The Inflation Narrative

20 min readMar 6, 2021

Is Inflation Really Coming? What Should We Expect?

What We Talk About When We Talk About Inflation

Inflation is the decline of purchasing power of a given currency over time. One of the primary reasons that economics prefer to have modest inflation is that employers don’t have to cut wages if you have a little bit of inflation. CPI (Consumer Price Index) is the most commonly used inflation index, albeit this is not a perfect measure. While the Fed’s preferred inflation measure is core PCE (Personal Consumption Expenditures), the market treads on headline CPI, and inflation expectations (i.e. breakeven inflation rate).

So what we talk about when we talk about inflation?

Core PCE

The PCE Price Index is the primary inflation index used by the U.S. Federal Reserve when making monetary policy decisions. The core PCE price index excludes food and energy. PCE and CPI include a different number of items in the basket. The CPI reflects out-of-pocket expenditures of all urban households, while the PCE price index also includes goods and services purchased on behalf of households. For example, the medical care category in PCE includes both the out-of-pocket expense by consumers and the payments by employers and the government. In addition, the weights assigned to those categories are different, driven by different items included, different data sources to measure the weights, and a higher frequency of updating weights in the PCE price index updated more frequently depending on changes in households’ spending patterns.

Headline CPI (Consumer Price Index)

CPI is a consumption weighted index. If you are an average consumer, how many more or fewer baskets can you buy over time. In 2020, the CPI weights are determined by the historical data of households’ spending patterns in 2017–2018.

Weights in the Consumer Price Indexes: U.S. city average, December 2020

Everybody consumes something different. The gap between young person CPI and old person CPI is ~2.5%, driven by different things they consume. For old people who already paid college education for their kids, the mortgage on houses, and have Medicare coverage, they are not hit by price increases in those items. They spend on vacations, cloth, etc, which are dis-inflationary or deflationary. But for young people, they need to buy houses, pay healthcare premiums, etc, they suffer from inflation.

In addition, there are data points that suggest that the official US CPI underestimated the inflation rate during the pandemic, as consumers spent relatively more on food and categories with higher inflation, and less on transportation and other categories experiencing deflation.

Regardless, CPI is viewed as a good indicator (price, wage increases, etc) for things that Fed would like to watch, and there are a lot of assumptions baked in the CPI. One of the reasons that central bankers like to have inflation above 0% is that there is an economic assumption that it is easier for prices in the economy to adjust when there’s a natural drift.
Main countries measure headline inflation fairly similarly. The main difference tends to be what they focus on as their core CPI. One major difference is housing in Canada, they use a mortgage-based approach vs. other countries using rental.
Different approaches to measure CPI have different natural levels, depending on how they account for housing and various things. And so a 2% core PCE inflation target in the United States is roughly 2.25% on CPI, which would be equivalent to ~1.5% — 1.75% in Europe, adjusting for some measurement differences.
CPI is kind of accurate, but it cannot be perfectly accurate. People think CPI numbers are not accurate, but a lot of them have to do with the cognitive biases that we make. People notice price changes in Starbucks, gasoline, etc. When prices go up, you attribute that to inflation, when prices go down, you attribute that to good shopping.

Fed’s 2% Inflation Target

There is nothing magic about that 2% inflation target number, which people in Australia came out that number from thin air. Central bankers seem to think they can control inflation to two decimals, but they have never succeeded that. The Fed can probably choose between inflation ~10% and inflation around 0% or 2%, but they can not choose between 2% and 2.1%.

The real reason that inflation has been as low as it has been, even though there’s been good money growth, is that the Federal Reserve has repeatedly lowered interest rates, which has led to a declining money velocity over time. That, along with some other things, has made it very difficult to raise inflation. In the old days, we move interest rates by affecting the quantity of money, as: (1) Fed would add or subtract money to affect the overnight interest rate; (2) And then, we let long-term interest rates do what interest rates were going to do, which were what the bond vigilantes did. But with QE, the Fed acts to hold down longer-term interest rates, which depresses money velocity. This is the reason that the 0% interest rate policy is such an awful idea. It’s pining money velocity at very low levels and trying to get inflation up.

