My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

Inflation

Inflation is topical at the moment, not because we are in an inflationary environment, but because there are concerns that unprecedented amounts of fiscal and monetary stimulus unleashed during the pandemic could reignite inflation once the crisis passes and the global economy begins to regain steam. The purpose of this article is to provide you with a basic understanding of inflation – what it is, why it can derail a stable economy, and why you should monitor price level changes in determining your optimal portfolio mix. Below is a headline summary of the points I will cover in this article:


  • Inflation is the rate of change in prices of goods and services in an economy over time,

  • Inflation usually increases above the target rate when an economy is growing too fast, an unexpected supply shock occurs (like a several-fold increase in the price of oil or food), or monetary policy is overly accommodative, and

  • Inflation has collateral effects on consumer behaviour and other economic parameters, like foreign exchange rates, interest rates, government deficits and debt, and wealth transfers between lenders (creditors) and borrowers (debtors).

To provide some historical context and to open the discussion about inflation, the graph below from FRED Economic Data illustrates the inflation rate (i.e. the consumer price index, or “CPI”) each year in the US since 1960, with the grey vertical bars illustrating periods of recession.



You will note that inflation was most problematic in the US from the late 1960s until the early 1980s. Each of the four recessions that occurred during this timeframe had a different set of causes, which I am not going to cover in this article. However, to rein in inflation that was persistent throughout this period, the federal government and Federal Reserve had to use restrictive policy tools to cool the economy. Since the early 1980s when this difficult period of recurring inflation finally ended, inflation has been much less troublesome in the US as illustrated in the graph. In fact, since the Great Recession (2007-2009), inflation has been consistently tame, hovering mostly below 2%.


With that short historical context as an introduction, let’s move into a more thorough discussion of inflation and the role it plays in an economy.


What is inflation?


Inflation is the increase in prices of goods and services in an economy over time. Inflation causes the purchasing power of money to decrease. For example, if a loaf of bread costs $2.00 today but $2.10 next year at this time, then the inflation rate with respect to the bread is 5%, since the bread increased in one year by $0.10 and the original price was $2.00. This means the value of a dollar is worth less at the end of the period – whilst two dollars was worth one loaf of bread one year ago, two dollars now is worth less than one loaf of bread.


You might instinctively think that inflation is bad, but in reality, most economists believe that modest inflation (circa 2%/annum) is acceptable and in fact preferred in advanced economies. Problems arise when actual inflation exceeds expected inflation over a prolonged period of time, which causes a deterioration in a population’s standard of living and other collateral effects on things like wealth distribution. For this reason, governments and central banks eventually react to above-target inflation by tightening fiscal and / or monetary policy to guide inflation back down to the targeted area (say 2%/annum). These policy actions slow an economy and in some cases even cause an economy to enter a recession. Today, an equally concerning problem in some parts of the world, like Japan and the Eurozone, is inflation that is stubbornly below (rather than above) the desired growth rate. This problem has been exacerbated by the COVID-19 pandemic because lockdowns of varying degrees have dramatically increased unemployment, led to capacity underutilisation and increased savings rates (at the expense of consumption), all of which have put downward pressure on prices in many developed economies.


Inflation is sometimes discussed – especially today – in the context of the prices of financial assets, referred to as “asset price inflation”. I will touch on this later in this article, but my principal focus will be on inflation as it relates to goods and services.


What is deflation, disinflation and reflation?


As discussed above, inflation is a positive rate of increase in the prices of a basket of goods and services in an economy over time. Deflation is the opposite of inflation, or a decrease in the prices of a basket of goods and services in an economy over time. Inflation leads to a decrease in the purchasing power of a currency, whilst deflation leads to an increase in the purchasing power of a currency. Deflation is problematic for reasons I will discuss later.


Disinflation refers to a reduction in the rate of inflation over time. For example, if inflation in year one was 6%/annum, and inflation in year two was 4%/annum, this decrease in the inflation rate over the two periods would be described as “disinflation.” Disinflation is a policy target when inflation is too high in an economy, normally leading to restrictive fiscal and / or monetary policies.


