I’ve got inflation on my mind these days. Who doesn’t? The U.S. 10-year treasury yield is up nearly 3-fold in the past year, stoked by fears of inflation. Commodities too are rocketing higher for similar reasons (in part). However, I’m not convinced these trends will hold. To me, the deck looks stacked against inflation. Its misinterpretation may present trading opportunities.
The COVID-19 pandemic is causing tremendous human and economic hardship across the United States and around the world (emphasis added). Amid progress on vaccinations and strong policy support, indicators of economic activity and employment have strengthened. The sectors most adversely affected by the pandemic remain weak but have shown improvement (emphasis added). Inflation has risen, largely reflecting transitory factors.Federal Reserve’s FOMC statement, April 28, 2021
It’s rare that I agree with Federal Reserve (Fed) officials. However, I fall firmly in the “transitory” camp when it comes to today’s inflation. It’s not that I think the Fed has been a good steward of the U.S. dollar’s value. Rather, it’s that inflation has little to do with monetary policy anymore. It’s the way in which we define inflation that makes me a secular deflationist. You see, I’m an optimist. I simply expect human ingenuity to prevail.
The U.S. 10-year treasury rate (blue) has nearly tripled from its all-time lows and commodities (purple) are rocketing higher as CPI (red) has increased.
Inflation’s meaning has stealthily changed
We take inflation’s meaning for granted today. It’s a foundational concept for valuing bonds that rolls off the tongues of laymen as easily as experts. There are volumes of books chronicling it, reams of academic literature analyzing it, and scores of metrics to measure it. Inflation is one of the most studied and commonplace financial concepts in the culture.
Yet, inflation is completely misunderstood today. Its definition has evolved over the years; however, many hold on to its old one which no longer applies. Inflation once meant the debasement of a monetary standard of value. Today, it simply means “price increases.” These are very different definitions with equally distant implications.
A historical look at the origin and uses of the word inflation, arguing that although the term has become nearly synonymous with “price increase,” its original meaning—a rise in the general price level caused by an imbalance between the quantity of money and trade needs—is the definition driving many of those who advocate an anti-inflation policy for the Federal Reserve.Michael F. Bryan, On the Origin and Evolution of the Word Inflation
All is not “on average”
Monetary debasement is a ubiquitous condition that applies to all goods, services, and actions. Nothing is spared since the standard unit of value itself is altered. It is also an instantaneous event occurring on the date of (political) decree. Imagine doubling the definition of an inch one day. Everything would instantly measure smaller in these new inch terms no matter what you measured; all that was four inches would now measure two. This is inflation’s historical use.
“Price increases”, on the other hand, are completely different. Prices routinely fluctuate with commercial conditions—as supply and demand dynamically shift. They are an economic phenomenon unique to each good and service that garners a price. Some go up and some go down, but all do not move together, even if they appear to do so on average.
In other words, all is not the same as “on average.”
Money defines value and requires a standard
Recognize that inflation today means growth in the consumer price index (CPI). It bears no resemblance to its former definition of monetary (standard) debasement. Yet, we still treat inflation the same. While inappropriate, I nonetheless sympathize with the usage. Economies require an independently observable measure for money, just as they do for length and time.
Grasping money’s meaning is simple when its units are defined. Under a gold standard, for example, a dollar was equivalent to a fixed weight of gold. While it may seem arbitrary, it’s anything but. A fixed weight of gold requires a certain amount of effort to produce. It’s a value that anyone can wrap his/her head around, irrespective of one’s familiarity with gold mining. Thus, a dollar’s meaning was relatable to all and objective.
Remember, money is an abstraction. It’s a placeholder for real-world value in fungible form. Money represents goods and services that we already produced and those that we will come to purchase in the future. It’s not arbitrary nor a subjective social contract. It’s a literal measurement of the fruits of our labor.
However, there is no monetary standard for value in a fiat currency regime, by definition (i.e. fiat)! A dollar, to continue with our example, is simply worth whatever it will fetch in trade. Thus, it has different values to different people. It is subjective. While innocent sounding in theory, it’s a disaster in practice.
Imagine remodeling your kitchen using vendors that each had its own measurement standard. Coordination becomes impossible. How could you know which oven to order, or how many tiles you need, or if the cabinets fit together? Each item would come in sizes that bear no resemblance to each other. Ultimately, you’d need to guess with your orders and then modify and/or rebuild each item yourself once they arrived to fit the spaces; assuming you even could. The remodel would be highly inefficient and a complete disaster by today’s standards.
