November 02, 2020
Debates about inflation expectations are commonly rendered one of the most boring topics – some sort of esoteric discussions reserved for dull, old-fashioned economist clubs and usually not an elevator pitch to collect readers and clicks. Nevertheless, we believe that inflation is the most important long-term issue facing investors.
While trying to forecast inflation, we should never forget that the track-record of economists, central bankers and more broadly financial pundits is not particularly good. A well-known joke by Ken Galbraith is that “the only function of economic forecasting is to make astrology look respectable”.
Inflation is often described as a ‘thief in the night’ (stealing part of our purchasing power) and the root cause of rebellion around the world. On the other hand, deflation is commonly associated with some sort of black hole, leading economic activity into an ice age of procrastination, where no one knows the way towards the exit.
Inflation is caused by a mixture of demand-pull and cost-push factors. Key determinants of it are the economic growth rate, unemployment, the amount of spare capacity in the economy, changes in commodity prices, taxes and wages as well as global trade and the organisation of supply chains (e.g. globalisation).
The Velocity of Money
The quantity theory of money states that increased money supply will lead to inflation. Empirical evidence has shown that an increased in money supply is not a sufficient condition to face higher inflation. Indeed, if people hoard the money at hand instead of spending it, there is little reason for inflation to accelerate. So the velocity of money is also part of the equation. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. This does not only give an interesting insight into whether consumers and businesses are saving or spending their money, it’s also a critical ingredient in the inflation recipe. Inflation rears its head when “too much money is chasing too few goods” (demand-pull inflation).
By definition, money velocity increases when money is spent more frequently per unit of time. Therefore any factors that cause people to hold money will decrease the velocity of money, while factors that increase spending or investment will increase the velocity of money.
From that perspective, there are two major takeaways. First, behavioural factors are as relevant as economics. Secondly, this helps to explain the massive divergence in between financial and real asset prices. Monetary policies and liquidity injections by central banks in the last 13 years massively supported asset prices but did little to boost real activity. But do not be too quick to blame central bankers, nobody is able to reverse-engineer history to measure what would have happened to economic activity without their massive support.
Don’t even blame banks for anaemic credit creation. We should not forget that credit creation is constrained by credit demand, not reserve requirements. The ECB’s 2012 decision to divide its reserve requirements in two did not result in a doubling of broad money through a quick expansion of credit. On top of demand for credit, digging into the supply dynamics, banks do not lend ‘reserves’. Banks are limited by profitability considerations. Given a certain demand for loans, banks base their lending decisions on their perception of the risk-return trade-offs, not reserve requirements. If bank lending is constrained by anything at all, it is capital requirements, especially as those are specified as a ratio with a denominator that consists of risk-weighted assets. The point is that inside the velocity of money, there is also the concept of the money multiplier that is not a mechanical and stable relationship overtime.
The past as a guide
By experience the best way to predict inflation is to look at what happened in the recent past. Again don’t be too quick to chastise economic theories, econometric models and economists. Use them to be prepared, while avoiding overconfidence.
Think about inflation as some sort of magnet. Expectations of runaway inflation risk create inflation and expectations of deflation create deflation. Physicians call this hysteresis . Common people call it a self-fulling prophecy loop. The role of expectations is key. If inflation is low, people will expect low inflation in the next year. On the opposite, if inflation is high, then people will be expecting higher inflation in the future, a situation where removing inflation from the system usually ends up in a recession.
Even the Fed acknowledges that long-term inflation expectations are not very accurate. “When using measures of inflation expectations to forecast future inflation, policymakers and forecasters should focus on market-based measures of inflation expectations. They are much more accurate than survey-based measures”. 
As long as inflation is low, monetary and fiscal authorities can respond to shocks with stimulus measures, leading to recoveries in asset prices as observed during 2020. The problem is that if inflation were to rise, authorities would be unable to respond the same way.
Reasons for inflation having been so low in developed economies are to be find in connection with globalisation, demographics and central banks credibility to fight inflation. We observed that inflation is stubborn. When it’s low, it tends to stay low.
The Ketchup Theory
Then comes the ketchup theory of inflation. As stated by Nassim Taleb, “the problem with inflation is it’s very non-linear. So, it’s like a ketchup bottle. Nothing comes out and then suddenly things jump out”. Many people have been expecting inflation to rise on monetary stimulus but nothing has happened because of the collapse in the velocity of money. The difference as of today, is the fact that monetary stimulus is now coordinated with fiscal policy.
Central Banks want higher inflation, but they don’t want it to go too high, knowing how painful it could be to bring it down.
By formally shifting its inflation approach, aiming to average 2% inflation over time, rather than taking this target as an absolute goal, the Fed made a historic change to its monetary policy framework in August 2020. Financial market participants are not convinced that the adoption of an “average inflation target” effectively raised the inflation outlook in the USA, but seem convinced this will give time to the Fed to keep interest rates at low level. For us this means some sort of exit from the autopilot mode in which monetary policy had been cruising, leaving the central bank flexibility for action: A clear indication that monetary policy will stay loose for longer.
If you take the view that a resolute Fed with little fear of overshooting has the ability to cause prices to generally rise, then we should brace for inflation to overshoot the 2% in the near future and we should expect long-term inflation expectations to better anchored near 2%.
Overshoots in the low single digits are probably fine if temporary. But high single digits would be a problem for investors and financial asset valuations, affecting portfolios by eroding the value of future cash flows.
Higher but controlled inflation would benefit real assets (incl. equities, gold,..) over nominal fixed income assets (with the exception of bonds with coupons directly tied to inflation levels). This is what is currently getting priced by financial markets for the US. A moderate increase in inflation that is positive for earnings, but not the idea of a Fed falling asleep, ultimately not able to spot unhealthy price pressures.
Accelerating inflation is not an immediate threat, as the world is currently facing its deepest recession ever recorded. Initially, the pandemic took the form of a supply shock, but second-round effects have now generated a massive aggregate demand shock. The overall impact on prices will depend on which of these two shocks dominates, but at this stage, it seems that deflationary forces continue to dominate in Europe.
There might be some significant relative price changes with increases in the prices of some indispensable goods and pent-up demand. However, prices of services and other goods could decline because of structural behavioural changes resulting from the pandemic.
Despite global monetary growth and fiscal stimulus reaching highest levels ever in recent months we believe that inflation risks are lower than many think. This is especially valid for Europe. The ketchup bottle doesn’t deserve to be in the fridge anymore, as it is mostly empty. Welcome to the continent of “noflation”.
If you care about your health, it’s maybe
time to reconsider ketchup in your alimentation. Following the Kraft merger
with Heinz some years ago, I personally got rid of industrial ketchup having being
shocked when discovering that Kraft Singles cheese could not be melt. Today, I’m
wondering how many of us are also facing the discrepancy in between inflation
measures and the evidence provided by day-to-day life.
 The number of times one unit of currency is spent to buy goods and services per unit of time.
 “Hysteresis is the dependence of the state of a system on its history. For example, a magnet may have more than one possible magnetic moment in a given magnetic field, depending on how the field changed in the past” – Source Wikipedia
Author: Group Investment Office