Ah inflation, that pesky stat we shove in the back corner of our minds as politicians print money, after all, who doesn't like free stuff? No matter your political affiliation, prices are rising, inflation is running up, and that's a cold hard fact. The United States July 2021 inflation rate came in at 5.37%. To put that in perspective, that's higher than 79% of all observed inflation rates in the 1872 to present data set I analyzed. There were only 21% of all values that were greater than the 5.37% inflation we saw in July.

I don't think there's much debate on what is causing this elevated inflation; excessive government spending. If you've seen a more compelling rationalization I would honestly love to look into it. Please feel free to email it to me: Morgan.Price@QuantitativeFinancialAdvisory.com.

So government deficits, spending more money than they actually have. Well, I'm getting free stuff, I'm not paying for it, the government doesn't have the money for it, it wasn't paid for with taxes... so it's free... isn't it? Well, I guess we need to define free;

"Without cost or payment" is what a quick google search returns.

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Let's put some data to this question. Below is annual inflation/consumer price index (CPI) data for the USA From 1913 to July 2021:

"Without cost or payment"

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Imagine it's 1913, consider wanting to leave an inheritance for your great grandchildren. You save a fair sum of money, $1,000.00! Equivalent to $27,724.00 in 2021 dollars. Due to the recent bank runs, you have a fear of banks. You put the money under your mattress.

108 years later your $1,000.00 has the buying power of $34.20. Your dollar has lost 96.58% of its buying power.

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There's a few take-aways here:

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1) Do not save your money in cash/chequing/bank savings accounts. It will slowly, but certainly, lose its value.

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2) Inflation has made buying $1,000.00 of 1913 product cost $27,724.00! Clearly we need to incorporate this into our financial planning.

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3) Inflation is thought to be a product of an increasing supply of money. See below:

So, when the government prints money, likely to hand out the next thing they bought votes with is it free? Technically, you are getting goods/services for free at the present. You don't outlay any cash now for whatever it is the government is handing out for "free", right?

Right.

Inflation is a general increase in prices and fall in the purchasing value of money. inflation is just another tax, a very, very, well hidden one. Inflation, in large part, is caused by adding more money to the circulation, and the speed or velocity at which it is spent. The amount of money is mainly effected by government deficits. After all, who else can print money?

When an individual, or government, or anyone/anything spends more than they take in they need to borrow the difference. This money comes from private investors buying government debt or the countries central bank printing more money (simply adding zeros to their bank account). This, even just a number on a screen, increases the amount of money in existence. If you have a hard time visualizing how this increases inflation, imagine you're at the following market:

This is a hypothetical world set in a single room with you selling a gadgets for $100. Your supplier is selling gadget ingredients across the room for $98 and a multitude of your customers are actively, and rapidly, shopping for gadgets. Your competitors are eagerly selling gadgets. At 8:00am the market opens and there is $10,000.00 in the room. Every hour some of your customers and competitors receive 3% more money for their products/services than they began with. Someone in the room has the exclusive right to print this money and does so at their discretion. This will carry on for the foreseeable future. Every hour the total amount of money in the room increases. Not for you though.

You can't print money.

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Now imagine this market is a closed system, much like our earth is essentially a closed system, no matter how vast our resources it is still a fixed amount of resources. Remember, this entire hypothetical world consists of this one room. You've noticed that the amount of money is steadily growing. You realize that if the amount of money in the room is steadily growing, then, everyone else has more money to offer higher prices to your supplier. That will probably entice your supplier to give up your gadget ingredients to these higher paying customers/venders. You realize that no matter how large the resource, with a fixed quantity of gadget ingredients and a growing money supply the price will have to rise. There will be more dollars chasing the same number of goods. If you wait around for too long, this price increase might get higher than the $100 you're selling the gadgets for. If the price of gadget ingredients rises higher than your selling price your business will be ruined, you wont have the money to buy more stock. So you plan for this and raise your price to $103. You know that there is 3% more money in the room, therefore, the market can afford to pay the higher price. You are able to sell your stock and buy more.

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Another hour has passed, there's 3% more money in the room again. You raise your prices to $106.09. Say the market closes after 12 hours. By the end of the day you've raised your prices to $142.58. Your suppliers prices are now slightly lower than your selling price.