At the time of this writing (Feb 23, 2021), Fed is expecting inflation to be volatile in 2021, with increased CPI driven by base effect in spring and strong spending in summer, and softer at year-end. “ Powell’s commentary suggests that FED does not believe the massive fiscal stimulus could drive long-lasting inflation: “We don’t really see how a burst of fiscal support or spending that doesn’t last for many years would actually change those inflation dynamics”. “There perhaps once was a strong connection between budget deficits & inflation… there really hasn’t been lately”.

Inflation Expectations (Breakeven)

The breakeven inflation rate: A market-based measure of expected inflation.

10-year breakeven inflation rate = 10-year nominal Treasury rate — 10-year TIPS (Treasury Inflation Protection Securities) yield.

This is a decent indicator of the direction of where the inflation expectations would be. It is called the breakeven inflation rate because you would (roughly) receive the same total return on TIPS as you would a nominal Treasury if CPI inflation averages that level over the next 10 years. As I’m writing this article (March 6, 2021), 10-year U.S. Treasury at a yield of 1.57%, and the 10-year TIPS yield at -0.67%, so the 10-year breakeven inflation rate is 2.24%. There would be no difference between owning TIPS and Treasuries if the CPI inflation average 2.24% over the next 10 years. But if we believe inflation will prove to be higher, TIPS would have a better return vs. Treasuries. And vice versa.

Which Inflation Matters for Investors?

While the Fed uses PCE, people trade on headline CPI as opposed to realized inflation or PCE. Because the two enormous components of US headline inflation are housing costs and healthcare, we won’t have a sustained increase in U.S. headline inflation unless housing and healthcare costs rising significantly. The markets are only going to respond to the CPI that they see printed as opposed to breaking down the components.

Still, different asset classes have varying degrees of sensitivity. Gold responds to real rates vs. inflation expectation. Platinum or corn response more to changes in inflation expectations (breakeven inflation) vs. real inflation.

How Does Inflation Fit Into Macro Picture

Correlation Between Inflation and Velocity/Savings

The main driver of velocity is the interest rate. When interest goes down, velocity goes down. Zero interest rate means there is no penalty for holding money in a bank account. There is a natural floor of money velocity. Once we reach that floor, then money growth goes right into the system.

Essentially, velocity is the inverse of demand for real cash balances (PQ = MV). If you have more of the desire to hold cash balances, and more people choose to do that, you have lower velocity. The decision from a group of people to save more doesn’t necessarily change the aggregate bank cash balance, it can be a transfer from people who want more to people to want less. Increase personal savings could mean less saving in government, so change in the personal saving does not necessarily change the aggregate bank cash balance. Fed can choose bank reserve balance.

That’s also the case when over the last year. The Federal Reserve has grown the money supply by 27%. GDP hasn’t responded as quickly. Mechanically, money velocity has declined. It’s not that people are choosing to hold more bank balances, they don’t really have a choice to go and spend it. In that case, it’s really more of a question of reaching equilibrium.

Correlation Between Inflation and Business Cycle

The best way to think about it is that inflation and the business cycle are unrelated. It looks correlated because the business cycle correlates with the interest rate, which drives change in money velocity. The Fed output model assumes that growth cause inflation, but it doesn’t explain the volatility of inflation, e.g. 1970s inflation can not be explained by the Fed output model.

Correlation Between Inflation and Debt Levels

Dr. Lacy Hunt argues that over-indebtedness (1) undermines economic growth; and (2) reduces the productivity of debt, which will lead to lower money velocity. [See my last article here: Dr. Lacy Hunt’s Deflation Argument]

Michael Ashton agrees that debt level decreases the equilibrium growth rate. He differs from Hunt in that he’s not convinced with the correlation between debt level and velocity. He used to factor in the ratio of private debt to public debt in his inflation model. The idea was that public debt — countries that tend to have a lot of public debt, government debt, tend to end up in inflation because there’s an incentive for them to inflate. Countries with lots of private debt tend more towards disinflation because if you are heavily indebted, you care more about cash flow than you do about profit, which means more pressure to keep your prices low and keep the money coming in. But that model stopped working heading into GFC and was abandoned.