Reflation is the opposite of disinflation and refers to an increase in the inflation rate over time. The term “reflation trade” is used today to mean investors shifting their equity portfolio towards companies and / or sectors likely to benefit from the global economic recovery expected post-pandemic, which logically should eventually lead to higher inflation. Reflation is a policy target when an economy has slack capacity and anaemic economic growth, often leading to the adoption of accommodative fiscal and / or monetary policies.


How is inflation measured?


Two measures that are often used by economists and policymakers to measure inflation are the Consumer Price Index, or CPI, and the Producer Price Index, or PPI.

  • CPI measures the change in prices of a basket of goods and services from the perspective of consumers in urban or metropolitan areas. It includes both domestically-produced and imported goods and services. The change in CPI from period to period is inflation, the most important indicator on which policy makers tend to focus.

  • PPI measures the change in costs of goods and services produced domestically, as measured from the perspective of producers, manufacturers or providers rather than consumers. Since it is a production cost measure, it includes only goods and services produced domestically, not imports. Unlike CPI, PPI excludes sales mark-ups and sales taxes, as its focus is on input costs, not what consumers are actually paying for goods and services.

CPI is focused on consumer price changes, and hence, is used to calibrate cost-of-living increases in things like wage agreements or social security payments. PPI is focused on production costs and is used to make adjustments to output figures so as to isolate volume changes from price changes (e.g. when calculating an economy’s real GDP). Importantly, PPI is considered to be a leading indicator of inflation since increasing costs of production are eventually passed onto consumers, reflected in the CPI. The Bureau of Labor Statistics provides a concise and digestible 2-page summary of CPI and PPI that you can reference here.


In 2020, the International Labour Organisation (ILO) – in collaboration with the IMF, The World Bank, Eurostat, the OECD and others – updated its methodology for calculating CPI. The ILO presented its updated methodology in a manual entitled “Consumer Price Index Manual: Concepts and Methods, 2020”. It is available to download in PDF here, but let me warn you that it is very detailed and has around 500 pages! The purpose of this manual, which is updated every few years, is to provide countries with a common methodology for calculating CPI. I believe that most countries comply with this methodology, although there might be subtleties from country to country regarding things like the composition of the basket of goods and services, the relative proportion of certain goods and services included in the basket, and so on.

These extracted tables should give you a flavour of the major categories of goods and services tracked by the US and the EU for calculating CPI. US CPI data is from the US Bureau of Labor Statistics, “Consumer Price Index: 2020 in Review”. EU CPI (or HICP as it is referred to) data has been extracted from the ECB website “Measuring Inflation – the Harmonised Index of Consumer Prices (HICP)”.


Many countries also provide CPI calculations excluding food, energy or both, as food and energy are both subject to unusual volatility that can distort CPI, making trends over time less clear. Food and energy have other unique attributes


as well, e.g. being fairly price inelastic (meaning that consumers continue to purchase them regardless of their prices) and also actively traded as physical assets (e.g. oil, wheat, corn, etc.). A CPI figure that excludes energy and food price changes is referred to as “core CPI” or “core inflation”, and many economists prefer to monitor this figure over time when trying to interpret price trends. CPI is often also adjusted for seasonality and short-term fluctuations in prices, with the intent being to provide economists and policy makers with a more accurate feel for long-term underlying price trends.


I have included two graphs below from the OECD (link here) that will give you a flavour of inflation in the G7 and the BRICs countries during the pandemic-stricken year of 2020. The first graph is the G7 countries, illustrating three parameters for each country: i) headline CPI (including food and energy), ii) energy CPI, and iii) food CPI. This graph shows that energy had a downward effect on headline CPI figures in 2020, not surprising given what happened to oil prices last year, whilst food had an upward bias on headline CPI (except in the UK). In addition, the graph shows that Japan and the Eurozone countries all experienced deflation in 2020, whilst Canada, the US and the UK had modest inflation of less than 2%.



In the emerging BRIC economies included in the graph below, you can see that inflation tends to be higher in these developing countries, not surprising given their state of evolution. For reasons I cannot explain, China has unusually low inflation, particularly strange in that China is a fast-growing developing economy.



What causes inflation?


Things that can cause inflation over time include changes in the supply and demand of goods and services; changes in money supply; and supply shocks. Most concerning are changes in inflation that cause the rate of price increases to drift away from the level of expected inflation, or in other words, unexpected inflation.