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I hope this was a clear illustration of why price levels rise and inflation rates increase when more money is created. People don't want to lose their buying power, sellers don't want to lose the ability to buy inventory, and suppliers/wholesalers want to realize the highest prices for their raw materials.

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Now consider another vender who has kept far more stock of gadgets than our original salesperson. This vender was a responsible saver and always made sure to save enough money to have far far more than a full days inventory on hand. At the end of the day this vender is thrilled. All their stock has been sold. For some reason all of the competitors were raising prices; it was a record day for sales, since everyone was so happy to see that this vender hadn't raised prices, the customers bought all this venders the gadgets.

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At the end of the day this vender goes to the wholesaler to place an order for gadget ingredients. The price of gadget ingredients rose 3% an hour and is now unaffordable to the vender that didn't have the foresight to raise prices. The responsible act of saving money came back to bite hard. The purchasing power of those dollars has been eroded away.

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Inflation is simply a government tax on savings accounts. The only way to beat inflation and grow your purchasing power is to invest in assets that beat the rate of inflation. If it is businesses that are raising prices, due to government deficits, then why not own a piece of these businesses? After all, that's where the money is going. Buying stocks would be a good first step to fighting inflation.

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Now of course the simple printing of money doesn't even begin to tell the whole story. Continuing with the market metaphor, let's consider an auction, the below examples illustrate how simple supply and demand also affects inflation.

Scenario 1 is a single seller and a single buyer at the auction. You want to sell your gadget for $100. This individual wants to buy at $95. Until one of you moves you're at an impasse. Perhaps the prices goes down, maybe it goes up, maybe now sale is made. The inflation is uncertain.

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Scenario 2 is a single seller and multiple buyers at the auction. You want to sell your gadget for $100. These individuals want the gadget, but are unaware of the extent to which everyone else wants it. They want to buy anywhere between $95 and $105. These multiple buyers will bid the price up until the buyer who wants it the most/is willing to pay the highest price takes home the gadget. It sells for $105. A 5% inflation rate.

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Scenario 3 is multiple sellers and a single buyer at the auction. They want to sell the gadgets for $100, but some really need the money, and are willing to sell at $95. This individual wants to buy at $95. Until one of the sellers moves there's an impasse; however, the sellers are more desperate than the buyer. One thing's for sure, if a single seller is willing to sell at $95 and the buyer is sufficiently stubborn, the prices goes down to $95. A -5% inflation rate, a deflationary environment.

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Scenario 4 is multiple sellers and multiple buyers at the auction. They want to sell the gadgets for $100, but some really need the money, and are willing to sell at $95, others are financially sound and won't budge on the price. They actually want $105. Some of the individuals want to buy at $95 and are quite indifferent about even buying. Others definitely need this gadget, they wont leave without it. They will buy at $105. Nothing is certain. If a single buyer or seller is willing to move from $100 a deal happens, however, we have no way of knowing if its a buyers or sellers market. The price could be anywhere between $95 and $105; perhaps not a single transaction could take place. Inflationary environment, deflationary environment, it's anyone's guess.

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The take away

Clearly an increase in the money supply and changes in supply and demand play an integral role in market pricing. If there are more buyers than sellers, prices generally rise. If there are more sellers than buyers, prices generally fall. When there are multiple buyers and sellers it's anybody's guess. When someone has the ability to print money the same number of goods/services are being demanded by more dollars and prices rise.

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Our current inflationary environment has been characterized at "transitory"... it's tough to say if we should buy that. We've just come out of a recession where governments multiplied the amount of money in the system many, many, times. They spent more than they had and simply invented the difference. Where did this purchasing power come from?

They took that purchasing power from your money.

Perhaps this was justified though. The US unemployment rate jumped from 3.5% to 14.8% in two months. GDP dropped from 21.7 Trillion to 19.5 Trillion. It plunged 2.2 Trillion dollars. That's twelve zeros. Trillion. $2,2000,000,000.00. Trillion. Now, considering all the lockdowns there would clearly be a pent up demand; more buyers than sellers, especially considering how supply chains were crippled and capital isn't as mobile as economists like to believe. Meeting an increased demand with a new factory is rather difficult and time consuming. Given all this, I do believe inflation rates will remain elevated for quite some time into this recovery. However, it's uncertain how long we will see these elevated approximately 5% inflation rates, there are other variables at play, they are described below.