Correlation between Inflation and USD

The correlation is driven by the price of imports. When we have an increase in the global money supply (not just USD but other currencies as well), we have global inflation. Then how that global inflation is divided depends on currencies. On a relative basis, countries with weaker currency have more inflation. When a country’s currency is strengthening, the country is exporting inflation to others, with prices are going down for this country relative to prices for others. When a country’s currency is weakening, then this country is importing inflation with prices going up relative to others.

How to Forecasting Inflation

The Federal Reserve has been using a predictive model, which has been wrong for decades. If you just use the actual inflation number from last year and guess that for this year, you’d be more closer to right than most economists. When models make wrong predictions, two things can be the culprit: (1) the wrong parameterization; or (2) the wrong model. Unfortunately, that’s not always easy to tell, whether or not you just need to parameterize things differently or whether you’re working with the wrong model. And the problem that the Federal Reserve and central banks around the world have right now is that they’re using the wrong model. Fed’s model is a Kenyan type model, centered around the output gap. However, there are pieces of evidence that suggest that the output gap is not important when it comes to inflation.

Actually, the headline CPI can be modeled off the energy price and PMI. And the price stats of the Billion Prices Project gives you a very rapid response and identifies CPI inflation in advance pretty well. To forecast core PCE, the housing price should be the focus.

Is Inflation Coming?

After 40 years of disinflation, there are a lot of people firmly in the disinflation/deflation camp, people don’t believe inflation will come, including the FED themselves. Fed’s dot plot basically projects a failure to reach 2% inflation target. But, there are some people who warn the risk of upcoming inflation, even sustainable inflation for the next few years, driving by:

Base effects. This is very powerful when we look at the rate of change of inflation, with the oil price being one important driver. The Fed’s already told you they will look past transitory base effect, but it will still matter to the market when CPI prints north of 2%.
The supply chain disruption due to COVID. Freight costs, lumber, housing, and car prices are soaring due to the shutdown. The extend of cost-push might still largely underestimated so far.
Dollar effect with USD being relatively weak. If we are in a very big dollar bear trend, weakness in USD will be hugely inflationary.
Deglobalization. Globalization is dis-inflationary, now the deglobalization is at least less dis-inflationary, and the trade war with China is inflationary.
Fiscal Policy. A paradigm shift from monetary policy dominance to fiscal policy dominance will cause inflation. The fiscal spending is HUGE, representing ~25% of GDP, albeit not all in one year. Because this recession is driven by a health crisis, congress feels obligated to do more, this huge fiscal isn’t even being challenged.
Wages. It’s hard to anticipate any higher realized inflation in consumption baskets unless you have a concurrent or perhaps proceeding rise in wages, which, after 128 months of expansion, ultra-easy monetary policy was barely able to achieve. For a long time, companies might need to pay up for labor to get workers back in the job, where the unemployment rate remains high. Ironically, unemployment insurance provided boosts their income. If they can get a wage boost from their employer to go back to work, start spending, hit supply-side bottlenecks, then we can get inflation. The reality is that wages are not set by the unemployed, it is set by the employed. Even if we end up with a high structural unemployment rate with WFH and other underlying trends. The top portion of the “K” is much more important than the bottom half in terms of wages. It’s not going to take a lot to have some wage pressure coming in.
Demographics. The retirees are slowly dying off, and millennials become the largest cohort in the US in a year or so, which could drive a period of inflation.

With this combination, there is a probability of realized headline inflation, not inflation expectations, is higher than it has been in a long time. To be very clear, it is not to say inflation will happen, it is to say that we have the backdrop in place.

The problem is that controlling inflation is an incredibly difficult thing to do. He thinks it is more likely that inflation can spike out of control at some stage in the process, and you get social problems.