Changes in supply of goods and services: The first thing that affects prices levels is the demand and / or supply of goods and services. If either demand unexpectedly increases (“demand-pull”) or costs unexpectedly increase (“cost-push”), the prices of goods and services (or the relevant component or components) will adjust until a new equilibrium price is reached. Demand-pull inflation refers to when demand for goods and services increase but supply cannot be increased in the short-term to meet the higher demand. Supply-push inflation occurs when input costs of goods and services increase and, as a result, the aggregate supply of goods and services is reduced. Prior to reaching the new equilibrium point, there will usually be upward pressure on prices ­– or inflation. I will focus quickly on demand-pull inflation.


When demand increases for aggregate goods and services in an economy, suppliers might be able to increase aggregate supply to meet the higher demand, assuming that there are no constraints on his factors of production, like labour availability or manufacturing capacity. Assuming supply can be increased, it takes some of the sting out of price increases, although prices are still likely to increase in the short-term whilst supply is adjusting. Expected inflation along these lines is normal, driven broadly in an economy by things like (for example) population growth or changing demographics. As I mentioned at the beginning of this article, most developed countries are currently targeting an inflation rate of around 2%/annum. The risk of inflation accelerating above the target rate becomes higher when an economy is producing at or near full capacity, meaning that suppliers are encountering constraints in factors of production that inhibit their ability to increase production to meet higher demand. For example, imagine a firm that had hired all the available qualified labour to work in its factories and is running 24 hours per day, seven days per week; or a firm that has built all of the production capacity it can on its existing land so cannot build additional manufacturing capacity. In these situations, prices will inevitably increase because the supply is fixed and is unable to be increased to meet the higher demand. It is important to note that in the longer term, factors of production that might be constrained in the short-term can be increased through improvements in productivity, innovation , automation and technological advances. Improvements in productivity help businesses increase supply in the intermediate- to long-term so that they can meet higher demand, thereby reducing bottlenecks that might otherwise prove inflationary.


In today’s pandemic-affected world, capacity utilisation plays a very important role in an inflationary context. When an economy is operating below full capacity – as is the case currently in most parts of the world due to the pandemic – higher demand does not necessarily put pressure on prices because suppliers have no capacity constraints. Even as demand gradually increases as the pandemic winds down, manufacturers and service providers should be able to increase capacity utilisation and hire more employees without cost pressures, meaning that inflation should be benign early in the recovery. However, it is almost certain that inflationary pressures will materialise once the global economy is back to full employment and is operating at full production capacity.


Changes in the money supply: A second thing that causes inflation is increases in the money supply by a country’s central bank. It is commonly believed that the money supply should grow at the rate of targeted inflation. In other words, a 2% targeted rate of inflation should translate into a 2% rate of growth in the money supply. Following this logic, if growth in the money supply is higher than the targeted rate of inflation (i.e. overly accommodative), then the excess liquidity in the system will eventually be inflationary. A portion of the excess liquidity currently sloshing around is most certainly being channelled into increased savings in the form of bank deposits and flows into financial assets like stocks, bonds, and real estate. The flows into financial assets are almost certainly pushing up their prices. People are also saving more because large portions of the economy remain shuddered, especially services. The result at the moment is more visible inflation in asset prices than in the prices of goods and services. The question of course will revolve around what happens post-pandemic as pent-up demand is unleashed and at least some of these savings are unwound and channelled into consumption. Although many central banks have an objective of increasing inflation, there is risk that this pent-up demand and excess savings will quickly push the economy back towards capacity, risking higher-than-targeted inflation. The art will very much revolve around how the stimulus, especially from central banks, will be unwound without inflicting damage on the economy. Time will tell.


