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Thinking About Inflation*

[*Throughout this piece I’m using the term inflation to mean price rises as that’s what most understand by the term. Not that long ago though it referred specifically to a rapid growth in money base and credit. Austrian school commentators like Henry Hazlitt insisted on using the term in its older sense to make clear the root cause of the problem of runaway prices was always and everywhere the action of governments and their lack of political will to tackle it. Another argument for another day.]

Preamble

Fail to prepare for inflation and it arrives? Your net worth will decrease substantially. Prepare and it doesn’t? A bit of debt and a few gold bars won’t do you too much harm. This asymmetry of outcomes requires investors to be constantly vigilant of inflation; especially at times like this when the possibility of its return, in large doses, seems so remote.

Governments in the developed world have done a solid job of convincing their citizens that inflation is a good thing and I’m concerned our collective guard may down. Unprecedented expansion of monetary bases suggest it may accelerate but the big gamble, and that’s what it is, is it won’t. What if does though?

For governments the bet is a heads-I-win-tails-you-lose proposition. Recoveries progress, inflation remains benign, hooray. If it gets out of hand blame greedy mercantilists, foreigners and speculators while repaying yesterday’s monetary obligations with today’s debased currency, hooray again. Governments like inflation, despite what they publicly profess; what’s good for governments though is often not good for individuals, inflation being one of the better cases in point.

Summary conclusion

Austrian-school commentators are presently in full retreat. MV, at least for now, has not turned out to equal PV*. Despite the unprecedented easing of recent years and astonishing growth of money bases around the world there are no signs of significant inflation on the horizon; yet. Now we’re all Keynesians¹.

I can’t see it coming either but in markets it’s the bullet you don’t hear that gets you. The consequences of not being prepared for inflation and it arriving are much worse than being prepared and it not showing up. The purpose of this note is to remind just how corrosive inflation is and to be very, very suspicious of Kool-Aid policy peddled by central banks that ‘a little bit’ of inflation is somehow a good thing.

‘Modest-inflation’ may prove a contradiction as impossible as British-cuisine, business-ethics or Microsoft Works and I don’t buy governments being either truly in charge or capable of effectively dealing with inflation if it shows signs of getting out of hand. A little thinking therefore now when we’re not vexed on the subject may be time well spent in the event today’s conventional wisdom proves to be misplaced. It wouldn’t be the first time markets produced an outcome few were braced for.

[*Non money-wonks can dip in here for clarity http://en.wikipedia.org/wiki/Quantity_theory_of_money. ¹Keynes did have this to say about the Quantity Theory of Money “This Theory [That more money leads to higher prices] is fundamental. Its correspondence with fact is not open to question.”]

Let’s start with the Kool-Aid.

Inflation is good because?

As a crude gauge to how widely this notion has infected the popular psyche I asked Google the same question. It produced 51.7m replies. I reversed the question and got only 19m responses. Looking through a handful of the reasons that Google supplied and cross referencing those with remarks by The Bank of England, The Bank of Japan and the US Federal Reserve (BTW, isn’t it a little spooky they all have the same 2% target?) there seems only one real reason that inflation is ‘good’. It stimulates consumption.

How does it do this? The best answer is that if consumers know inflation is, say, 2% per annum they know that delaying consumption has a cost and therefore at the margin will accelerate the exchange of their monetary assets i.e. savings, for real assets like refrigerators. That’s right; debase the hard earned $100 that a saver has today over ten years by 22% (that’s what 2% inflation for ten years will do) so they are encouraged to buy a refrigerator that in ten years’ time has no value whatsoever; seriously?

Who is this good for? Clearly the makers of refrigerators (and, yes, their employees; but only to an extent), the collectors of taxes and the big issuers of debt. Two of the three being government and the third a large provider of campaign funds. Who is this not good for? Mostly you and me. The government push back is that ‘a little bit’ of inflation is good and they stand ready to act if it starts to get out of hand; in the same way turkeys will flock to vote for more Christmases perhaps?

Don’t be fooled. Governments are less in control of this equation than they would like you to believe. Moreover, if the situation does look like it’s getting out of hand history shows that the bold action needed to correct the problem is often politically unacceptable when the cure needs to be taken.

Inflation is bad because?

Unlike the mostly theoretical reasoning that governments are advancing for their actions the following is a list of time and again observed reasons inflation is bad. These are real-world outcomes that have come up over and over in our recorded history; and not one of them is good for you.

#1. Future returns. Inflation, in any quantum clouds all manner of transactions that require an analysis of future return. I began my career in the 1980s in fixed income markets that had been ravaged by a prior decade of inflation. Cynically, just as it began to tackle the problem with proper vim, the UK government of Mrs. Thatcher bowed to investor pressure and began issuing index (inflation) – linked gilts. They were (mostly) a flop in no small part due to the fact that no one valuation methodology could be agreed on.

