— 2021 Q4 UPDATE —

Summary:

Boiled down to the simplest form possible, inflation happens when too many dollars are chasing too few goods. Most inflationary periods have followed periods of money or credit creation combined with a supply shock.

This market update is going to explore the following topics:

• The two types of inflation and what economic conditions tends to cause them
• Creating a generalized framework to analyze inflation as measured by CPI
• Creating a generalized framework to analyze financial asset price inflation
• Brief analysis of our current situation

Returns:

Returns and Standard Deviation calculated by K2 Financial Partners.

Read on for our full Q4 market update… 

Inflation: What Does Theory Say?

The debates surrounding the causes of inflation have resurfaced with fervor in recent months because the United States economy is experiencing inflation levels unseen in decades [1].

Source: FRED

The Oxford Reference dictionary definition of inflation is simply, “A general increase in prices and consequent fall in the purchasing value of money [2].”  While the definition of inflation is relatively simple to grasp, the mechanisms which cause this phenomenon is heavily debated everywhere from elite academic circles to investment practitioners. 

While there have been eloquent theories of inflation created by prominent economists throughout history, none have been sufficient to consistently predict inflation with any form of accuracy in different market cycles.  This is not a knock against the economists who have developed theories describing inflation, but these theories have turned out to be better at fitting a narrative to the past rather than being able to predict when inflation will strike next.  For example, monetary economist Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output [3].”  This view of inflation castigates an increase in the monetary base that is faster than production of goods and services can keep up as the culprit of inflation.  However, this theory, which posits that a rapid increase in the monetary base will cause inflation is exactly what mislead people to believe that after the great financial crisis of 2008 that there would be runaway inflation because the Federal Reserve performed quantitative easing.  Even though the money supply increased rapidly after the Great Financial Crises, inflation growth measured through core CPI had essentially been nonexistent until 2021.  This is partially because the theory only looks at one aspect of the inflation spectrum.

There are many other generalized theories of inflation including the cost-push theory and demand-pull theory, but these suffer from similar failures in either being too generalized to adapt to different market environments or being descriptive rather than prescriptive. 

These theories may be far from perfect for what we are looking for as investors, but there is knowledge to be gained from them.  Even though these theories have not given investors the ability to predict inflation in every market environment, they have given the ability to predict inflation in some market environments.  The difficult part is to figure out the macroeconomic backdrop we reside in which nuggets of truth from each model apply and where we need to completely fill in the gaps through original research.  Nobody said investing is supposed easy, there’s no free lunch in finance!

The Prerequisite: Money Supply Growth

Since our goal as investors is to create a framework for inflation that will work in any market environment, we need to identify any economic prerequisites for inflation to occur.  A proper framework will hopefully give us a fighting chance at identifying which economic environments at least have the potential for inflation.  

Although Milton Friedman did not give us a tool to predict when inflation would occur in any market environment, he appeared to be correct in identifying the key prerequisite to inflation, money supply growth.

Source: LynAlden.com [4]

As you can see from the chart above, money supply growth and change in CPI is not a perfect correlation, but there has not been a period in the U.S. where inflation happened without a 5-year growth in the money supply as measured by Broad Money Per Capita Growth [4].

According to Lyn Alden from Lyn Alden Investment Strategy, “There are two main forces that drive up the broad money supply over time: either banks make more private loans and thus create new deposits (which increases the money multiple, the ratio of broad money to base money), or the government runs large fiscal deficits while the central bank creates new bank reserves to buy large portions of the bond issuance associated with those deficits (which increases both broad money and base money).”  Therefore, watching the levels of fiscal deficits and bank loan growth throughout time is vital to this framework.

Source: FRED

We can look at money supply growth as a necessary but not sufficient condition for future inflation.  There are a few reasons why money supply growth is not always enough to predict inflation.  However, before that, we must separate our framework for inflation into two different categories.

