Inflation: a simple concept with complex causes

The elusive but important role of inflation in the economy and financial markets has been noted in the press recently, with titles such as “The scourge of high inflation”, “The return of the inflation spectre” and “Inflation is all over the place”.

Inflation is a tricky concept: its definition is simple, but its underlying causes are complex. The textbook definition of inflation is a broad increase in prices. In other words, inflation is equivalent with a decrease in the purchasing power of money.

“Inflation poses a “stealth” threat to investors because it chips away at real savings and investment returns. Most investors aim to increase their long-term purchasing power. Inflation puts this goal at risk because investment returns must first keep up with the rate of inflation in order to increase real purchasing power.” – PIMCO

As the chart below highlights, asset classes perform differently under various inflation regimes. Therefore, because it impacts capital allocation decisions, investors are always on the look out for potential causes of inflation. However, as we will see shortly, these causes are not always easy to spot or to interpret.

It is this embedded complexity of the underlying causes of inflation that we will look to examine in this analysis.

The Causes of Inflation

We will divide the cause of inflation into Psychological and Non-psychological forces. The latter will be further split into Monetary and Non-monetary factors.

Psychological forces of inflation

There are a couple of psychological forces that can underpin inflation. One of them looks at the past (extrapolations), while the other tries to predict the future (expectations). We will look at both in more detail.

Extrapolations of past data

Learning from history is essential for investment success. Capital allocators ought to strive to understand how the economy and financial markets have performed during different time periods in order to be able to make informed decisions about the risks they wish to take. Consequently, looking at past datasets and trying to see what we can practically apply is a natural and useful thing to do.

History offers plenty of episodes of high and low inflation from which investors can draw important information about how fiscal and monetary policies have changed during these periods and how different assets have performed.

For example, take a look at the chart below. It shows the rate of inflation in the United States, as measured by CPI and PCE indexes since 1944. As you can see, each of these episodes represents a different rate of inflation within a distinct economic and financial context.

However, extrapolation means more than just learning from the past. Extrapolation is trying to infer a data point or value for a variable based on information about past phenomena.

From a psychological perspective, extrapolation is looking at what happened in the past and believing (or wishing) that the process in question will either continue or that the present will resemble what it happened before.

A 2016 article from Schroders illustrates the above point: looking at the rate of inflation since the 1970s, the asset manager points out that “financial markets have extrapolated low levels of official inflation into the medium term.”

It can be difficult to measure whether and by how much investors are extrapolating past inflationary trends into today’s economic and market environment. However, reading the newspapers and paying attention to how frequent past episodes are mentioned to resemble the present is a good way to gauge the market sentiment on this issue. Those investors with greater IT resources can also mine the data behind these news stories in order to extract tangible insights about whether past inflationary data is being extrapolated into the near term.

However, investors need to be careful when trying to match the present situation with a similar episode in the past. Of course, some policy tools to deal with changes in inflation are the same – for example, interest rates – while others are relatively new – such as some of the central banks’ balance sheet operations.

Additionally, the attitudes of policymakers towards inflation can also change. The excerpt below comes from a recent Financial Times article and highlights this.

“First, came the inflationary fiscal and monetary policies of the late 1960s and early 1970s, the surge in the price of oil, labour unrest, failed controls over wages, price controls, and squeeze on profits, made worse by the failure to adjust taxation for the impact of inflation. Later, came the tight monetary policies of the early 1980s of Paul Volcker, chair of the Federal Reserve, in the US and Margaret Thatcher and her chancellor Geoffrey Howe, in the UK.

After these painful years, control over inflation moved to centre stage. The notion that inflation was a price worth paying for lower unemployment was rejected as a failed theory. Initially, the alternative was the monetary targeting recommended by Milton Friedman.

When this turned out not to work as well as hoped, policymakers shifted from the targeting of an instrument, money, to the targeting of the goal, inflation. Formal targeting of inflation began in New Zealand in the early 1990s and spread, along with central bank independence, to much of the world, notably including the UK.”

Consequently, while looking at the past for guidance as to what may happen next is a normal and useful thing, trying to come up with an exact value or direction towards which a financial or economic phenomenon may head, can lead to irrational actions and, as a result, to disappointing investment results.

Expectations of future inflation

Closely linked to the psychological factor discussed above, expectations of future inflation also play an important role in how investors act regarding a potential change in the general level of prices.

