Inflation Today, But Deflation Tomorrow | Lacy Hunt

Lacy Harris Hunt is an economist and Executive Vice President of Hoisington Investment Management Company (HIMCO). He is Vice-Chairman of HIMCO’s strategic investment policy committee and also Chief Economist for the Wasatch Hoisington Treasury Bond Fund. He has authored two books, A Time to Be Rich and Dynamics of Forecasting: Financial Cycles, Theory and Techniques, and has had articles published in Barron’s, The Wall Street Journal, The New York Times, The Journal of Finance, the Financial Analysts Journal, the Journal of Portfolio Management, among other publication outlets. He received the Abramson Award from the National Association for Business Economics for “outstanding contributions in the field of business economics.”

Investing Life Wealth

How Can Inflation Coexist with Deflation?

How does one explain a world in which macro trends are deflationary (DumbWealth: The Case for Deflation) yet the basic necessities of life are increasing in price?

While it sounds contradictory, the two paradigms can coexist. Look at housing prices and healthcare costs over the past 10 or 20 years. Look at commodity prices during the 2000s.

From the late 1990s to early 2010s commodity prices across the board were going through a super-cycle, driven by rising Chinese demand. Commodity prices were booming, yet – despite some cyclical bounces along the way – the secular disinflationary trend that began around 1980 continued until present day.

Medium Term Crude Oil Prices

Makes no fucking sense, right?

There are those who argue the CPI stats don’t reflect reality. The thing is, price ‘reality’ for one person isn’t ‘reality’ for another. We all have different baskets of goods and all spend different proportions of income on those goods, so our true experiences will differ.

ShadowStats has re-calculated CPI based on its own interpretation and has consistently printed double the reported inflation rate:

So, despite the long-term deflationary pressures of debt, demographics, productivity and imports, one must still respect how quickly commodity prices have risen lately. We’ve seen this battle before.

Over the near term, we’re going to see rising prices. Perhaps the scariest part of all this is how quickly global food prices are rising. Over the past year, the FAO Food Price Index has risen almost 40%!

This doesn’t necessarily mean that you’ll witness a 40% price increase in the grocery stores or a huge impact to your food budget. However, for the poorest portions of global society this could mean the difference between paying rent and feeding their kids.

In the end, the cure for high prices is high prices. This means two things.

  1. Much of the current increase in commodity prices is caused by supply chain issues created (exposed?) by the pandemic plus growing shortages of raw commodities. Higher prices are incentivizing production (and delivery) to quickly come back on line, which will eventually mitigate further price increases – potentially even lowering prices.
  2. Higher prices could break demand. At some point people simply can’t afford to pay higher prices. There’s an argument that the final straw that broke the housing market’s back prior to the 2008 Global Financial Crisis was higher gas prices. People could no longer justify longer drives, eroding demand for new suburban sprawl developments. Simply put, higher prices eventually erode demand somewhere, somehow and this can have a domino effect on the economy, ultimately replacing rising prices with a deflationary shock. This is what we saw in 2008.

Final thoughts

Although the ‘peak oil’ movement seems to have disbanded with the influx of lower quality, relatively expensive American shale oil, it is quite possible the world is riding a deflationary low-tide coupled with broad resource shortages that result in inflationary waves.

My prevailing shower theory (i.e. something I came up with in the shower) is that the secular deflationary forces will remain omnipresent, but most of the world will fixate on the boom/bust cycles driven by resource demand and shortages, exacerbated by fragility in the global just-in-time supply chain.

There will be rotation from good times to bad and back, but ultimately there is no end to this inflation-deflation battle. We can’t make more easily accessible, high quality oil, copper, etc. Yet, ‘economic progress’ requires us to use more and more. However, demographics and debt will continue to act as a counterbalancing force for our destiny.

Investing Wealth

The Case for Deflation

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.

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.

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.


The Origins of Money and Inflation

Since the early days of humanity we have strived to obtain the goods and services we desire by trading our surpluses to fulfill our deficits. Throughout history a society that could produce an excess of sable furs (for example) would trade with neighbouring societies that were especially efficient at producing wagons. 

Early trade simply entailed an exchange of goods, known as the barter system. This method of trade is very cumbersome because it requires both participants have coincident needs, appropriate divisibility of tradable assets and agreed-upon measures of value. These three conditions often prove elusive leaving many potential barter trades incomplete and many others unfair. As an alternative to the barter system, universally-accepted measures of value developed in different cultures around the world in many different ways.

The first universally-accepted measures of value were items with widespread appeal, easy division and widely-accepted values. In many societies, commodities were often used as a medium of exchange because they tended to have widely-known and stable value for most people in society. In many societies, commodities were the first form of money and gold was often the commodity of choice. 

In Britain goldsmiths helped to develop the modern banknote. During the English Civil War of the 17th century, citizens deposited valuables (gold, jewellery) into the safes at various goldsmiths for safekeeping. In return, the citizen would get a receipt that provided proof of ownership when the person wished to later withdraw. 

