What is inflation, how does it impact the global economy and markets, and what conclusions can investors take? This article is meant to complement John M. Mason's recent post It's Time to Talk About Inflation.
Let’s start with the definition. The standard statement that inflation is a general increase in prices is not correct. Precisely, monetary inflation is an increase in the supply of money. Then, it implies an increase in prices. The increase in prices is a simple consequence of money losing value. But you must not inverse the logic and conclude that an increase in prices will generate inflation. This is not correct, In fact, it is quite obvious to imagine a mechanism for price increases with no inflation. Suppose that the money supply remains constant but that the supply of a product X is interrupted or reduced for some reason. Then, prices of X will increase mechanically but no increase in money supply, then no inflation. Deflation, of course, is just the opposite: a decrease in the money supply.
It is not just academic wording with no significance for the world of markets. Inflation is an essential discriminator for bond prices, and bond prices themselves are directly anti-correlated to stock prices. Understanding this fundamental variable, what inflation is, will make the complete decision chain on financial markets more transparent and readable.
That said, we still have to determine what money supply means exactly. An interesting word exchange happened a few years ago when US Representative Ron Paul asked Federal Reserve Chairman, Alan Greenspan, what he considered to be the best tool to measure money supply. Greenspan plainly admitted that he was at a loss for picking out what such a measure might be. When US Representative Paul suggested that it must be difficult to manage something you cannot even define, Chairman Greenspan not only agreed with him but also said it was “impossible”.
Hmmm, interesting. If we don’t know what money supply is, how can we determine whether the money supply is increasing or decreasing? In practice, the monetary authorities can make some basic counts with what they call monetary aggregates, which include various forms of deposits at financial institutions as well as notes and coins in circulation. I will not enter into details which do not matter so much for the purpose of this post. For example, if interest rates are decreased, it gives more opportunity to write some credits and consequently to increase the money supply. Debt creation is by essence an increase in money supply, and therefore inflationary. However, we should never forget one key point: during an economic slow down, we can see an increase in the amount of defaults and bankruptcies. Therefore, if the lenders do the correct thing, which is to write the bad debt off their books, the money supply will be reduced and that is deflationary. Then, a situation such as the one we are living right now, is mixed up by inverse sentiments and forces.
My personal balance makes me think that the net result is under control with today levels of economic indicators. An increase of inflation is on the tabs, but it would not be a negative sign in the current stream of US economy.
Another technical point which enter into the game but is beside the scope of this post: I expect a slight increase in the velocity of money, which will also contain any inflation pressure to sustainable levels.
A temporary word of conclusion: there is no worries on fundamentals (concerning monetary management) for decreasing further Fed rates in the US or ensuring liquidity. In itself, the level of rates is of no significance. Never forget that what matters is the level of rates versus the income increase [GDP]. This ratio will lead the economy, the monetary balance and the stock to bond indices…