1. Inflation measured by the Consumer Price Index (CPI). This is what people experience when they go to the grocery store, and it is the inflation that most debates are circled around.   
2. Asset price inflation is what people experience when trying to buy a house at a decent price or find a stock that is not trading at a historically high multiple.

Splitting inflation into two types gives us the ability to investigate whether inflation of the CPI or assets prices will be more likely after the money supply increases because each type has different features.

In our framework, we have identified that there has been a growth in the money supply which is a necessary but not sufficient characteristic of inflation.  Next, we split inflation into two categories because they have fundamentally different features.  Now we must identify the general features of both of our categories of inflation.

Characteristics of CPI Inflation: 

Once we have identified that there is growth in the money supply, we need to figure out if that growth is likely to increase the aggregate demand for goods and service.  If there is money supply growth but that new money is not likely to increase aggregate demand, then it is not likely to add to CPI inflation and we can begin to investigate potential asset price inflation. 

Aggregate demand is likely to increase if the increase in money supply ends up in the hands of the middle and lower class because they have a higher marginal propensity to consume.  According to research done by the Federal Reserve Bank of Boston, “The marginal propensity to consume (MPC) is lower at higher wealth quintiles.  For low-wealth households, the MPC is 10 times larger than it is for wealthy households.”  This means that when money ends up in the hands of lower wealth households, it gets spent at a much higher rate in the real economy.  This is identifying a clear sign for an increase in aggregate demand. In our current situation, this this would be the excess government transfer payments causing a spike in savings.

Source: FRED

Now that the increase in aggregate demand has been identified, we must investigate aggregate supply.  If the growth in the money supply (increase in aggregate demand) is followed by a similar growth in the ability for businesses to supply goods and services, then prices should stay relatively stable throughout the broad economy.  Therefore, secular inflation in goods and services normally has a supply shock that accompanies the increase in the money supply growth.  A supply shock is anything that artificially hamstrings businesses’ ability to meet the increased demand for goods and services from the increase in the money supply. 

Throughout history, CPI has generally followed the commodity index because commodities are the input prices for goods.  Prices used to go up when commodity prices would increase, and prices would decrease when commodity prices would decrease.  This process has been slightly muted since Nixon completely abandoned the gold standard in 1971 which has allowed the Fed to pursue the mission of maintaining a positive rate of inflation [5].  Although slightly muted, input prices of commodities still have a pass-through effect on CPI.

Source: FRED, LynAlden.com [6]

In our current environment, the supply shock would be the global supply chain logjam which has caused a spike in commodity prices and the labor market shortage which has put upwards pressure on wages and strained business operation.  Both topics have been covered in detail in previous market updates.

Source: FRED

Source: Tradingeconomics.com

Through this framework we can clearly see why we are currently experiencing inflation.  We have had a large increase in the money supply which has increased aggregate demand.  On the supply side, the global supply chain crises caused a material increase in commodity prices and there has been a drop in the labor force participation rate which has caused an increase in wages (further increasing aggregate demand) and disrupted business operations (further worsening the supply chain problems). 

The fundamental essence of this framework is to identify whether there is likely to be a supply/demand mismatch in the real economy. 

In summary, we analyze this by using the following framework:

• Look for base money supply growth
• Determine whether that money supply growth will increase aggregate demand
• Determine whether there are any supply constraints that will increase commodity prices, increase wages, and/or disrupt business operations.

While this framework may be useful in predicting inflation as measured by CPI, asset price inflation is controlled by different mechanisms.

Financial Asset Price Inflation:

Historically, financial assets have been largely left out of the conversation when it comes to inflation and this lack of general understanding was the main reason so many market participants misunderstood the potential outcome of quantitative easing when the money supply drastically increased after the Great Financial Crises (GFC).

Financial assets have different characteristics than goods and services in the real economy.  Financial markets are complex and have countless cofounding variables.  This framework is not geared towards properly valuing any particular financial asset, it is geared towards identifying the probability of general asset price inflation in a similar way that we created a framework for analyzing general price inflation as measured by the CPI.  For example, the model for CPI will not tell you how much the price of an iPhone will increase over the next couple years, in the same way that this model will not tell you how much Apple’s stock price will go up.  However, by focusing on the right variables, we can hopefully identify general market trends.