Gold withdrawals were made to make a payment for goods and services. Some merchants, however, were willing to accept gold receipts as payment since they knew the receipts were ‘as good as gold’. Goods providers accepted gold receipts as payment since they knew the receipt could be converted into actual gold at any time. The exchange of gold receipts for goods eventually became common-place and, in effect, these receipts became early gold-backed currency.

Once they discovered gold was rarely withdrawn from their safes but gold receipts were being readily traded, some enterprising early goldsmith ‘bankers’ decided to start issuing and lending more receipts than the available gold to back up the receipts. They did this knowing that most customers never actually ever withdrew their gold, so the chance of having to back up all the receipts at the same time was miniscule. This was an early incarnation of fractional reserve banking with a portion of the monetary base tied to a physical commodity, such as gold.

The ability to convert to gold is the basis on which paper money was derived. Paper money wasn’t created out of thin air…it was a contractual ownership stake of a certain amount of gold that was held in a goldsmith’s safe. As long as the public was confident that an appropriate amount of gold was readily available for convertibility, they maintained confidence in the paper receipts that represented those claims.

Of course, some goldsmiths got greedy and lent out far too many receipts. These goldsmiths created the risk that gold would not be available if many receipt-holders redeemed at the same time. Some merchants would question the ability to easily convert the receipts into gold. If it appeared that not enough gold was kept at the goldsmith to back up the receipts, merchants would no-longer accept the receipts at face value. Instead, merchants demanded more receipts for the same amount of goods. In effect, the value of the receipts went down (therefore the prices of goods went up). This illustrates the basic monetary force that creates inflation.

Like the gold receipts of 17th century Britain, the US dollar was at times convertible into gold. The history of US dollar convertibility into gold is mixed – the US dollar has been taken on and off the gold standard a few times. The last time the US dollar (and most other world currencies) was tied to gold was after World War 2 under the Bretton Woods system. 

During World War 2, many central banks around the world shipped their gold to the United States for safe-keeping and payment for armaments. By the time the war ended, the US had by-far the largest gold reserves on the planet. In an effort to stabilize the global economy and create confidence in war-torn European economies as they rebuilt, the Bretton Woods exchange rate system was created. Essentially, the Bretton Woods system tied global currencies at a fixed rate to the US dollar. The US dollar, in turn, was tied to gold at a specified convertibility. Therefore, (whether or not they actually had gold in domestic vaults) all currencies were indirectly convertible into gold in US vaults.  

During the late 1960s/early 1970s, the US was running a fiscal deficit to pay for the Vietnam war, and for the first time in the 20th century was running a trade deficit with the rest of the world. Interest rates started to rise and it is widely believed that the US Federal Reserve began printing money to buy US Treasuries, thereby increasing money in circulation as a percent of available gold reserves. As the market grew more suspicious of the lack of gold reserves backing US dollars in circulation, confidence in the US dollar began to wane, and Germany and Switzerland left the Bretton Woods system in 1971. 

Foreign holders of US dollars started demanding gold in exchange for their US dollars. Growing conversions put pressure on gold reserves and, as the proportion of gold available for conversion declined, it was only a matter of time that all US gold was used up in the conversion process, leaving the remaining US dollars worthless. To prevent this, US President Richard Nixon abandoned convertibility in August 1971. 

The act of banning convertibility effectively freed US monetary supply from the anchor of the gold standard, allowing the US Federal Reserve to print money within less restrictive limits. Monetary policy’s only anchor became the ‘full faith and credit’ of the US Treasury and the US Federal Reserve. Of course, central bank and treasury credibility becomes far more subjective with the elimination of a gold standard. 

During the 1970s, growing money supply, combined with a decline in productivity, a slowdown in post-war disinflationary forces (due to the tightening of post-war economic capacity in Europe and Asia) and the oil supply shocks were the ingredients that led to high inflation and stagnant economic growth – stagflation.

After a decade of haphazard economic initiatives (e.g. price controls) and ambivalent US monetary policy, Paul Volker – who became chairman of the US Federal Reserve in 1979 – significantly raised short-term US interest rates, starting one of the greatest post-war recessions. It was this dramatic change in interest rates that crushed inflation helping the US Federal Reserve regain credibility. 

Why did the US Federal Reserve wait so long to combat inflation? With the memory of the Great Depression still fresh in the minds of many policy-makers, US economic policy was targeted at maximizing employment, and inflation was not seen as a primary economic threat. It was widely felt that aggressively combating inflation would tip a teetering US economy into another depression. Meanwhile, countries like Germany that were familiar with the pain of hyperinflation were quicker to combat inflationary pressures. (This highlights how the collective memories of a society shape political willpower and can lead governments to create erroneous economic policies.)

For the United States, combating inflation early in the 1970s by slowing economic activity would have been political suicide. It took a decade of inflationary pain before policy-makers and the public were willing to accept that inflation was as much a threat to the economy as deflation and unemployment.