Debate Around Monetary Policy

Deflationists’ Debate — Dr. Lacy Hunt

Dr. Lacy Hunt argues that getting real inflation need:

Something that allows for the true monetization of the debt, which would require an act of Congress in reopening the Federal Reserve Act of 1913; and
Delivering money directly into the hands of people, which Lacy Hunt says is not going to happen. But Janet Yellen, a UC-Berkeley trained labor economist, has been talking about this nonstop.

It it happens, it will be real inflation, not the kind of modest inflation that the Fed can control.

[Dr. Lacy Hunt’s Deflation Argument]

Deflationist Who Moved To The Inflation Camp

Russell Napier has been firmly in the deflation/disinflation camp for decades, while many other economists worried about rising inflation given the monetary policy since the financial crisis. But he changed his mind this time, as he sees the broad money growth driven by government guarantees.

Russell Napier argues it is the broad money that matters to inflation, not narrow money aggregates and central bank balance sheets. The key point is that most money in the world is not created by central banks, but by commercial banks creating credit.
Since the Global Financial Crisis, central banks kept interest rates low, which inflated asset prices and allowed companies to borrow cheaply through the issuance of bonds (i.e. QE never triggered commercial banks to create credit and therefore to create money). This resulted in no growth in broad money, low nominal GDP growth, and high growth in non-bank debt. The broad money has been growing very slowly for the past 30 or so years, which was one of the factors that led to low inflation, albeit China being the most important.
Now, the broad money growth is created by governments intervening in the commercial banking system. Governments give credit guarantees, therefore commercial banks will freely give credit, which has changed the game fundamentally. In the US, M2, the broadest aggregate available, is growing at more than 23%. You’d have to go back to at least the Civil War to find levels like that. In the Eurozone, M3 is currently growing at 8%-9% and approaching the previous peak of 11.5% in 2007.
PPP Loans (government guarantees) vs. MMT: The government guarantee is not MMT, but can be effective. The MMT is lending money to the government, which will be treated as a loan. Government guarantee is a contingent liability, it’s not on the government’s balance sheet. There are a lot of debate around MMT, which makes it tough to get through, but no one is arguing against government guarantees. Politicians have gained control of the money supply and they will not give up this instrument anymore.
So Russell Napier made two key calls: (1) with broad money growth that high, we will get inflation. (2) More importantly, the control of the money supply has moved from central bankers to politicians, who have different goals and incentives. They need inflation to get rid of high debt levels. A credit guarantee is a mechanism to create inflation, and it is cheap because a credit guarantee is not fiscal spending, it’s not on the balance sheet of the state, as it’s only a contingent liability. Politically, this is incredibly powerful to have a cheap way of funding an economic recovery and then green projects. This is the magic money tree for politicians.

If We Have Inflation…

What Inflation Are We Expecting?

The Fed and congress working together, coupled with other aforementioned factors, tend to lead to higher inflation.

Once we get inflation up to 3%, 4%, or 5% levels, if we can get there, then there is a chance that we could have much higher inflation. This will not be the modest ~2% inflation that the Fed is targeting.

The Biggest Question: Can We Get Real Growth?

Reflation

Reflation is a consensus trade.

We need reflation in the system to help reduce the value of debt (no one wants debt jubilee). At this point, it is not a real reflation, driven by a weak dollar vs. a real demand push. Inflation trade now is a supply-constrained story, which will be addressed at some point, but the market is logically looking through this as they expect the demand to increase. If we have strong demand, this weak dollar reflation could become a permanent reflation trade.

Digital goods (e.g. NFLX) can be supplied with no incremental cost, but in 2021, especially with the vaccine, there will be physical constraints to meet pent-up demand as people will move to real goods. We are seeing some restocking impulse constantly, and yet not so much on intentions to invest long term.