For financial assets those key market variables worth investigating are interest rates and central bank liquidity.

Interest rates:

Financial assets are generally valued by discounting the expected future cash flows back to the present value.  The risk-free interest rate is generally a key input in any valuation.  This means the value of financial assets are generally inversely related to market interest rates.  In other words, when interest rates go up, financial assets tend to fall in value and visa-versa.

A key indicator of general market valuation is called the Buffett Indicator [8].  This is the Wilshire 5000 index divided by GDP.  This is simply one of many market wide valuation indicators and none of them are perfect but this metric can be useful to get a general sense of how cheap or expensive the overall market is in relation to the economy. 

Source: FRED

Source: FRED

As the charts above show, since the Great Financial Crises interest rates have continued their downward trend while the Buffett indicator has soared to levels unseen before.  The Buffett indicator has continued to rise in part because interest rates have continued to fall which has pushed up the valuation of financial assets.  However, this trend of lower interest rates started in the 1980s and appears to be a derivative of something deeper in the financial system.  Therefore, falling interest rates would not have been enough of an indicator to predict asset price inflation after seeing the increase in the money supply.  This raises the question, why the parabolic move in asset prices in the last 10 years versus the previous 30 years?  The main answer to that is the shift in the central bank.

Central Bank Liquidity: 

The Federal Reserve balance sheet is a rabbit hole that can be useful to go down, but it is not particularly necessary for our purposes of building a framework to analyze asset inflation.  There are only a few important concepts to understand about the Fed’s balance sheet for our purposes. 

1. The main source of assets are the Securities they hold outright, which generally consist of U.S. Treasuries and Mortgage-Backed Securities. There are a few other sources of assets, but they are relatively small in comparison to the securities held outright.

Source: FRED

2. The main liabilities are the Currency in Circulation, Reverse Repurchase Agreements, and the U.S. Treasury, General Account.

Source: FRED

3. The difference between these assets and liabilities equals the reserves balances held at banks, which are also considered liabilities of the Fed and assets for the banks.

The main differentiator between the increase in the monetary base since GFC and previous increases in the monetary base is the function the federal reserve played in it.  The M2 money stock was traditionally a function of the monetary base because bank lending would cause a relatively consistent multiple of the money stock which would create M2.  This concept was known as the money multiplier which we explained in detail in a previous article.  This concept was a core reason that so many believed that quantitative easing would cause hyperinflation, because the monetary base increased exponentially.

Source: FRED

However, inflation did not run out of control because much of this increase in the monetary base was bank reserves, which is the currency that commercial banks use to transact with the central bank.  A great description of this process comes from Joseph Wang of fedguy.com in his article about the two-tiered monetary system, “Reserves are an unsecured liability of the Fed that can only be held by entities with an account at the Fed.  Think of it as a checking account at the Fed, except that deposits in the account can only be used by entities who also have a checking account at the Fed.”  Therefore, these reserves could never be lent out even though they increased the monetary base.  Later in that same article Joseph Wang said, “Since reserves can only be sent to entities who also have a Fed account, the total level of reserves in the financial system cannot be changed by account holders… it is a closed system where the total level of reserves is determined by Fed actions.” 

Below is a simple illustration of what quantitative easing looks like from an accounting perspective when the Fed buys treasury securities from an investor.

Source: Fedguy.com [7]

After understanding this process, it is natural to wonder why that $100 that the Fed paid the investor for their treasury security would not contribute to inflation.  This boils down to a concept in the beginning of the article which is the importance of analyzing which class of people are receiving the bulk of the increase in the money supply.  Higher net worth people who are selling their treasury securities to the Fed typically are not using that cash to buy groceries.  Instead, they are reinvesting it somewhere else in the marketplace.  Over time, as interest rates continued to drop further and liquidity became more abound, the valuations of markets have skyrocketed.