The 2008 collapse of the global financial system has parallels to the inflationary experience of the 1970s. Throughout the late 1990s and early 2000s, many policy-makers were aware of the growing threat that concentrated financial intermediaries, leverage, derivatives exposure and skyrocketing real estate values posed to the financial system. It was no secret that these elements posed massive systemic risks. However, the political will-power did not exist to do anything. As these elements of the economy had yet to cause severe economic pain, it was very difficult to get politicians, businesses and consumers to accept the preventative measures that needed to take place. Preventative measures would have slowed economic growth and prosperity – all to safeguard the economy from threat that, at the time, was theoretical and intangible. 
Similar circumstances exist with homeland security, cancer prevention, driving behavior, etc. It is extremely difficult to mobilize a population to willingly experience current pain (financial, lifestyle, effort, etc.) in exchange for reducing a potentially larger theoretical future pain.

Today, the US dollar remains a free-floating currency not backed by gold or any other commodity. Instead of being backed by gold US banknotes are backed by the full faith and credit of the US government. Currency value is predicated on the faith that governments won’t print more than what is necessary to keep up with real economic growth. However, with the largest fiscal and monetary expansion in US history currently occurring, combined with the collective global memory of an extremely painful recession/depression, the risk of inflation over the medium/long-term is very high. 

Investing Wealth

Prepare for Food to Get Way More Expensive

Nothing in life – or the markets – is totally predictable. It was only a year ago that the world was totally side-swiped by a global pandemic. Did anyone see that coming before the first reported cases coming out of Wuhan? Hardly.

This is why I believe a big driver for wealth management is risk mitigation. Today, I believe we must prepare for the possibility that food prices rise significantly.

After toiling away for 40+ hours a week the last thing you want is for your hard earned money to be devalued. While most investors think about total returns, embedded within that expected return is a data point called inflation.

When you let someone else use your money (i.e. you invest), you expect to be compensated for the risk they won’t be able to pay you back, the general cost of money and the devaluation of that money when they do. Some investments have a greater risk premium than others. Some are simply linked to the price of an underlying commodity. These commodities – such as copper, iron, wheat – are the most raw form of prices in the economy.

Commodity futures markets are probably best explained by the Duke brothers in the 1980s comedy “Trading Places”, starring Eddie Murphy. (OK, there are probably better explanations, but when else am I going to get to include this clip in an article?)

Commodities are inputs into much of what the world produces and consumes. If the price of a commodity rises, the cost to produce items using that commodity also rises. Those prices are typically passed onto consumers.

If the price of wheat rises, the price of bread in the grocery store will eventually tend to rise.

Agricultural commodity prices are determined by current and anticipated supply and demand (plus any related costs of ownership, such as storage). Commodity prices are also affected by the amount of money that exists within the economy and the value of the US dollar (since most commodities are priced in US dollars). At the moment – and for the foreseeable future – it appears that many of these factors are converging to lead to higher agricultural commodity prices.

Indeed, general agricultural prices are already at a 7 year high. Perhaps most concerning, prices have risen about 50% since just the middle of 2020.

Figure 1 and 2

We’ve seen these kinds of price rises before, around 2008 and 2012. These historical price changes have led to dramatic social and economic upheaval. Many argue that the 2008 commodity price pressure (this goes beyond agricultural commodities) helped tip the global economy into recession, ultimately leading to the Global Financial Crisis. Leading into 2012, many suggest skyrocketing food prices led to the ‘Arab Spring’ uprisings across much of the Arab world. My point is these surges not only affect our pocket books. They can have serious knock-on affects for the economy and society in general.

Since around 2014, we’ve benefited from relative agricultural price stability. This stability was assisted by surplus production in the United States, referred to by some as the ‘global food reserve bank’.

Unfortunately, this period of stability might be over. As demand (and prices) picked up throughout 2020 US producers have offloaded stockpiles to a worrying degree. Lower surplus reserves could exacerbate future price increases.

The world is always just days away from total anarchy.

Don’t believe me? Go look in your fridge right now. You probably have enough food to last a week. I’m not predicting grocery store shelves will go bare, but I’m pointing out the extremes to which food shortages can go.

We are all dependent on ample food stockpiles, and any deficiency will QUICKLY be priced to bring supply and demand back into equilibrium. Without a buffer, a weak harvest – perhaps in Russia or India – could send global food prices soaring.

The base case is for an orderly rise in food prices, but anyone that cares about their wealth and health must consider scenarios where food prices lurch higher.

One doesn’t have to look to Russia or other foreign nations to see supply risk. There are serious problems in our own backyard.

Weather patterns in the US have become increasingly unfavorable over the years. Currently, a massive portion of the US is experiencing drought. Climate change is only making it more challenging to reliably grow food.

North American’s only spend about 5% of their income on food, so we take food stress for granted. Of course, that proportion is not the same for everyone as income inequality polarizes spending patterns. That 5% figure probably doesn’t show the true nature of food insecurity across North America. The rise in food prices will hurt many.

My point is simple: the risk of food price inflation is real. People need to consider ways to mitigate that risk. This includes better grocery shopping habits, stockpiling non-perishables and allocating a portion of investment portfolios to assets that might benefit from inflation.