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Clearly the inflation rate, or erosion in purchasing power, is heavily related to the growth of the money supply. That doesn't tell the whole story though; clearly that big spike in M2 money supply (due to heavy government spending during the COVID-19 scare) should have exponentially spiked inflation... but it didn't, why?

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M2 money supply isn't the whole story of inflation. Inflation is a product of the amount of money, more specifically the growth rate of money, and how quickly it is spent.

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So, money can be created by government printing. Additionally, the growth of money can be measured through a process called the "money multiplier". When you deposit funds at a bank they only hold a small fraction of the money on deposit (low single digit percentage bank reserves in Canada) and they lend out the rest; "artificially" creating money. there is a few more factors to this statistic; the retention of money by the public (cash holdings), the demand for bank loans, the supply of bank loans, how much excess reserves the bank desires for a cushion of safety, the legislated bank reserve ratio (the amount of deposits withheld), and what's called the marginal propensity to save/consume - which ties into the amount of money the public will deposit.

A basic example:

a) The money supply increases $1000.00.

b) The public deposits 75% in the bank.

c) The bank holds a 5% reserve on deposits.

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With these assumptions we can see that if the government creates $1,000.00 of new money the total money created in the economy is $3,520.74. Following the flow of money growth in the table (left to right and top to bottom) we can see that the growth is coming from banks creating new loans.

Logically, if we are in a recession there will be a low demand for loans to fund new ventures and the bank will additionally be more hesitant to lend money due to the stressed macroeconomic environment. Below is the above described "money multiplier" shown throughout time.

As can be seen in the money multiplier timeseries graph, the money multiplier seems to contract during recession. As mentioned above, it may be logical for banks to be more hesitant to lend in adverse macroeconomic conditions and entrepreneurs may be less willing to risk their livelihood by taking on more loans during an economic contraction. Something else to note, interest rates have been declining for, essentially, four decades. The world is already leveraged. Our parents have mortgages, we have student loans, car loans, credit card debt. Businesses have been tapping cheap debt for decades... do they have the margin of safety to take on more debt?

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If individuals and companies are already overextended with debt banks may find it difficult to establish new loans. This may serve to keep the money multiplier low (at least until interest rates go up and we deleverage ourselves or have a worldwide bankruptcy crisis). This depression of the money multiplier may serve to keep inflation at bay, even through the governments rapid money creation.

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As mentioned above, another influence on inflation is the velocity of exchange. The speed at which money is spent in the economy or the number of times a single dollar is spent in a year. Lets think back to our auction example, think of the velocity as the number of bids on a product. If more people have a demand for a product and if in the short term supply can't match demand, the price will rise.

Alternatively, there could be a more disheartening reason the velocity of exchange could decline. It's more difficult to notice the negative relationship between the velocity of exchange and recessions in the earlier years, but it is present. It is glaringly obvious during the last recession, February to April of 2020, it seems like it fell off a cliff.

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Another factor of inflation is the velocity of exchange. The number of times, or velocity, that a dollar is spent in a year.

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After reaching a peak of 10.64 in 2008, the velocity of exchange has been continually declining. It's easy to extrapolate an opinion about the COVID-19 recession; people were/still are under at least some form of lockdown which makes it difficult for them to go out and spend their money. Some additional anecdotal evidence I've observed is that many recipients of the government stimulus, the CERB, the student benefit, and to a lesser extent the business subsidies/grants are actually just sitting in a bank account. I talked with many CERB recipients that are keeping it in a separate bank account incase they need to pay it back. Observe the time series chart of Canadian savings rates:

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During the Coronavirus pandemic savings rates hit an all time high, approaching 30%. I would posit that an increase in savings is driven by a fear of where and when the next paycheck is coming from. The uncertainty is absolutely rational, I can sympathize. On March 16, 2020 it was announced in the USA that we would have 15 days to "slow the spread". We're well past 15 months now. There's been numerous lockdowns and "temporary" business closures with each one supposedly the last.

Many different stats have come out so it's hard to lock down a single number; a report from the board of trade stated "with only half (of businesses), 53%, expecting to reopen once the restrictions are eased on workplace operations, while 38% are unsure, and 8% will not reopen." It's easy to see why people are spending less money, holding onto their dollars, trickling down to lower the velocity of exchange. Uncertainty causes people to save, in my opinion, they are saving out of fear.