Supply shocks: A final thing that can cause inflation is a supply shock. In 1973, OPEC implemented an embargo on oil which caused prices of petrol, heating oil and other petroleum products to increase significantly almost overnight in oil-importing countries. The dramatic increase in the price of petroleum products had knock-on effects that reverberated throughout the economy, leading to higher prices in petroleum-based goods including gasoline / petrol (i.e. at the pumps), but also in products that were reliant on petroleum-derivatives like plastics. In the US at the time of the embargo, the US economy was already feeling severe inflationary pressures as the government had been overly accommodative in the late 1960s and early 1970s. This confluence of factors pushed inflation to 11% in the US in 1974. Nearly simultaneously and perhaps unique to a supply shock, the economy went into reverse gear, dipping into a recession even though inflation was very high. Although eventually addressed, most of the rest of the decade was spent by US policymakers dealing with high inflation which – before it was completely checked – reached as high as 13.5% in 1980. Although under very different circumstances, a similar supply shock occurred when supply chains were unexpectedly interrupted at the onset of the coronavirus pandemic in late 1Q2020. Many products in different countries were reliant on supplies of component goods which were halted or restricted as the virus set in around the world. One very important difference though compared to the 1973-74 oil embargo is that these supply chain disruptions occurred in a world in which there was large amount of concurrent slack demand, so aside from isolated or essential goods, the inflationary effects were modest and proved to be short-lived.


What does inflation have to do with GDP?


Growth in output in an economy is measured by its gross domestic production (GDP), or the total value of goods and services produced during a period (usually measured quarterly). This figure is “nominal GDP”, which you might visualise as the amount of all goods and services produced in an economy times the costs to produce the goods and services. Economists are most interested though in the actual increase in production (i.e. volumes) when measuring the strength of an economy, meaning that price changes need to be removed. This is done by applying a GDP price deflator – normally PPI discussed earlier – to nominal GDP, so as to remove price effects and isolate production, resulting in “real GDP”.


Why is inflation problematic?


Once inflation is built into an economy, the knock-on effects are severe and can become embedded in everyday behaviour. Inflation above-expectations in goods and services reduces people’s standard of living unless it is supported by higher wages. In other words, to maintain the same standard of living, a person would need to have higher wages in order to purchase the same basket of goods and services at higher prices. This creates a vicious circle in which, in a high inflation environment, businesses have to pay their employees higher wages so that their standard of living does not deteriorate. Higher wages in turn lead to larger amounts spent on goods and services, fuelling further price increases for these goods and services. The cycle continues, and inflationary expectations can easily become part of people’s mindsets making it harder to unwind without aggressive and painful policy steps.


Unexpectedly high inflation can indeed lead to difficult policy decisions for governments and for central banks. Governments can tighten fiscal policy to combat inflation by reducing government spending (e.g., transfer payments like welfare, food stamps and unemployment compensation) or by raising taxes. The effect of fiscal policy measures can at times be difficult to calibrate with precession due to things like multipliers and time lags. Central banks are often the first to act to address inflation, usually by raising interest rates or by reducing the money supply. These restrictive fiscal and / or monetary policy tools can take the heat out of an economy and cool inflation. Whilst these restrictive policy measures would certainly reduce inflation, overshooting could risk dampening demand so much that it pushes an economy into recession.


What is hyperinflation?


Hyperinflation is generally defined as inflation that is 50% or more in a month. Hyperinflation can be caused by overly accommodative monetary policy or excessive fiscal spending, leading to strong demand for goods and services in an economy that is capacity-constrained. Hyperinflation is relatively rare fortunately but can be the result of ill-advised fiscal and monetary policies that are difficult to unwind. It’s very simple – too much money with no concurrent increase in the stock of goods and services leads to extensive currency devaluation, or in other words, rampant inflation, and if the cycle catches hold, it can easily lead to hyperinflation.


Hyperinflation is extremely damaging, because once it becomes entrenched, people will spend money as quickly as possible since the purchasing power of the currency is decreasing by the hour. Can you imagine a loaf of bread costing more in the afternoon than it did that morning, and this occurring every single day? The acceleration of spending fuels more inflation, because suppliers raise prices quickly to cover ever-increasing costs. You can visualise the vicious cycle. The only real way to reign in hyperinflation is by raising interest rates dramatically and reducing the money supply, and these actions almost always push the economy into a deep and often protracted recession. Collateral damage normally occurs in the form of defaults on government debt, in turn leading to a country being shut out of the international capital markets for what could be many years. Aggressive but painful actions like this end hyperinflation, but the cost is severe in the form of a steep and at times prolonged economic downturn.


