Featured in the Florida Association of Public Pension Trustee's Monthly Publication in August, 2021.
What is inflation?
Answering this question should be brief, right? It is just about rising prices, right? Well, not exactly. While prices typically rise during an inflationary period, there is more to it. Inflation, in its purest form, is an expansion of the money supply in the economy. This broad description underlies some colloquialisms which speak to how inflation is experienced by the public. For example, since the Global Financial Crisis, expansion of money supply in the economy has often been dubbed “monetary inflation,” but in reality, this is pure “inflation.” In addition, when most people say “inflation,” they are referring to when prices rise. This is actually called “price inflation.” So, from a semantic perspective, the correct way to think about it is inflation leads to price inflation, not that monetary inflation leads to inflation. While this may seem like mere semantics, it is an important distinction with practical investment implications.
Why do we care about inflation as consumers? Does this differ from how we care about inflation as investors?
Consumers rely on price of goods and services to measure inflation because of the reasonable expectation that when there is inflation, either via an expansion of the monetary base or an expansion in consumer and corporate credit available, holding all else equal, prices will rise. After all, if there is a larger amount of currency chasing the same amount of goods, then economics dictates that the nominal price of goods will rise. Theoretically, the prices of everything should rise by a similar percentage if the excess money gets distributed proportionally across the entire population across all goods and services, in which case the inflation would be relatively benign.
For example, suppose everyone in the U.S. finds that the monetary value of everything had increased by 10%. Every price was 10% higher. Paychecks were 10% higher. Interest rates were 10% higher. The amount of money—everywhere from wallets to savings accounts—was 10% larger. While this seems crazy, people would realize that their real wealth stayed the same because everything rose pro rata. This inflation had no economic impact. Everyone’s wages could still buy the same set of goods and services as before. Equal levels of inflation in all wages and prices ended up not mattering much at all and tend to benefit many stocks.
However, practically speaking this is not the case, which leads to divergences in how we think of price inflation as consumers vs. how we think of it as investors.
Because of this, monetary inflation will not always lead to price inflation in consumer prices. But the money will find a home somewhere, whether that be in consumer spending, consumer savings accounts, or in investment assets; consumer preferences will determine where the money ends up.
Investors rely on asset-class metrics like the CPI to measure inflation, though this metric does not necessarily accurately reflect the price increases that result from monetary inflation. For example, recall that much of the monetary and credit inflation in the aftermath of the internet bubble found its way into the housing markets. Though consumer prices did not rise much, housing prices sure did, which had no impact on inflation statistics because housing prices do not factor into the CPI calculation. The value of housing reflects not only current consumption but also the capitalized value of future housing consumption. Thus, including house prices would not measure solely current consumption prices but rather an amalgamation of consumption at different times, which makes it is unsuitable for measuring the price of consumption basket at a specified time. Instead, the owner’s equivalent rent measure is used to estimate what a homeowner would pay to rent an equivalent property. While somewhat understandable because of a temporal mismatch, excluding housing led to a misleading conclusion that there was no inflation from 2003-2006 even though there was clearly an increase in prices, but it all went to housing instead of consumption of goods and services.
What impact does inflation have on different assets and on overall investment portfolios?
Inflation is typically bad for bonds, as the principal repayments are in dollars that are worth less than when originally loaned out. However, slow-moving, relatively consistent inflation is generally not a problem for equities.
Modest amounts of inflation can benefit stocks, but this will be selective based on which companies and industries have pricing power (i.e., the ability to pass on input cost increases to customers). As a result, industries with pricing power benefit while industries without pricing power see their margins compressed. Industries with more non-discretionary products and services continue to thrive (and perhaps thrive even more so) while industries with more discretionary products are likely to suffer. Frequently, spending may suffer at the face of increased investment in long-lived assets and investment assets. So even though we see monthly headline CPI figures come out, the reality is that such a figure contemplates hundreds of goods and services across many industries and is not necessarily reflective of a price increase in any particular item.
Not surprisingly, historical price inflation has tended to trend in line wage inflation levels. The typical cycle in this case, which is benign, is that rising prices encourage spending, which drives higher corporate incomes. As a result, wage growth accelerates, most importantly at the lower wage level. This drives even more consumer spending, which begets further price rises. This is what is known as demand-pull inflation, as stronger demand from strong economic growth is what drives prices higher.
Of course, consistency is rarely the case. In reality, prices might rise while wages do not rise at all, or wages rise more slowly than prices. Or some wages rise while some do not. Where this demand-pull cycle is most likely to break down is if higher corporate income is flowing more so to owners of capital and higher wage earners and less so to the lower wage earners. This can come as a result of either slow wage growth or higher unemployment. As a result, it is likely that any demand-pull inflation right now will be unsustainable until we see blue collar wages rising and/or unemployment coming down.
In contrast with demand-pull inflation, there is also cost-push inflation, which was what we experienced in the 1970s. In contrast with the demand/supply imbalance being driven by higher demand, in this case the imbalance is spurred by lower supply; in the 1970s, the supply shocks were driven by Mideast geopolitical turmoil. In a similar vein, supply shocks a year ago from supply chain disruptions as the coronavirus spread also led to sharp rises in the price of consumer goods, though more ephemeral than experienced in the 1970s. It is this type of inflation which is insidious because people’s real wealth lessens as their wages generally fail to keep up with the price increases. Additionally, companies rarely have pricing power in these cases, except perhaps those who are selling the inputs that are rising sharply. As a result of this kind of inflation, stocks suffer as corporate margins compress in the face of higher input costs.
So, in summary:
Inflation always involves an expansion of the money supply. It does not always involve resultant price inflation.
When price inflation does result, it is not consistent across good and services, and often the price inflation occurs in asset prices more so than consumption prices.
The idea that all inflation should be feared is an overgeneralization, as not all inflations are created equal: demand-pull inflation resulting from economic growth (i.e., demand grows relative to stable supply) is generally a positive for stocks, whereas cost-push inflation resulting from supply shocks (i.e., supply shrinks relative to stable demand) is generally a negative for stocks. Both types are generally bad for bonds, though the former is often not as bad because the decrease in credit risk offsets the devaluation from increased interest rates.
Read about how inflation signals a post-coronavirus economic recovery in this blog post.