Inflation is a hot topic right now. Understandably so, as prices for a range of commodities (lumber, copper, etc.) have risen substantially over the past several months.
Chart: Google Search Trends for ‘Inflation’ in the United States
Raw materials price pressures are now showing up in consumer prices with CPI rising 4.2% year over year ending April 2021. This level of CPI has not been seen since the early days of the 2008 global financial crisis.
However, it is becoming increasingly clear that this inflationary burst is temporary. The conditions simply don’t exist to support long term inflation, like that seen during the 1970s.
There are several reasons.
1) Milton Friedman once said that “inflation is always and everywhere a monetary phenomenon”. I’d argue that he is only half right. Central banks can increase the money supply all they want, but to have an inflationary effect the velocity of money must remain stable or rise. Real world experience clearly shows that money velocity is not constant and tends to have an inverse relationship with the level of a country’s indebtedness. And as you all know, we are drowning in debt right now.
The relationship between indebtedness and money velocity is clear in the following chart. As the level of indebtedness of the US economy started to significantly rise in 2008, money velocity declined. Ultimately, money velocity plummeted to new lows during the Covid-19 crisis and has yet to recover, despite an improving economy.
Effectively, what this means is that new money entering the system (generally to fund new debt) is simply tucked away, mitigating any inflationary effects of monetary expansion.
This phenomenon is also illustrated by the declining marginal economic benefit created by new debt. The economic impact of additional debt today is much lower than it was in decades past. Therefore much more money needs to enter the economic system to have the same impacts it did in the past. Of course, more new money means more debt. By now you’ve probably noticed this is a vicious cycle.
2) The current inflationary pulse was triggered by the partial paralysis of the global supply chain. Exports out of low-cost producing countries grinded to a halt, forcing Western countries to purchase from more expensive domestic suppliers or compete over dwindling supply.
As vaccines are delivered the mechanisms for global trade – offshore manufacturing + shipping – can resume. Imports into the US are already back to pre-pandemic peaks and it’s only a matter of time until renewed competition from cheaper sources pushes prices down.
3) Labour productivity tends to rise coming out of recessions. Higher productivity offsets higher wages, thus putting a cap on unit labour costs that can flow into prices. I believe this phenomenon will be even stronger as we exit the pandemic.
The nearly immediate and widespread adoption of new software and methods of working have compressed a decade’s worth of productivity gains into the present. Not only that, but companies that maintain a remote workforce can benefit from labour cost arbitrage across geographic regions. Over the long run, both of these advances will keep a lid on unit labour costs. This is disinflationary.
4) Population growth in the US continues to be very weak and will be for the foreseeable future. 20-something year olds simply can’t afford to have kids. Or they are choosing not to bring new people into the world for ethical reasons.
The point is that forward demand driven by new consumers entering their prime spending years continues to decline. When demand declines prices fall.
While nobody can predict the future, one can use data and hard evidence to create a guide. Evidence suggests that those calling for a shift in the economic regime – from disinflationary to inflationary – could be wrong. I believe, as a diversified investor, it is important to prepare for the possibility that the pundits are wrong.
While I won’t know if I’m right or wrong until some point in the future, it appears that the bond market might agree with my thesis, as the yield on the 10yr has flatlined since March 2021.