There have been several examples over time of hyperinflation. One of the most interesting periods which I have studied occurred in Germany following the end of World War I. The Germans had borrowed extensively to fund the war, so they were left with a large amount of debt by the time the war ended. The victorious allies also required that the Germans pay wartime repatriations to each of them in “hard currency”, not in the domestic currency Reichsmarks. This forced the Germans to continuously sell Reichsmarks during the 1921-23 period, and as the currency depreciated, the German central bank was forced to print larger and larger amounts of Reichsmarks. Hyperinflation accelerated dramatically through 1923, reaching at one point 30,000%/annum as prices were doubling every few days (source: Investopedia). A loaf of bread in Germany which cost 160 Reichsmarks at the end of 1922 increased in price to 200 billion Reichsmarks by the end of 1923! Finally, in the autumn of 1923, newly-appointed finance minister Hans Luther created a new reserve central bank (Rentenbank, began operating in 1924)) and a new currency indexed to gold, the Retenmark, equivalent to one billion old Reichmarks. Through this measure and a series of concurrent fiscal steps, the period of hyperinflation was eventually ended. This period in Germany is covered extensively in the book “The Lords of Finance” by Liaquat Ahamed, which addresses the much broader topic of the actions of the four most powerful global central bankers in the world after WWI, and the series of policy steps they took which eventually led to the Great Depression.


Other examples of hyperinflation include Zimbabwe (2007-09), Hungary (1946), Greece (1944), Yugoslavia (1994) and Argentina (mid/late 1980s).


Why is deflation such a problem?


Deflation shares one very important characteristic with hyperinflation – once it becomes entrenched in an economy and in people’s minds, it is very difficult to reverse because certain consumer behaviour becomes the norm. Deflation means that consumers are motivated to defer, rather than accelerate, consumption because goods and services will likely be less expensive in the future than today. Again, you can see the vicious cycle. As consumers defer purchases, demand wanes and economic growth falters, potentially leading to a prolonged period of economic stagnation and further price decreases.


One needs to look no further than Japan to see how deflation can become entrenched. Following the bursting of the stock market bubble in Japan at the beginning of 1990, Japan has – over the years – tried numerous rounds of fiscal and monetary policy measures to stimulate economic growth and inflation. Because regulatory reform, mainly involving banks, was slow coming at the beginning of this period (early 1990s), the economy stagnated and inflation continued to fall in spite of heavy stimulus. Later on, the Bank of Japan became the first central bank in a developed economy in modern times to unleash a quantitative easing programme to combat stagnant economic growth and quell the persistent threat of deflation. However, even today – 30 years later – re-igniting economic growth and achieving a 2%/annum inflation target has proven difficult. The fear of deflation is a long-standing cloud that looms large over the Japanese economy.


The Eurozone has faced a similar problem since the Great Recession, as its attempts to revive growth in the currency bloc and achieve a 2% inflation target have failed time and time again. In fact, the annual inflation rate has not met the 2%/annum target since 2012 and has four years since then (2014-16 and 2020) been below 1%/annum, raising fears of deflation and stagnant economic growth becoming the norm. Inflation in 2020 was a modest 0.25%, and deflation occurred in every month since August. To be fair, there are unique issues to the currency bloc compared to many countries, including the lack of centralised fiscal policy (until just recently). Nonetheless, try as they might, the European Central Bank – much like the Bank of Japan – has not found the right combination of accommodative policies to see off deflationary risks once and for all.


How does inflation affect interest rates?


Nominal interest rates are the figures on which most people focus because they are the rates that people pay to borrow money to buy a house (i.e. a mortgage) or to buy a car. Lenders price their loans to ensure that they are compensated both for future inflation and counterparty (credit) risk. Similarly, investors in financial assets like corporate (credit) bonds also want to be compensated for inflation and for credit risk. What matters most to lenders or investors is that they earn a return in excess of inflation, meaning that the real interest rate is positive.


However, the situation is very different in the government bond market, where in many jurisdictions nominal yields are historically low and real yields are negative. As strange as this may seem on the surface, it reflects the unique dynamics of the government bond market. For example, many insurance companies and pension funds are required to maintain liquidity reserves in government bonds regardless of their yield. Other investors cater to the desire of their end investors to hold the highest tier available debt, even if the yield is negative. However, the most powerful factor by far driving down government bond yields is the unprecedented amount of unconventional quantitative easing being unleashed by central banks in many developed countries, including the US, Japan, the Eurozone and the UK. This enormous buying pressure has pushed down yields across the curve, with some countries even moving into negative territory. For example, negative nominal rates currently exist in much of the Eurozone (German 10-year Bund is yielding -0.60%) and in Japan (10-year yield managed by the Bank of Japan to effectively 0%).