Source: FRED

Below shows household net worth divided by GDP and the amount of assets the fed purchased.  The second graph shows the market value of corporate equities and mutual fund shares divided by GDP in relation to the amount of assets the Fed held.

Source: FRED

Source: FRED

Since the upper class of society are the ones who are benefiting from the excess liquidity by being able to reinvest back into the markets, they are also the ones who enjoyed the explosion in valuations which has further exacerbated wealth inequality, but that is a topic for another time.

Source: FRED

Final Framework: 

This attempt to build a viable framework for analyzing inflation is simply one tool of many that could be used to try and predict future inflation.  There is no guarantee that it will be successful because the past is not a guarantee of the future.

To recap the framework:

1. Check for growth in the money supply and use different definitions of the money supply to get a comprehensive view.
2. Based on how the money supply is growing, determine who the growth in the money supply is going to.
3. Determine if the growth will affect aggregate demand.
4. Determine if the growth will affect interest rates and/or capital flows.
5. Determine if there are any supply constraints.
6. Lastly, analyze the potential magnitude of the situation to determine whether it is likely to be transitory or secular, which is a topic I wrote about in detail in a previous article.

Current Situation:

Using the framework developed above, we find out were in a situation where we have had a decade plus of asset price inflation fueled mainly by central bank liquidity now combined with inflation as measured by CPI.  Recently, the Fed has said they are going to raise interest rates and taper their balance sheet to quell inflation as measured by CPI [9].  However, it will be interesting to see how effective their policy will be considering that inflation as measured by CPI has been largely induced by government transfer payments, supply chain issues, and labor market shortages.   It will also be interesting to see how the markets react to the Fed withdrawing liquidity over time through quantitative tightening (i.e., the reverse of quantitative easing).

There is a possibility that the Fed could indirectly increase the labor force participation rate by reducing the gross savings of individuals through reducing asset values.  This would help the supply issue disrupting business operations but that might be a more painful process than the Fed is willing put the citizenry through. 

Ultimately, it will be interesting to see how the current situation develops.  Hopefully the framework that has been built here gives readers another tool in their toolkit that they can use to better understand the economic landscape.

Conclusion:

Here at K2 Financial Partners, our main mission is to help you reach your financial goals.  We understand that the financial markets are an ever-changing adaptive marketplace and that is only exacerbated during a time when inflationary pressures are coming to the forefront.  Therefore, it is important to have a well-diversified portfolio and contact your advisor when you have questions, comments, or concerns.  At the end of the day, we are here to help you!

Sources:

1. Inflation at 40-year high pressures consumers, Fed and Biden | AP News
   
2. Inflation - Oxford Reference
   
3. Federal Reserve Bank of San Francisco | Monetary Policy, Money, and Inflation (frbsf.org)
   
4. Investing With Inflation: 150 Years Of Data | Seeking Alpha
   
5. FDR Takes United States Off Gold Standard - HISTORY
   
6. Factors Led To Strong US Stock Market Performance In Recent Years | Seeking Alpha
   
7. Two Tiered Monetary System - Fed Guy
   
8. Buffett Indicator Valuation Model (currentmarketvaluation.com)
   
9. Traders Weigh Bigger Fed Rate Hike in March as U.S. Yields Soar - Bloomberg
   
10. United States Wages and Salaries Growth | 2022 Data | 2023 Forecast (tradingeconomics.com)
    
11. Estimating the Marginal Propensity to Consume Using the Distributions of Income, Consumption, and Wealth - Federal Reserve Bank of Boston (bostonfed.org)
    

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.  While there is no assurance that a diversified portfolio will produce better returns than an undiversified portfolio, and it does not assure against market loss, a diversified portfolio may reduce a portfolio’s volatility and potential loss.  Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, widely used as a cost-of-living benchmark, and uses January 1982 as the base year. Core CPI is the consumer price index (CPI) excluding energy and food prices.