But, the reflation trades are based on soft data, which are getting nuanced, and under the surface, consumer confidence and unemployment are not as good. A recent survey from Bank of America showed that people who have incomes of $125,000 and above are the ones with the savings. If the savings are concentrated in the hands of so few people, the effect from pent-up demand after reopening might not be as meaningful as people are expecting.

Right now, we are seeing a bear steepener, with bond sold-off on both ends, but the long-end got sold-off more than the short-end. This is a standard reflationary scenario (i.e. let things run hot), in which the front end is anchored while a little tightness at the end of the curve. This is actually quite bullish, as the market is anticipating the growth and inflation coming through and they don’t think the Fed is going to move initially to constrain it.

Stagflation

Price increased due to severe disruption in the supply chain, but unemployment remains high and the real economic growth doesn’t follow through. In that scenario, we could see a situation where commodities continue to see strength, and yet precious metals also starts to recover.

Hyperinflation

We could see higher inflation if the central banks begin to directly finance the governments. The Brits are doing it already, and Brazil. The structurally weaker economies like Brazil and Turkey will most likely run into hyperinflation. But for the industrialized economies to get hyperinflation, you really need people to lose confidence in the currency. It’s hard to see that scenario happens real soon, but no one who had hyperinflation had predicted that hyperinflation could come.

Deflation

The permanent employment right now is higher than it was in the 2001 or the 1990–1991 recession, the baby boomers aging. Those types of things are disinflationary by nature.

Policy Response to Inflation

The Central Banks’ Playbook

The view of central banks is that easier financial conditions create jobs and inflation. Right or wrong, every central bank believes that they need to keep financial conditions loose to meet their dual mandate of the inflation target and maximum employment.

Over the past 10+ years, the other key part of the central bank activities has been suppressing the real interest rates in order to: (1) support equities and risk assets; and (2) bring more and more consumption forward from the future. The game is to avoid a liquidation event by keeping real rates down and in the future, further down.

Yield Curve Control (YCC)

On the surface, this is what the Fed wants — monetizing the debt, pushing inflation higher, capping the yields, and having negative real yields fund everything. But there are many factors in play:

Potential yield curve control. YCC faces a lot of resistance within the Fed because it is the end of the toolbox. With Fed not willing to have negative rates, YCC is very close to negative rates in terms of how much they don’t want to go there.
Curve steepening. Fed love steepens the yield curve (to please the banks) and will likely allow it. In fact, you need a steep curve to produce inflation, because you want banks to lend, growing money supply and stabilizing velocity of money. Banks won’t lend if the yields are so low, at least not without a government credit guarantee.
Debt levels. People think nominal interest rates can’t go up because of the debt level, but eventually, we need inflation and negative real rates to inflate away the debt. And it could work, if inflation increases to 3%-5%, the real rates can still be negative with nominal interest rate at 2%-4%. However, they can inflate away existing debts, but cannot refinance what has to be refinanced in the private sector, which will be very problematic in the near term, given the massive amount of investment-grade bonds, commercial real estate that has to be refinanced in 2021.
If Fed lets yield raise before YCC, risky assets can fall sharply for a short period. Fed is reactive, not proactive. They will only step into the MMT or YCC (either implicit or explicit) when there is a pain in the market — which would be sharply higher bond yields, sharply stronger dollar, sharp sell-off in the equity market. If the Fed is forced to react, they will start to pull these tools out they’ve been reluctant about — YCC, going out the curve, entertaining the idea of central bank digital currency.
If Fed does yield curve control, they are likely to pin the very front end of the curve at effectively zero, and go out to 3-year or 5-year of the curve. It retains a bit of steepness for the banking system but the long-term rates come down as well. Low nominal yield across the curve implies that central banks and the market are not confident about growth. A deadly combination is that the risk-free treasury curve is locked at a very low nominal yield and we can’t create inflation, i.e. positive real rate and tightening when we have no real growth.
Yield Curve Control in an environment of rising inflation expectations: Fed capped Treasury yields at 2.5% between 1942 and 1951, as we also had rationing, price controls, and credit controls. Yield Curve Control is easy when everyone is expecting deflation, which the current policy of the Bank of Japan shows. But market participants will all want to sell their bonds when they expect inflation. Governments will need to force their domestic savings institutions to buy government bonds to keep yields down, as a measure of financial repression.