It is impossible to predict future inflation over a long period of time with confidence. However, investors would very much like to be protected from future inflation. With this objective in mind, a relatively deep market has developed for inflation-protected bonds issued by governments. Many countries – including all G7 countries, many other non-G7 European countries, and some emerging markets countries (Russia, Argentina and Mexico, for example) – offer long-term inflation-protected bonds, or inflation-linked bonds. In the US, these are called “Treasury Inflation-Protected Securities”, or “TIIPs.” In Europe, they are often referred to simply as “linkers”. These inflation-protected bonds essentially offer a real interest rate to investors over their life, protecting the investor from unexpected fluctuations in future inflation which cannot be predicted with certainty. The mechanisms for adjusting the yield vary from instrument to instrument and country to country, but at the end of the day investors are protected from inflation eroding their returns over the life of a bond. For example, the US 10-year US Treasury closed on January 21st 2021 to yield 1.12% (see link here), and the 10-year US government TIPS closed the same day to yield -0.98% (see link here). This means that the inflation rate in the US is currently expected to be around 2%/annum over the next 10-years.


The graph below from FRED illustrates the yields on the US 10-year constant maturity bond and the US 10-year TIPs since the early 2000s.



How does expected inflation affect foreign exchange rates?


Inflation is different in different countries depending on the government and monetary policies adopted by the country. Inflation is carefully monitored by economists and investors, and it is one of a number of factors that have an influence on foreign exchange rates. Very weak inflation (or even deflation) signals a stagnant economy, ripe for central bank or government stimulus to stoke inflation. Overly strong inflation signals an overheated economy in which the central bank or government is likely to apply the brakes in order to rein in inflation, leading to slower economic growth. Investors prefer stable and predictable inflation and tend to avoid countries with erratic policies that might lead to negative economic surprises. These concerns are perhaps even higher for international investors in local currency bonds who are taking broth credit and currency risk.


How does inflation affect borrowers and lenders?


Inflation – especially higher than expected inflation – favours debtors (borrowers) at the expense of creditors (lenders). The reason is simple. A borrower pays back the principal amount of debt at its maturity, say in five years, but the amount repaid is actually less in real terms because the currency has devalued due to to inflation. For example, if you borrow $10,000 for five years to finance the purchase of a car, the $10,000 borrowed today might equal a year’s supply of groceries today. However, if the inflation rate is 3%/annum, then the same amount of groceries five years from now would cost around $11,593. The borrower is paying one year’s supply of groceries to buy the car but will pay less (11.6%) than one year’s supply of groceries to repay the loan it in five years. The creditor (lender), on the other hand, is getting back his fixed $10,000 loan which no longer buys a year’s worth of groceries. Some economists would argue that inflation can benefit lenders in certain circumstances too. For example, temporary blips in inflation cause nominal interest rates to increase, meaning that lenders earn more on their term loans. This is true so long as inflation then returns to a more normal, or expected, level.


Who is most affected by inflation?


So long as actual inflation is generally in line with the target of the central bank (normally around 2%/annum in developed economies), people generally are not affected adversely by inflation on a day to day basis. Some facets of the economy even have inflation protection built in. For example, this can be the case for wages and is often the case for government transfer payments, which have built in cost-of-living adjustments. However, even modest inflation can be problematic over time for people living on fixed incomes, like annual pensions, that do not benefit from annual cost-of-living adjustments.


Inflation results in a wealth transfer in other ways. From an investment perspective, investors in real assets (like real estate) and equities benefit from inflation, which often pushes up the price of these assets. Investors that do not own real estate or stocks, or that are instead invested in cash (i.e. bank deposits) or bonds, are relative losers because inflation causes an erosion in their asset values and purchasing power. You can understand the obvious effect on wealth disparity, as those most able to afford their own home and / or have savings invested in financial assets like stocks that appreciate in inflationary environments see their net worth grow much more rapidly than those that are not able to afford or choose not to invest in such assets.


