Inflation
Too much money chasing too few goods
Free posts teach investment foundations. They are introductory in nature and designed to be accessible with no background on a topic.
In the first installment (link), we explored the functions of money through the lens of history and using Bitcoin as an example. Check it out if you missed it.
DM me on Twitter (@BowTiedWombat) if you have any questions or a future topic you would like me to cover.
Introduction
This post teaches the general mechanics of inflation. It can be broken into 2 sections.
The first section walks through definitions, a framework to understand macroeconomic dynamics, and how the Fed fits in.
The second applies that framework to the current situation.
Background
3 Types of Inflation
The first step in understanding inflation is learning to differentiate the 3 types of inflation:
Demand-Pull
Cost-Push
Monetary
Demand-Pull
Demand-Pull inflation is just what it sounds like, when an increase in demand pulls prices up. When a product becomes the latest trend, demand outpaces inventory, and the price typically increases. Said differently, economic growth and inflation move together.
Demand ↑ → Price ↑ (positive relationship)
Cost-Push
Cost-Push is inflation driven by the supply side. If a refinery goes offline, the amount of oil hitting the market decreases, causing the price to go up. A higher oil price increases the cost of transportation and thus the cost of most goods. This is usually passed onto customers. Prices increase, but demand falls as people can afford less as incomes usually take time to adjust. Real growth falls as people have less disposable income to spend. Cost-push is where inflation rises, but real economic growth is either flat or falls.
Supply ↓ → Price ↑ (inverse relationship)
Monetary
Monetary is inflation driven by the money supply. If all the money in the world was suddenly multiplied by 10x, what would happen to prices? They would likely all go up 10x, and nothing real would change. Monetary inflation is where prices go up, and real economic growth is not directly affected.
Money Supply ↑ → Price ↑ (positive relationship)
Velocity of Money
Another key concept: velocity of money is the number of times a dollar changes hands.
Example: You start with $1 and pay someone, who turns around and pays someone else, who pays a 3rd person, who ends up paying you
Over this time period, there was only $1, but all 4 people had $1 of income (total of $4). In this example, the velocity of money is 4. It is not directly observable, and it is calculated similar to how you calculate an asset turnover ratio (in this case, Nominal GDP / Money Supply).
What drives the velocity of money?
Broadly, emotions are an important driver (all else equal). When people feel confident and secure in the future, spending increases, and when they are nervous or uncertain, spending decreases. Hyperinflation is the main exception to this generalization (discussed in more detail below).
Self-Reinforcing
Don’t miss this: Inflation is self-reinforcing. If spending increases, incomes increase. If incomes increase, people feel confident and are more likely to spend. There is a feedback mechanism there.
A couple key takeaways:
Your spending is someone else’s income
The velocity of money can increase incomes without increasing the supply of money
All else equal, velocity picks up when certainty is high (and slows with uncertainty)
MV = PQ
This simple framework will help explain macroeconomic relationships.
Since we have already covered velocity of money (V), let’s briefly define the other 3 variables.
Money supply (M) is the literal amount of money in circulation.
Price (P) is the price of goods and services, which makes the rate of inflation the change in P.
Quantity (Q) is the quantity of real goods and services (Real GDP).
This makes PxQ and MxV equal to Nominal GDP.
You can understand the relationship between inflation and the other variables by changing 1 and leaving the other 2 constant.
↑ V → ↑ P (Demand-Pull)
↓ Q → ↑ P (Cost-Push)
↑ M → ↑ P (Currency debasement)
How does the Fed fit in?
The primary way the Fed “manages” its dual mandate (stable inflation and full employment) is raising or lowering the overnight Federal Funds Rate.
The Fed Rate is the benchmark rate that all other interest rates are based off on. If the Fed increases their target rate, other interest rates tend to increase.
This raises the cost of borrowing for cars, mortgages, business loans, etc. The net effect of a rate increase is decreased marginal spending. For example, if mortgage rates increase, monthly mortgage payments increase, reducing the amount of money people can spend on something else.
DON’T MISS THIS: Interest rate hikes do not increase supply; they work by decreasing demand. Said differently, raising interest rates does not pump more gas, but it does change behavior around gas consumption.