#2. Higher interest rates. Inflation leads indirectly to higher rates or directly as a result of government intervention. The worrying thing about this is that once an inflationary mindset takes hold vendors of all services tack on a number to present day prices to reflect the assumed debased forward value of money. This is how the so-called wage-price spiral begins. Governments latterly respond with higher official rates, always too late, which usually then makes matters worse.

#3. General uncertainty. The points above refer to specific cases of uncertainty that inflation produces. It seeps into every corner of economic activity though creating a pernicious and enervating effect on all forms of economic activity. Despite tough talking governments who assure agents about their commitment to holding inflation at certain levels anybody who has been through a serious bout of this knows such talk of firm hands or bold action, when ultimately required,  is poppycock.

#4 Diverted productivity. Because inflation comes in unpredictable waves and doesn’t affect all parts of the economy simultaneously what look like a number of ‘good’ new businesses spring up. None of these businesses creates any real value. As inflation is a monetary phenomenon how can any business that hopes to profit from it be in any way productive? This is not what the vendors of stamps, old master paintings, wine or gold will tell you though while pocketing their (monetary of course) commissions.

#5. Iniquitous wealth redistribution. Sure, at the margin, there are always some borrowers who deserve a break; but inflation rewards the profligate in direct proportion to how much other people’s money they’ve loaded up on. The net effect is a wealth distribution from lenders to borrowers. The biggest beneficiaries are governments and here’s the core of the agency problem which retards their swift action to curtail inflation when it takes hold. Pledges, in effect, are serially reneged upon.

#6. Punished savers. According to recent data from Mercer’s the trend away from equity allocation continues (at least among European pension funds http://www.mercer.com/insights/point/2014/2014-european-asset-allocation-survey.html). Globally, allocations vary but because debt markets are so much bigger than equity markets (2:1?) we know that savers must, in aggregate, be heavily weighted towards fixed income products. In no way is a bout of inflation good news for them.

#7. Tax bracket bumps. Most salaried workers are taxed in developed markets in bands. As noted already governments will be slow to address root causes of inflation but even slower to deal with many of its collateral effects (index-linked gilts for example?). In an environment of rising prices the price of labor inevitably rises; but the problem with this is as you get knocked into higher income bands your taxable income becomes of more interest to your government who will then take more of it from you.

#8. Speculation is encouraged. We’re all speculators to a greater or lesser extent; what else is investment? Of course I’m not talking about the everyday business of making low risk bets to preserve capital. I’m talking about all manner of zero-sum strategies that pop up like weeds in inflationary environments. Like? Property flipping, asset-liability currency mismatching, hoarding and increased use of leverage. None of these activities are productive and most have profoundly negative long term consequences.

#9 Social tension and unrest. Few argue Germany’s hyperinflation of the 1920’s had something to do, ultimately, with the death of 2.5% of the world’s population (http://en.wikipedia.org/wiki/World_War_II_casualties). An extreme example for sure but as a child growing up in a high inflation environment I remember the divisive and toxic nature of politics back then. Yes, we got punk rock; personally though I’d have taken more social cohesion over ‘Never Mind the Bollocks, Here’s the Sex Pistols’ any day.

Lead us not into deflation, but deliver us from a Japan-style outcome

Part of the inflation-is-good-for-you propaganda package includes a homily on Japan. So, you may be asked if you question the official line, you want Japan-style deflation and all that goes with that do you?

This is to stand the Japanese situation on its head. Japanese policy makers never targeted deflation. Deflation was only one of many bad outcomes that arose due to multiple policy failures in other areas.

In fact we have the term Quantitative Easing from the Japanese who tried it from 2001 to 2006. The conclusion at the end of this was that it may have helped corporations by fixing interest rates at stable and low levels but falling asset prices over the period obliterated most of the beneficial effect. [This 2006 BOJ paper has more detail http://210.174.171.233/en/research/wps_rev/wps_2006/data/wp06e10.pdf]

It did kick inflation up a tad and that was cited as one of the main reasons for abandoning the policy. So Japan has not only never targeted deflation; it tried what it could to stop it.

Today we have Mr. Abe still trying to fix what ails Japan but deep rooted problems like labor force rigidity, culturally-rooted insularity, poor corporate governance, government beholden to industry special interest groups and so on (and on) lie at the heart of what’s wrong with Japan. Deflation is just one of many carbuncles on the surface of the Japanese economy produced by more serious illness deep within.

In conclusion

I don’t believe we’re headed into a period of persistent and high inflation; but a period where it’s persistent and low, such as we enjoy presently, could be the complacent launch pad for such a step change. Governments the world over have taken us into uncharted territory and only charlatans or the very naive will say with certainty that everything is going to work out alright.

Thinking the unthinkable, being prepared for the worst, challenging orthodoxy but hoping, always, for the best is how I observe successful investors stay that way and that’s largely been my aim in rolling out my thought above. We buy insurance hoping bad things won’t happen and I think it helps to turn over even vague future possibilities from time to time for the same reason.

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