How does inflation affect government debt and deficits?


I have already discussed the general issue of wealth transfer from debtors (borrowers) to creditors (lenders) caused by inflation. The same is true for governments that borrow money, but on a much larger scale. The money that governments borrow today is repaid at maturity in depreciated currency (assuming there is inflation). Inflation also benefits governments in a second way. Over time, inflation increases wages, which means that people pay more taxes as their wages increase because income tax brackets are not indexed to inflation. In general, inflation is deemed positive for government debt and for deficits, which is why you occasionally hear pundits say things like “a country can inflate it way out of its huge debt burden.”


Inflation and gold (and other commodities)


I wrote about gold in my blog on May 1, 2020, and you can find the post here. Gold and silver are two commodities that are often used as a hedge against inflation. The reason is that the existing stock of both is known, as is the remaining unmined stock and the extraction rate. Unlike central banks that can create new money just by ramping up the printing press, gold and silver have restrictions on their amounts because only so much is available. As a result, these assets are considered protection against overly accommodative central bank policies that might ultimately lead to high inflation and currency devaluation. Although not the subject of this paper, historically on many different occasions in the past, countries have tied their currencies to in-country gold reserves, meaning that the central bank is effectively forgoing its ability to indiscriminately print money. By forgoing this ability, confidence in the currency should be much higher because prices should be stable over time. However, in nearly all cases in which currencies were linked to gold, this gold standard was eventually abandoned so that central banks could reacquire the full set of policy tools to enable them to fine-tune their economy.


One other thing to point out is that gold prices increased markedly during the early stages of the pandemic as policy stimulus was falling into place. This of course reflects the simple fact that gold is considered the ultimate hedge against inflation and store of value. With central banks setting overnight borrowing rates at or near zero and simultaneously unleashing huge quantitative easing programmes, post-pandemic inflation was being largely anticipated. The desire to purchase gold cooled off though in the summer, and the price of gold eventually stabilised. Since the summer, the price of gold has remained reasonably range bound as investors look for the eventual winddown of the pandemic.


I would be remiss were I to ignore cryptocurrencies. Recently cryptocurrencies like Bitcoin have also been touted as a protection against inflation. Although it is not right to compare gold or silver to any cryptocurrency, what is true is that – similar to these commodities – the stock of Bitcoin and some other cryptocurrencies is fixed.


Where are we now?


The world’s largest developed countries continue to take steps to shield their economies from the damage done by COVID-19. The measures have included unprecedented amounts of fiscal and monetary stimulus, with the latter characterised by zero (or even negative) short-term interbank borrowing rates in many economies, along with large amounts of asset purchases via quantitative easing programmes (essentially funded by central banks printing money). Governments have also provided unprecedented amounts of stimulus in the form of excess unemployment payments, furlough payments, loans and grants to businesses, and even direct stimulus cheques (“helicopter money”) in the U.S. The huge amount of liquidity dumped into the market is meant to spur consumer spending and investment in an attempt to soften the blow of the pandemic in the first instance, and ultimately to provide the fuel to ensure that economies return to growth once the pandemic passes. Inflation of 2% is generally targeted, with the Federal Reserve saying it would tolerate even higher inflation for some period of time so long as the average inflation rate stayed around 2%.


There continues to be overcapacity as far as production / manufacturing. Consumers are finding it difficult to spend money for some goods and many services as economies remain partially or fully shuddered depending on location, and businesses are finding it difficult to invest with confidence because of on-going uncertainty. As a result, a fair amount of the excess liquidity from stimulus programmes is being channelled into fixed assets like residential real estate and equities. Indeed, initial concerns about inflation caused by the accommodative policies, which pushed gold to record levels early in the crisis, gave way to the expectation that should inflation materialise, it would be later. The result for now is that prices of many asset classes have been bid up, since consumers earn next to nothing on bank deposits. Much of the excess liquidity not invested in hard assets has been channelled into bank deposits, which are at near-record recent highs in many countries, including the US. The pandemic will end eventually, and I suspect that consumers will unleash a spending spree that could easily stoke inflation once employment and capacity utilisation increase sufficiently. How governments and central banks will eventually calibrate the unwind of the unprecedented amounts of stimulus without jeopardising economic growth remains to be seen.


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