The link between extrapolation and expectations has been noted by Tobias F. Rötheli in his 2020 book, “The behavioral economics of inflation expectations : macroeconomics meets psychology”. Rötheli explains that “pattern extrapolation is shown to be the key to understanding expectations of inflation and income.”

Our own expectations about the future can (and often do) influence how we act, just like our perception of the past does. Therefore, if we believe that prices will increase going forward, our spending habits and capital allocation decisions will change accordingly.

Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, explains that there are three main ways of measuring inflation expectations:

• Surveys
• Interest rates
• Exchange rates  

There are numerous surveys which can be used to gauge what economists and market professionals believe the direction of inflation might be.

For example, the IMF regularly publishes the expected rate of inflation based on surveys. Moreover, the there are several such measures from the United States, including: the University of Michigan Surveys of Consumers, the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia and the Survey of Consumer Expectations done by the Federal Reserve Bank of New York.

There are other surveys which could offer insights into investors’ expectations about future inflation, such as European Central Bank’s Survey of Professional Forecasters and Bank of England’s Kantar Inflation Attitudes Survey. All of these are useful tools to gauge what other market participants, as well as economic actors, are thinking in terms of general price increases going forward.

Interest rates are another tool to measure inflation expectations. “To understand the link between expected inflation and interest rates, consider the Fisher equation, where a nominal risk-free interest rate (which is what treasury bond rates) can be broken down into expected inflation and expected real interest rate components,” writes Damodaran.

Finally, exchange rates can also be used to gauge market’s expectations of inflation by using the spot rate and forward exchange rate of a currency, such as the USD. However, this approach assumes that purchasing power parity is the most critical determinant of changes in exchange rates over time.

All of the above measures of expected inflation have a psychological component embedded in them – the market participants’ views of future changes in inflation – while they also impact the psychology of investors, influencing how they allocate capital given what they believe the future will be like. As an interesting aside, this behavioural loop (we act on something while that something acts on us and so on) is called reflexivity, a social theory that George Soros successfully applied to financial markets.

However, what we expect the future to be like is often not how it will turn out. This can be seen in the chart below.

To conclude: the above psychological factors– extrapolation and expectation – are causes of inflation because they drive market participants to act in a certain way: the first one, affects investors’ perception of how the past links to the present, while the second one affects investors’ views of the future. They are both interlinked, but we separated them for a clearer discussion on what they are and how to measure them.

We now move to non-psychological forces of inflation.

Non-psychological forces of inflation

We breakdown these drivers of inflation into two: Monetary forces of inflation and Non-monetary forces of inflation. As with the psychological factors above, these too are linked between them and, of course, they are also connected with extrapolation and expectation. However, we will look at them separately so we can clearly identify and measure them.

Monetary forces of inflation

The argument here is that an increase in available purchasing power can lead to inflation. Economist Irving Fisher in his book, “The Illusion of Money”, explained this with the bread and butter analogy: if we think about money as the butter and the economy as the bread, if the surface of the bread does not increase, adding more butter on it will result in a thicker layer of butter on the same amount of bread.

To explain this more scientifically: if money supply grows faster than economic output, then we will likely see inflation. This is captured by the QTM (Quantity Theory of Money) which has the classic equation: ​(M)(V) = (P)(T), where M is money supply, V is the velocity of money, P is the average price level and T is the volume of transactions in the economy.

The main actor in controlling the money supply in a given currency the central bank. Easy monetary policy ought to result in more purchasing power available for the economy and financial markets, while tighter monetary policy should have the reverse effect.

However, there are a couple of criticisms to this perspective.

The first one is how to measure the supply of money in the economy more accurately. There are various measures that go from narrow money supply (M0) to broad money supply (M3). The table below comes from the Bank of England and illustrates this point.

According to Professor Tim Congdon, “the broader the better”. The argument in favour of the broadest measure of money supply is to get a more complete picture of spending dynamics (purchasing power flows) in both the economy and in the financial system.

The second criticism is that inflation (as measured primarily by the CPI) has been subdued for the best part of the last ten years, despite loose monetary policy that included ultra-low interest rates and central bank balance sheet expansion in major economies such as the United States, the United Kingdom and across the European Union.

Indeed, up until recently, the puzzle of low inflation in a world where easy monetary policy (deemed inflationary) was a hot topic of debate. See for example this 2019 article from the Financial Times entitled “How our low inflation world was made”, and this 2018 study by the Federal Reserve of St. Louis called “Why is inflation so low?”.