The same standard requirements apply to value, and thus to money. Money is abstract so it’s harder see, but it’s nonetheless real. To be sure, we get this. The inherent need to relate money’s denominations to our actual lives has led people to CPI (as fiat regimes lack any). While we don’t actually define a dollar’s economic value, we do try to track its relative fluctuations. When CPI grows, we call that inflation; when it falls, we say there’s deflation. It’s valiant attempt, really. Nonetheless it’s problematic. The result is doom: either for inflation or prosperity.
Inflation is shortages
Today, inflation can only result in doom. Either CPI continues to decline—wiping inflation from the face of the planet—or the arc of human prosperity reverses course. They cannot coexist.
Just think for a moment: How can deflation—falling prices and improving quality of goods and services —be bad? They are literally the calling cards of prosperity. Consider that, according to one study, “an unskilled laborer saw his or her purchasing power double every 34 years” over the last hundred years when scaling food prices to wages. That’s some serious deflation! Yet, is there any doubt that life is better now?
Humans being humans—and companies being collections of us—are driven to improve our circumstances. We are profit maximizers in a deeply profound and inspiring way. Businesses do this by lowering prices while increasing operational efficiencies that result in higher volumes, margins, and profits—the ultimate goal. So long as economies stay free, companies will work to debottleneck supply chains, increase production, and grow profits. This means lower prices to come. Inflation should go extinct.
Yet, today we find ourselves with rising prices and growing CPI. Why? Did the central bankers finally get monetary policy “right” and achieve their inflation goals? Did legislatures perfect their fiscal spending budgets? No, not lowering interest rates to zero (and below), nor endlessly buying bonds, nor spending trillions on stimulus had any impact on CPI growth.
Rather, today’s intensifying inflation was caused by the global lockdowns. Inflation only came from severe economic disruptions, mass unemployment, and bankruptcy. Inflation resulted from shortages.
Just let that sink in for a moment.
There’s opportunity in transitory
Thus, I believe today’s inflation is transitory. Forced lockdowns and abrupt economic restarts created widespread shortages that should prove to be temporary. Companies and people will get back to work and solve these supply chain bottlenecks in order to meet the unyielding demand. It’s what we do: seek to improve our lives.
However, these actions will take time to implement. Price changes filter slowly throughout the economy, both increases and decreases. How long a lag—weeks, months, years—will be specific to each good and service as companies react with varying abilities and speeds. Remember, inflation today is the average price change. By definition, it will transition, not leap like a debasement.
Thus, CPI growth could continue to trend up before it ultimately falls. This may have important implications for various assets like bonds and commodities that correlate to these moves. Trading opportunities may be created—in both directions—if people mistake “on average” for all.
No better cure for high prices than high prices
The recent rise in inflation has understandably captured the market’s attention. It’s an important valuation component for many asset classes and thus has significant investment implications. Furthermore, runaway inflation is a popular doomsday scenario. People are naturally concerned that Fed will be late to act.
However, inflation’s link to monetary policy is a relic. Inflation’s definition changed over the years. It no longer means the debasement of a monetary standard. There simply is no monetary standard to debase in a fiat currency regime. The Fed plays no role.
Today, inflation simply means “price increases”—on average—of some defined basket of goods and service. Prices are determined by supply and demand dynamics throughout the entire economy, not monetary policy. People and corporations seek to lower prices in order to maximize profits and prosperity. Inflation is caused by shortages. Hence, it’s rising in the post-COVID-lockdown economy as demand returns to a shrunken supply base.
Today’s rise in prices is nothing to fret. It bears no resemblance to the hyperinflation experienced by the Weimar Republic, Zimbabwe, or Venezuela. While certainly unpleasant, the CPI growth is simply the market doing what it’s supposed to do. Soon enough, enterprising people will debottleneck supply chains to meet demand and lower prices. Deflation will surely return so long as people are free, though it will take some time.
To be sure, trading opportunities may be created if people conflate inflation’s historical and contemporary definitions. Remember though, there’s no better cure for inflation than inflation.
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12 comments on "Inflation Is Shortages And Thankfully Transitory"
Fascinating read Seth, thanks! As a fellow buy sider I have read endless research on this topic and it’s hard for me to disagree with your conclusions. The thing that fascinates me is how many extremely smart analysts/economists/investors with 3 decades plus of experience have polar opposite views on the inflation outcome from here. From all my research, it seems the only thing that can really move the needle from structural disinflationary forces to more inflationary (and not just transitory) is a true psychological change of the population at large. The reason I say this is because I’ve lived on the other side my whole life, i.e. too high inflation that struggles to get broken – I’ve lived in South Africa most of my life and the mindset is “price increases start at 6%” and then we negotiate from there. The reason for this is inflation targeting started here in 2000 with a range of 3-6% but in reality actual inflation struggled to get below 6% “on average” sustainably, so everyone just assumes 6% is what they can start increasing prices at annually, even when inflation recently went to 3% (and unions ask for increasing starting at 10-15% which makes it harder to shift the psychology). While there are obviously a lot more nuances to it than this, I would be interested in your views on the US psychology around inflation given the price increases people are clearly seeing everyday plus the wage increases, especially at the low end to get people back into the work force (and signs of more permanent MMT-type policies with double-digit budget deficits for years to come potentially given the obvious inequality issues)?
