these levels the discount rate effect starts to dominate the real asset effect (i.e. the adjustment of future income with inflation). In other words, inflation is good for stocks, but too much of a good thing will be bad for stocks.

I wonder what the investors who not only fear inflation but almost seem to desire inflation as a means to increase the value of their stock portfolio think about that. Do they think that if we get inflation, the value of stocks will forever increase no matter how high inflation gets? Or do they think that if inflation rises it will somehow stay below 4% or 5%? 

Unfortunately, history shows us that this is not how things work in real life. If inflation rises towards 4% or 5% it is a sign that central banks have long since lost control over monetary policy and inflation will only be tamed at the cost of much, much higher interest rates, and likely another deep recession (see the double-dip recession in the United States in the early 1980s that killed the 1970s inflation).

Thus, to all the investors who think their equity portfolios will protect them from rising inflation, I say: “Fear what you wish for. You are much better off with a Japan-like scenario of low inflation and low rates because that will truly increase the value of your shares.”

The relationship between inflation and share of wealth of the top 1%

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Source: El Herradi et al. (2020). Note: Red bars indicate the Second World War.