However, nowadays is not uncommon to see articles with titles such as “Taking Inflation Serious” or “Buckle Up: 3 Reasons Why Inflation Is Rising” in which the link between the growth in money supply and inflation are being made with more conviction.

An explanation for why inflation, at least as measured by the CPI, hasn’t been increasing for the best part of the last decade has to do with the transmission mechanism of monetary policy: most of the excess purchasing power created through easy monetary policy has been going into asset prices rather than consumer goods or services. Consequently, a measure of inflation, especially during times of extremely accommodative monetary policy, should account for increases in asset prices.

Besides central bank policies, another monetary factor for inflation is government spending, or fiscal policies. However, as with monetary policies, the key determinant of whether government spending will result in a general increase in prices is the transmission mechanism of these policies: are the money that the government is spending getting directly in the hands of the end consumer or not? If the answer is yes, such as it is the case with the stimulus checks in the Untied States, than this is like to be inflationary.

However, there are other, non-monetary, factors that can lead to inflation and which investors should monitor.

Non-monetary forces of inflation

These factors include economic capacity, supply chain disruptions and structural changes.

Economic capacity has to do with how much slack is in the economy. If the economy runs close to its full capacity, i.e. it has a high rate of employment, inflationary pressures may come from the workers’ power to negotiate higher wages or from intense competition as employers have to provide bigger financial incentives for people to work for them.

Supply chain disruptions can be inflationary if the demand for the good or service which is now provided in lower quantities remains relatively elevated or further increases. Less supply of something, coupled with the same (or higher) level of demand, means that the provider of that desired good or service will see an increase in prices.

Structural changes can mean all sorts of things, from technological advancements to a country moving away from a manufacturing-based to a service-based economy. As Professor Damodaran explains: “There are times when structural changes in the economy, arising as it transitions from a manufacturing to a service economy, or from one that is domestically focused to one that is export-oriented, can create periods where inflation stays subdued in the face of monetary expansion.”

These structural changes are difficult to measure, and the best investors can do is to try to spot them. Some of the questions to ask include:

• How has the GDP composition changed over the years?
• Has the economy become more reliant on intangible assets?
• Have there been any technologies that created new industries or jobs and how much do these novel sectors contribute to economic growth?

Before we conclude this discussion, let’s take a brief look at a few well-known measures of inflation.

Measures of Inflation

Looking at inflation can be done from two perspectives: that of the consumer and that of the producer.

The most followed measures of consumer-focused inflation are the CPI (Consumer Price Index) and the PCE (Personal Consumption Expenditures Index). Both of these indexes provide a headline (overall) figure and a core (excluding food and energy) value of inflation. Both the CPI and the PCE are lagging indicators of inflation. In other words, they provide investors with information about what has happened with prices.

Meanwhile, in the United Kingdom, you also have the RPI (Retail Price Index) which differs from the CPI in its composition but aims to highlight a similar phenomenon: whether consumers have faced a general deterioration of their living standard due to an increase in prices.

The PPE (Producer Price Index) measure price changes from the perspective of the seller. “This contrasts with other measures, such as the Consumer Price Index (CPI), that measure price change from the purchaser’s perspective. Sellers’ and purchasers’ prices may differ due to government subsidies, sales and excise taxes, and distribution costs,” explains the BLS.

There is another measure of inflation which comes from the financial markets: commodities futures prices.

“Prices for the building blocks of the economy have surged over the past year. Oil, copper, corn and gasoline futures all cost about twice what they did a year ago, when much of the world was locked down,” writes the Wall Street Journal in an article called “What Commodities Prices Are Saying About Inflation” published in May 2021.

If the prices of raw materials are expected to be higher, the concern is that these increases will be passed on the consumers, fuelling inflation in the economy. Futures prices are a leading indicator of inflation, telling investors what the market expects to happen going forward.  

Conclusion

Hopefully, this analysis provides you with a roadmap to the key forces of inflation. We have divided them into Psychological (extrapolation and expectation) and Non-Psychological (Monetary and Non-Monetary).

We have seen that all these factors are linked and that there are different ways to gauge them. Some of these methods are more data driven than others.

Finally, we discussed some of the key measures of inflation, looking at both lagging and leading indicators from the perspective of consumers and producers.

Thank you for reading.