Hello Warren, thanks for reading and your thoughtful comment. My approach to this topic is very different. First, it’s to recognize that inflation today is price increases and thus, for the most part, non-monetary. IMO, MMT-type policies could create widespread price increases, though, simply by putting more money in people’s hands. (Note that the monetary channel involves bank intermediaries and a whole lot of assumptions.) However, supply and demand dictates that as prices rise demand will wane, leading to oversupply and eventual price declines. So “inflation” in its modern context corrects itself in a mostly free economy. High prices can only persist when artificial forces (i.e. government) prevents this natural dynamic from working; to be sure this happens. As for the cultural psychology, I can only say that it’s confused …. very confused, and hence this article.
Thanks Seth, for explanation on inflation but their is one correction ,one percent increase in product prices have higher impact on overall profit verses one percent increase in volume or quantum. In any pendamic doing business is always difficult due involvement of local authorities. So inflation may be more sticky than you think.
Thanks for your comment Yogesh. Your observation re: price is (generally) true, however, a change in price is likely to also impact volume. These are complex relationships which is why I defer to broader principles in this matter. I also agree that governments impede market responses to price, hence my qualifier “So long as economies stay free.” But my main contention is that inflation is not what most people think.
Really well-written article. I enjoyed it reading it. Your points all were clearly articulated and well-argued. However, I couldn’t help but pause and reflect on the last line in the second to last paragraph:
“Deflation will surely return so long as people are free, though it will take some time.”.. As long as people (and thus businesses?) are free.. seems a fairly significant assumption.. especially given the past 15 months. Curious what may change with regards to the inflation equation and constrained freedoms in certain industries/sectors to thus work out the bottlenecks you referred to.
Hello Marc, thanks for reading and your comment. It’s a great question and really is the crux of it all. Economic liberty is required for people/companies to respond to price signals (and thus lower prices via improved efficiencies). Thus, higher regulations and government involvement in the economy are risks to my deflation thesis – just look at what lockdowns did! Unfortunately, I’m no expert here. But imagine how the speed of debottlenecking will depend upon distancing requirements, capacity restraints, etc.; which are not necessarily safety related. Plus the new administration will have its own economic agenda. Does this answer your question?
The effects of debasement are incubated by “stickyness”, the micro level resistance to prices changing over the short term. This is why the inflationary effects of monetary policy are subtle at first and requires a keen investor to spot. Take the red pill and profit, continue to be brainwashed and get cleaned.
My entire contention is that debasement is not possible in a fiat monetary regime. This is merely definitional and fact. Prices for all things will fluctuate with supply and demand. This is not a defense of fiat currency; quite the contrary. Rather, it’s a argument to stop conflating CPI price increases with monetary standard debasement.
My concern is two fold. First of all, the current party in charge seeks to implement mandated energy shortages and price increases. Michigan’s Governor Whitmer’s order to shut down Line 5 is an example of policy driven shortages. Those higher costs will ripple though the entire economy. The second concern is the much higher food prices in China, which I fear will end up being exported to the US. Any thoughts?
I’m with you that government mandates can create shortages and higher prices. In fact, I see political intervention as a risk for market mechanisms and prosperity. Hence my sentence: “So long as economies stay free, companies will work to debottleneck supply chains, increase production, and grow profits (emphasis added).” With respect to China food prices, in market economies – where we specialize and trade – higher prices will likely be passed on to its trading partners; but for how long? The market will not sit idle, but respond to those higher prices with more supply and lower them in short order.
While you make some excellent points, I think that, at the very least, transitory will be longer than imagined because the psychological impact of not only actual rising prices, but the ongoing narrative of rising prices will reverberate in the echo chamber that has become social media and will encourage many to believe that prices will continue to rise and buying ahead of these future higher prices is the prudent action.
As I saw elsewhere, just wait until somebody tweets a picture of the $20 Big Mac price on a menu and how that will go viral. Things will straighten out, but I fear it will take much longer than you indicate, especially as the Fed will be, by definition, behind the curve and the echo chamber of higher inflation will simply get louder.
Thanks for reading and your comment. I’m with you that it’ll take some time just watching how prices filter through businesses. However, I suspect that it may be quicker than expected as companies focus on profit and market share and not price. As for the Fed, I just don’t believe there to even be a curve for it to be behind. Monetary policy plays no role!