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So where we're at now is some logic/theory/relationships between the inflation rate and the growth of money, both government spending and bank creation (fractional reserve banking), the velocity at which the money is spent (the average times per year a dollar is spent/changes hands), and the relationship that personal savings rates tie into it. Additionally, interest rates are widely believed to have a large negatively related effect on inflation.

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Central banks use short term interest rates as what they refer to as a "policy tool". They adjust the interest rates, normally in a +/- 0.25% band around a target for banks to lend/borrow at. The intuition behind this is in times of recession interest rates can be lowered to stimulate the economy. This is thought to be achieved through the lower rate stimulating borrowing, which drives investment. A lower interest rate is also thought to raise the relative exchange rate as foreign investors will look to invest their money in other countries that have higher interest rates, this causes the international investors to sell the domestic currency for a foreign currency which lowers the domestic exchange rate. This lowered exchange rate causes the domestic currency to be cheaper for the rest of the world driving more international buying of domestic products which drives domestic exports, raising GDP. Lower interest rates also have the effect of making borrowing cheaper for individuals and theoretically causing a disincentive of savings due to the lower interest rate and increasing consumption (i.e. cheaper funds for mortgages, car loans and general purchases). Lower rates also cause asset prices to rise; houses can be financed cheaper causing increasing demand and prices, lower discount rates cause stocks/bonds to be priced higher as well as governments being provided with less expensive funding to fuel more spending to prop up the economy.

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In theory, lower interest rates will prop up the economy. Observe the chart of the 20 year US government bond rates below:

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Interest rates have been on a strong and continuous downtrend for near four decades. This might throw a wrench into the whole intuition of lower interest rates being effective at propping up the economy.

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Let me explain.

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With interest rates at or near all time lows, can lowering the cost of borrowing really incentivize more borrowing, spending, and investment? If most of your disposable income is already going to the necessities, whether that's from being un or under-employed over the pandemic, will dropping from a 2% cost of borrowing to a 1% rate really make you want to go buy that new gadget? Dropping from 7% to 1% I can entertain but reducing something that's already near zero to something closer to zero doesn't entice me.

With interest rates being so low for so long I believe that most people are near their limit when it comes to adding more debt. According to the IMF, Canadian household debt is current over 100% of GDP, I have a hard time seeing how we can sustain much more (https://www.imf.org/external/datamapper/HH_LS@GDD/SWE). It seems that central banks have backed themselves into a corner; debt has been so cheap for so long that their most effective tool, moving interest rates, may become ineffective. The only way to reload their weapon is to raise interest rates so that they can lower them in the next economic contraction. An increase in the cost of borrowing for an unbelievably indebted world would be catastrophic.

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However, it seems like low interest rates may be a double edged sword. If you believe that these low interest rates will in fact spur growth then we are going to see higher and higher levels of inflation. This rampant inflation will cause bank account savers to have their purchasing power stripped away from them. Huge chunks of the public could have basic necessities become unaffordable due to a lack of inflation hedges; no appreciating assets like a house, investments in stocks, inflation tied wage increases, etc. This will likely result in the government stepping in to provide assistance. Of course the government will just print more money to finance this assistance. The problem will get worse and worse. We've seen it play out in many countries already.

So that's what happens if interest rates stay low an inflation runs wild... so what about if interest rates get raised?

Ah yes, the great recession of 2008 comes to mind. With everyone carrying such high debt now I can't imagine the repercussions of raising interest rates from the low single digits back up to something closer to the 15% interest rate mortgages of the 1980's. Now I can't see rates going that high but the point still stands that interest rates cant stay at near 0 forever. The central banks need to raise interest rates in preparation for the next crisis. So what would bond returns look like if rates stayed here? As of 8/31/2021 a 20 year US Government bond yielded 1.85% with the last reported inflation numbers, July 2021, at 5.4%. If rates stay exactly where they are inflation will overpower your bond return by 3.55% a year. But why would we entertain rates not moving, the central banks have already provided guidance for rate increases in the next couple dozen months.

Below are the bond returns in a rising rate environment. I've simply reversed the growth rate of interest rates we saw in the last 20 years as an easy example of a return to normalcy.