What Is the End Game

We have tried to devalue currencies, we have tried to bring interest rates down to zero or below, nothing worked in terms of driving economic growth or creating inflation to get the debt to GDP down.

Now, with the gigantic fiscal spending, the government debt explodes to an even higher level as well as the government share of our economies.

Financial Repression

We are at the beginning of a new era of financial repression, in which politicians will make sure that inflation rates remain consistently above government bond yields for years. Financial repression will again be the measure taken by governments to reduce debt. It’s often an emergency that gives governments these extreme powers. Total debt to GDP levels was already way too high even before Covid-19. There are a limited number of ways you can bring down your debt to GDP ratio, and inflation is probably the least painful one. It’s preferred over defaults or austerity. Basically, the entire developed world (the US, the UK, the Eurozone, Japan) will choose that same path after WWII in coming years: achieve higher nominal GDP growth through higher rates of inflation. The cornerstones of the last period of financial repression after World War II were capital controls and the forcing of domestic savings institutions to buy domestic government bonds.

The consequence is wiping out savers. It was the savers who were forced to hold treasuries when inflation was higher, and government bonds were called certificates of confiscation. This could look pretty good for the first few years if 30-year fixed-rate mortgage below 3% but nominal GDP growing at 7%. But over the long term, inflation is the taxation without legislation and turns bad even for the average guy in the street. This isn’t a direct attempt to move money from savers to debtors, but no doubt it’s supposed to move money from one section of society to the other. Essentially, it is stealing money from old people slowly. If done slowly enough (Russel Napier defines as nominal rates <2%, inflation <6% or maybe never go above 4%), the savers will realize but they won’t scream, which is a transfer of wealth from old people who live on a fixed income to young people who borrow over a very long period of time without the savers absolutely screaming.

As government controls the supply of money, central banks will become more regulatory than a monetary organization. Imaging government print money at 12% y/y vs. Fed target of 2% inflation. Paul Volcker had the courage to ride a full-blown attack on our democratically elected government by raising interest rates, today’s central bankers don’t seem to have guts to do that. Where we are today is a good parallel to the 1960s, when the Fed did nothing about rising inflation, because the US was fighting a war in Vietnam, and the administration of Lyndon B. Johnson had launched the Great Society Project to get America more equal. Against that background of massive fiscal spending, the Fed didn’t have the guts to run a tighter monetary policy.

The banking system is starting to become utilities of the government, which they’ve always been in China. The government tells them who and when to make a loan to.

Or Monetary Reform

This massive fiscal spending increases the government’s share of the economy. In 2Q20, the government share of nominal GDP jumped from the mid-20s to the upper 40% in the U.S., ~50% on average in the eurozone, very high in France, and 55%–58% in a few Scandinavian countries. The government share has jumped by at least another 10% by now, which means the government share is already bigger than the private sector in those economies.

In a situation like this, the path we are usually going is that the fiscal authorities, the governments, and the central banks, work together running the show, with more regulations, more dictations, less freedom, etc. Historically this usually ends up in hyperinflation and then a monetary reform.

We don’t know how a monetary reform will play out, but there will be no real winners in it. What is more likely is that they will, at some point, try to get rid of cash money, paper currencies, make all the money electronic, and then they can guide people through monetary reform. We do not know how it looks like, but the bottom line is that a lot of people will lose a lot of money. Those who are stuck with nominal investments will lose a lot of money. Those that are invested in real assets may do better but they will also lose money. If you knew exactly what the authorities would do and you did the right thing and you came out as a big winner, all the profits would be taxed away.

Disclaimer

For general information purposes only. It does NOT constitute investment advice or a recommendation or solicitation to buy or sell any investment, and should not be used in the evaluation of the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the author and are subject to change without being updated. Not all information will be accurate. Consult a financial professional before making any major financial decisions.