Current Situation
How did we get here?
↑ M - during COVID, central banks and governments turned on the money printers and dramatically increased the money supply (42% increase Dec 2019 to March 2022)
↓ Q - Supply shocks due to lockdowns
(source)
Why did inflation not hit sooner? The V fell through the floor. You had the combination of lockdowns restricting spending on things like travel and restaurants as well as people generally feeling fearful and cutting back on spending.
The Fed increased the money supply to offset the crash in the velocity of money.
When the world opened back up, people had excess savings in aggregate and began to feel more confident in the future. Spending began to pick up causing incomes to rise.
All of this was happening on the backdrop of supply lines that were still reconfiguring (and couldn’t keep up with the increased demand) causing prices to start their initial climb.
Jason Furman posted a good chart on Twitter about how this has flowed through savings.
(source)
Remember the MV = PQ framework.
You had a 42% increase in M, while the goods side of Q was reconfiguring itself (so temporarily restricted).
Most of that 42% increase was soaked up and saved (V falling), so prices didn’t immediately rise.
The world opens up, V picks up with more M and less Q (so all 3 types), and inflation explodes.
Hyperinflation
Hyperinflation is usually caused by a rapid increase in the money supply, but it also a sociological phenomenon. Behavioral changes turn high inflation into hyperinflation.
When inflation is high, consumers start to change their behavior by pulling purchases forward in anticipation of price increases.
Example: From Spring 2020 to 2021, lumber prices quadrupled in the span of a year. Someone who has put off a lumber intensive project might franticly decide, “I need to go buy the lumber for it TODAY! Otherwise I might not be able to afford it.”
That type of response is what turns inflation into hyperinflation. Customers pull purchases forward for fear of prices continuing to increase.
This is exactly the situation the Fed wanted to avoid, so why did they wait so long to raise rates?
Transitory or not transitory
In August 2021, Fed Chair Powell (now) infamously used the word transitory to describe inflation. In his speech (link), he outlined 5 reasons, which can be paraphrased as:
Inflation is only in certain areas (where there were supply shocks)
High inflation items are falling
Wage growth is stable
People don’t expect inflation
We haven’t had inflation in a long time
Translation: Inflation is only in certain supply constricted areas, and we expect that to work itself out (1 and 2).
The comment about wages (#3) supports this fact. Inflation was isolated and had not spread into incomes (yet).
The call to start raising interest rates is a hard one. Start too early and you crash the economy. Start too late, and inflation becomes entrenched and reinforces itself.
Remember: Interest rate increases do not increase supply; they work by decreasing real demand. Thus, they were essentially playing chicken with inflation hoping it was largely cost-push inflation and supply lines would work themselves out before becoming entrenched.
That was clearly wrong.
Now they are playing catchup.
Tie It All Together
Where are we today? Back to the framework: MV = PQ
M is high and falling slightly (seen on the graph above)
V is elevated but falling from higher interest rates
Both sides on the left side of the equation are falling.
That points to something on the right hand side falling.
Remember: Interest rate increases do not increase supply; they work by decreasing demand.
So to tame inflation, the Fed can only decrease real demand for goods and services. In plain language, the Fed has to crash the real economy to get inflation down.
What am I watching?
Short answer: Unemployment and wages
Velocity of money is not observable, so you have to look for other signs. The labor market will be where you truly see it play out. Look for early warning signs like an increase in initial jobless claims, the unemployment rate, broad based layoffs, and therefore wage growth slowing.
The issue with all of those measures is they tend to be convex in how they change, meaning they deteriorate fast and take longer to improve.
The speed and size of rate increases have been a shock to the economic system that has become increasingly reliant on cheap debt. The question is: which of the following has occurred but not yet been seen in the data:
Inflation is far more entrenched and requires more aggressive hiking for longer
Growth has already been crushed but is not fully reflected in the data
Some combination of both 1 and 2
Or, the Fed has perfectly managed the economy into a Goldilocks state
Number 4, the Goldilocks state, is what the market is currently pricing in. History would indicate that is the least likely scenario.
Hope you enjoyed. Not Investment advice. Remember always do your own research. Let me know what you think either in the comment section or on Twitter (@BowTiedWombat)