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A hypothetical $1,000.00 investment in default risk free government bonds would be worth $526.28, nominally, at the end of its 20 year life. Lets assume a conservative 2% inflation rate on that, the Bank of Canada's target rate. But consider that Canadian July 2021 inflation was 3.7%. After accounting for 20 years of 2% inflation your $1,000.00 bond investment has a purchasing power of $354.17. Using an aggressive 3.7% inflation rate leaves it at just $254.47.

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So bonds are out of the picture as a long term investment.

How will stocks do? I would bet that they will be positive. However, a high inflation rate if interest rates were left near zero would greatly reduce the real rate of return. So if rates stay low, you can expect lower real returns due to inflation. Not only will inflation affect your real rate of return but a high inflation rate will leave the average consumer with less money to spend in the economy as the average consumer doesn't own many inflation hedges to protect themselves.

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So stocks aren't going to perform great in a low rate environment.

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Well how about if we raise rates? That should read when, not if, we raise rates. Well, without getting too complicated here, stocks are priced as the sum of all the companies future earnings adjusted for a rate of return. If you owned stock in a company that would pay you $110 next year and your rate of return or discount rate was 10% you would pay $100 for the stock ($110 in a year minus $100 today = $10 and $10 is 10% of your initial investment). As interest rates rise, so do the discount rates applied to stocks earnings. This causes stocks to be priced lower. Additionally, the economic factors effecting earnings would be massively negatively affected. Higher interest rates means a higher cost of borrowing, less spending, and more saving. GDP would decline and the foreign exchange rate would rise, decreasing exports and lowering GDP further. Businesses would have to pay more interest expenses and have less money to invest in the economy.

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So I guess stocks won't be performing very well in a high rate environment now either. Cheap money for the past four decades is finally catching up to us.

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I know you think I've written far too much about inflation. Trust me, I haven't emphasized it enough. However, as detrimental to our investments, economy, and overall life as inflation is: it displays an approximately normal, symmetrical non-skewed, and an essentially normal kurtosis of 3.11 vs the standard normal distribution's kurtosis of 3.00 (the degree to which there is a tall peak/a tight distribution). This is important as it means we can assume a normal distribution for forecasting inflation.

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​​The above distribution is built off annualized monthly inflation rates from January 1914 to July 2021. The average inflation rate is 3.22% with a standard deviation of 4.98%. After calculating a t-stat of 1.96 for a 3.51% inflation rate we can say, with 95% confidence that, on average, the annual inflation rate is not lower than 3.51% over the long term. There is a 5% chance we are wrong.

The Takeaway.

1. Inflation is not free, the government finances its deficits by robbing your purchasing power.

2. Inflation is a tax on savings.

3. You can beat inflation by investing in appreciating assets, stocks, land, real assets.

4. You need to plan for high future inflation

5. You can expect inflation to be a product of the growth in money, the speed it is exchanged, and the volume of transactions for goods and services.

The general quantity theory of money is given by the equation:

Average Price Level = ((Amount of Money)*(Velocity of Exchange))/(Volume of Transactions)

Lets look at the current levels of these variables:

January 2020 M2 Money Supply: $15,406.8 Billion

January 2021 M2 Money Supply: $19,393.2 Billion

Increase in M2 Money Supply: $3,986.4 Billion

January 2020 Velocity of Exchange 1.374 (Max of 2.190)

Most Recent (Q2 2021)Velocity 1.120 (Max of 2.190)

We see that the predicted inflation rate, based on the observable variables, was 2.60%.

The US CPI was 258.687 in January 2020 and 262.231 in January 2021, and most recently, 272.265 in July 2021. So we have a one year inflation rate of 1.37% and an inflation rate of 5.25% for the period January 2020 to July 2021... 2.60% doesn't seem far off and is statistically significant to be in that range.

Let's assume that the quantity theory of money has some basis and make some predictions.

Lets vary the unknowns, the Volume of Transactions, as COVID-19 would have greatly impacted this, as well as the Velocity of Exchange.

Well, a base case inflation rate of 2.60% going all the way up to 122.70% when we go up to the historical max of Velocity of Exchange and only grow the M2 Money Supply by 1% per row.

All I can do is provide the data, I guess it's up to you now.

Posted September 12th 2021.