The Tale of "Transitory" Inflation

25th November 2021 Kevin George

It's a word with mixed connotations. For some, i.e. central bankers and debtors, inflation is magical, a wonder to behold: borrow currency printed out of thin air today, and use ever more worthless currency in the future to repay your creditors. For many of us, by contrast, especially the more careful and cautious among us, this same wonder turns parasite: each Pound diligently earned today and saved for tomorrow is gnawed at as more and more Pounds are conjured up over time. A borrower is crowned king, while a saver is rendered a lowly pauper.

Despite what you may hear, inflation in the purest sense, as defined by Mises, is a monetary phenomenon. But what of money? Indeed, money is a commodity and, by extension, subject to the same supply and demand dynamics as other commodities: the more money in circulation relative to other available goods and services in the economy, the less valuable the money becomes.

However, the “inflation” generally bandied about in the mainstream financial media today often is a reference to current prices as expressed in currency. So, with a tip of the hat to the Austrians in acknowledgement of their superior economic understanding, we must return our focus to the modern-day madness, and treat “inflation” on such terms.

When it comes to price inflation, two factors are chief determiners: firstly, the overall money supply (how much currency central banks have printed); and, secondly, velocity - the number of transactions facilitated by each new unit of currency. Put another way, the Bank of England can run the printing press until it claps out, but prices will seldom change in response to this if the new currency does not move beyond banks' currency reserves and out into the real economy.

Now, it's possible to entertain many different viewpoints on the current economic outlook: there are plenty who, now that Covid restrictions are largely lifted, see only green, green grass in front of them, with business reopening, people returning to work and ready to spend as they had done prior to the first lockdowns. It's perhaps difficult to deny that many consumers are more active than before, owing to a combination of Covid-weariness and the aforementioned general relaxation of restrictions.

Nevertheless, the real world is beginning to reveal itself. Of course, people are beginning to (be allowed to) spend their money again, and therefore the velocity of money is bound to increase. Central banks across the world (the US Federal Reserve chief among them) have yet called a halt to the magic money machines, and so we now see price inflation.

The picture is more complex still, though: when the majority of the world's governments decided to lock down their citizenries, businesses the world over had to adjust; lower consumption forced companies to lower production. And, tied up in that part of the equation is the logistics of global supply chains: fewer goods being produced leads to a diminished requirement for container ships and other freight or transport services.

Consequently, it should come as no surprise when consumption (demand) finally picks up again that the various parts of the supply chain each must respond accordingly. The trouble is, however, that responding is proving to be a rather tough challenge: the same businesses who made many staff redundant (or sent on furlough) now need to hire again, but they're unable to compete with the furlough pay or enhanced unemployment benefits handed out to the laid-off workers in the time between firing and hiring. The demand for consumer goods is going one way, but the supply of workers necessary to facilitate the scaling-up appears to remain suppressed.

While inflation is surging in the consumer space, other sectors also tell quite startling stories. A number of commodities throughout the past two years have been subject to massive spikes in price: from lumber and copper to, now, natural gas and uranium. Of course, there are geopolitical factors behind the rise in energy commodities (especially fossil fuels and non-renewables), but, despite what the climate crusaders wish to implement, it still comes down to the same dynamics: more demand for energy as a result of an increase in commercial and industrial applications, and lower supply from the recent stifling of resource production.

Without doubt, this bout of inflation will mean belt-tightening for the majority of the public as basic household expenses outgrow increases in wages. However, it presents a conundrum for the central banks: the stated policy aims of the central banks of the western world are full employment and small but controlled inflation. Indeed, the Bank of England holds a target inflation rate of 2% per annum but in reality there's only so much central banks can do. The US Federal Reserve, for example, has since its inception in 1913 consistently missed both its inflation target and the target of full employment, yet still it continues its quixotic pursuit, as do many other central banks in developed economies.

A means by which banks try to offset inflation is the base interest rate, which historically has been raised when inflation has shown signs of rising. The result is that borrowing becomes more expensive, debt more costly to service, while savers are rewarded more handsomely. However, with an economy entirely run on debt and personal savings historically low, raising the interest rate inevitably means borrowers can no longer service even the interest on the outstanding debt – and, considering the amount of debt in the global economy today, it could be a mere matter of a few pips to lead to a catastrophic cascade of defaults and bankruptcies.

And there we have the central banks' quandary: let inflation run wild and plunge the public into poverty; or, tackle inflation with an interest rate hike, thus sending many debtors over the cliff edge, taking many leveraged institutions (and the stock market) with them. Which way out is the right one? It's not obvious that there even is a right way.

So, what does all this mean for those of us with an investment portfolio? It's no business of ours to make predictions or give investment advice, it must be said. Though, if the inflation parasite is growing more and more ravenous, then we may well expect to see advisers looking to appropriate hedges: maybe portfolio managers will look more at commodities, especially the precious metals space. Also, though it may appear counter-intuitive, an increased allocation to cash in the short-term might form part of many recommendations, to give liquidity in the event of an upcoming market crash (sorry, "correction")!

Additionally, it's highly likely that certain funds in the ESG space will become more popular (owing to government subsidy and preferential policy than actual sound underlying fundamentals). Then again, with an energy problem brewing in Europe and China, it perhaps would be shrewd to look at opportunities in fossil fuels or nuclear; energy will need to come from somewhere to fix the short-term trouble, after all.

As ever, many factors are going to affect the course of the economy over the next few months and years. Inflation is one that seems like it's made itself at home under the current conditions – and don't be too faithful in the central banks to keep it under control; the magic is starting to fade.

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