Poking The Inflation Monster - The Parts Of The Beast

Summary

• We start the discussion on inflation by bringing you the analysis of the tried-and-tested forces of inflation.
• We go over how the three major forces that control inflation are intersecting today.
• This is Part 1 of a series we are writing on risks of inflation.
• We set up Part 2 of our series where we will explore the bigger risks for even higher inflation down the line.
• Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »

Co-produced with Trapping Value

We are currently in a very low inflation environment that is likely to remain with us for the next 24 months. However, following COVID-19, a perfect storm is brewing that would very likely result in higher inflation as soon as the year 2022. This inflation could be very significant and erode your savings. This is Part 1 of a series of articles whereby we explain why inflation is set to go higher (or possibly much higher), and how to hedge against it.

With COVID-19 being firmly the story du jour, you could be forgiven for focusing on little else. We, however, have also been noticing an economic indicator rearing its expensive head, the possibility of inflation. We will tell you why we have started thinking about this in earnest. We will also give investors a brief primer on the forces that are intersecting to create inflation and those that are counteracting it. In a series of articles, we will break down what we think the outcome will be and also stress the time frame over which we expect a resolution.

Where Exactly Is Inflation?

The pandemic has created an extremely sharp pullback in demand for most items. We did see the initial stockpiling effects as stores ran out of essentials, but that was simply a pulling forward of demand. On the whole, demand has cratered, and consumer spending, even assisted by huge government spending, has plunged. Hence, it is no surprise that we are seeing every single aggregate inflation measure collapse. The Consumer Price Index, or CPI, (excluding food and energy) showed its biggest month on month drop.

Source: Bloomberg

Based on that, investors must be wondering why we would even touch a topic like inflation when the opposite appears to be the path. That is a key question we need to tackle. For that, though, we need to explain how the economic forces are interacting to change prices at the consumer level.

Inflation Force 1: Demand For Goods

Inflation is created at the apex where three forces intersect. The first is the demand for goods. As we saw clearly during the pandemic, on shorter timescales, prices are firmly set by demand. As demand for oil collapsed with airlines being grounded, some benchmark oil prices briefly went negative.

Source: New York Times

On the other hand, as demand for hand sanitizers and face masks went parabolic, prices went up 1,000% in some cases. Below, we show Governor Gavin Newsom documenting the rather absurd pricing on Purell.

Both events happened rather close to each other, showing that prices don't move homogeneously across all items. Both also show that demand generally rules the day on shorter time frames as supply response times are slower. Today, this is still the primary driver, as overall demand has tanked for a large variety of goods.

Inflation Force 2: Supply Of Goods

In both cases cited above, things reversed rather rapidly as supply responded each time. Negative prices incentivized widespread shutdowns of oil production.

The U.S. oil industry reacted to cratering oil prices by cutting production by 900,000 barrels a day in just a month in what appears to be the biggest one-month decline since the Great Recession. U.S. government data shows that U.S. production fell to 12.2 million barrels a day last week

Source: CNBC

Alongside that, OPEC cut production by a rather hefty 10 million barrels a day. Hence, just as everyone was making absurd claims about where oil prices would go, the reverse happened.

Source: Bloomberg

Oil prices literally bottomed as the whole world bought into the silly notion that producers with large operating costs will produce oil and pay people $100 to take that barrel away.

Source: DailyFx

Just as oil's woes were cured by the supply side response, so were the problems in hand sanitizer prices. Massive markups redirected supply chains to manufacture large amounts of hand sanitizers. The supply of existing and new (with Aloe Vera no less) hand sanitizers exploded. In cases where firms had excess capacity (due to loss of demand of other items), that excess was also directed towards manufacturing items to keep our hands germ free. The results showed.

Source: Amazon

Prices have normalized to a large degree as demand and supply moved rapidly into balance.

Inflation Force 3: Supply Of Money

According to the Austrian school of thought, inflation is always a monetary phenomenon. In other words, you cannot really have inflation unless the supply of money increases. A simple way to think about it is, if everyone suddenly had twice the money they previously had and the supply of all items remained the same, prices would overall double in order to match supply of money with the supply of goods. So, increasing money supply should theoretically increase prices. Globally, the supply of money has exploded as central banks have created digital dollars at an ever faster pace.

Source: Forbes

In the U.S., the Federal Reserve has started buying high-yield bonds and treasuries at an unprecedented pace.

Source: Banking Strategist

The Federal Reserve has slowed down this pace recently, but it is still expanding its balance sheet at an annualized rate of $2 trillion. It is this factor that will be key to determining where ultimately prices go.

Why We Have Not Had Serious Inflation...Yet

It is not uncommon for investors to buy into conspiracy or doomsday scenarios. A cursory glance of the web shows how much attention the Federal Reserve balance sheet gets. However, there are quite a few reasons that the balance sheet expansion has been neutered. First, we have a serious decrease in consumer ability to purchase goods as unemployment has gone vertical. While the lagging official rate is at 14.7%, we may ultimately hit a brutal 25% mark in the United States.

Source: BLS

This represents a serious headwind to inflation at least in the short term. Coupled with this, the US consumer decided to save at a rather extraordinary pace to deal with the pandemic.

Source: Statista

This again represents a serious loss of demand for goods and the expansion of the monetary base loses its effectiveness as consumers are reluctant to chase goods. Bank credit has also been contracting and loans are harder to come by.

If you're looking to buy a home it might be a little harder to get approved. New JP Morgan Chase customers will have to come with better credit and more cash.

A 700 credit score is the starting point, plus a 20 percent down payment of the home's value is what the bank is looking for in an applicant.

Industry experts say as the economy's future remains unknown lenders are shying away from high risk borrowers.

"Meaning they're going to have to have some money to put into the transaction. Their credit scores are going to have to be at certain levels, they're job will hopefully be restored or they never were laid off," said Diversified Members Credit Union Lending VP J.R. Smith.

Lenders say the shift can be attributed to widespread unemployment and a slump in the housing market.

Source: CBS

So, while the M2 Money supply has moved up, the cash is not creating inflationary effects as downstream participatory factors are conspicuously missing.

Conclusion

Ignoring the shorter-term demand and supply factors which generally resolve soon, we have seen the setup for inflation via a very high growth of money supply. On the flip side, consumers don't want to borrow, and financial institutions are reluctant to lend. Until that fact changes, the potential inflationary cycle will remain in hibernation. However, there is definitely a storm brewing under the surface, and the potential for serious inflation is very high. We will look at what could be that spark and how it will likely play out in the next part of this series.

For income investors and retirees, inflation is a major risk as it can erode the value of your hard-earned savings. In the final part of this series, we will highlight the best asset classes to own in order to mitigate against this risk. Inflation is coming back. Higher inflation is not a matter of "if", but rather a matter of "when".

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.