All About Inflation

Inflation is one of the scariest words in finance. It is something people have been especially concerned about ever since the Fed started printing money in 2008. You have all seen the commercials telling you to buy gold (or perhaps more recently bitcoin) to save yourself from the impending collapse of the dollar. Since then, we have seen almost no inflation at all, struggling just to get over 2% CPI (consumer price index) growth. At long last, is it finally here?

In this blog, we are going to discuss the current inflation, the types of inflation there are, and what type we may be experiencing. This is a preview to a more in-depth piece we will be putting out in our client newsletter, WJ Notes, talking all things inflation as well as it’s implications on how we manage money.

First, there is no question that we are currently experiencing some amount of inflation. We just saw the biggest month over month change in Core CPI since 1981.

We are certainly seeing signs of wage inflation.

And commodity prices have been soaring, such as lumber (chart as of a couple weeks ago).

So the question is not IF we are experiencing inflation, but WHAT type and for HOW long?

Inflation can generally be boiled down to three types:

1. Supply side inflation: In the last year, examples include various factories having to shut down due to COVID concerns, a shortage of truck drivers keeping goods from getting to their destination in time, and the Ever Given container ship blocking all other shippers at the Suez Canal for over 6 days.
2. Demand side inflation: Sudden shifts in demand influence supply, so the two are often intertwined. For example, everyone being stuck at home has led to a boom in buying “stuff” rather than spending on services or entertainment, like a vacation or restaurant. This rapidly shifting demand puts pressure on suppliers to change their output suddenly, and it can take a long time for this dynamic to balance out. The sudden surge of homebuying activity putting pressure on lumber, or electronics demand putting pressure on semiconductors are a couple examples.
3. Currency Debasement: All types of inflation can be bad (some can even be good), but certainly the most damaging type would be the collapse in the value of the dollar. In this scenario, there may not necessarily be a supply/demand related shock, but for a variety of reasons people (other countries) may lose faith in dollar as being a stable store of value. Examples of this include the infamous Weimar Republic (Germany after WWI) and Zimbabwe. To give you an idea of how bad hyperinflation got in the Weimar Republic, in 1919, one loaf of bread cost 1 mark; by 1923, the same loaf of bread cost 100 billion marks. As for Zimbabwe, they had to create a trillion-dollar bill.

So what combination of the above are we facing now?

The Federal Reserve/Government would like you to believe that current inflation is “transitory.” This means that the inflation we are experiencing are just supply/demand pains coming out of a global pandemic. It will work itself out with time. This seems to be the consensus opinion at the moment, and there’s some evidence to support it.

Although the recent inflation numbers were high relative to the last decade, if we look further back you can see that inflation is still very low relative to history.

About 60% of the latest inflation numbers come from just a few categories, such as lodging and transportation.

In addition, the amount of money the government has paid out directly to citizens is substantial and has no doubt encouraged spending. If you assume these transfer payments are a thing of the past, and people need to get back to work, demand could slide off.

In many ways the transitory explanation makes a lot of sense. We are starting to open the country up after shutting down in some parts for about a year. It is expected that there would be some serious demand fluctuations as well as supply chain disruptions in that environment. With a little time, as supply and demand begin to find their equilibrium, we may go back to the same stable inflation numbers we have been accustomed to.

However, there are many people who believe we are entering into a much more ominous stage of inflation. The basis of this fear is almost always the increase in the money supply, due to the Fed’s asset purchases but perhaps more importantly because of the Government’s direct payments to its citizens. That fear is reflected by the blue line in the chart below.

As you can see, M2 money supply (which is mostly cash, checking deposits and savings accounts) has spiked in the last year. However, you have to pay attention to money velocity as well, which is a measure of how frequently that money is exchanged in the economy (the yellow line). It is extremely low, meaning most of that money is not really doing anything. This helps to keep a lid on inflation despite the rapid increase in the supply.

Of course, that could all change. Velocity could pick up before the supply goes back down and we could find ourselves in a bad situation. But there is another thing to consider when you worry about currency debasement. What is the dollar losing value to?

A currency is always valued in relation to something else. Typically, another country’s currency or some other store of value like gold (or who knows, maybe bitcoin one day). So if the rest of the world were to lose confidence in our currency, what would take its place? Keep in mind, we are the dominant reserve currency for the world. It is hard to imagine what will replace it given the fact that the Euro remains somewhat dysfunctional, and the Yuan remains discredited due to the lack of transparency in China. I do not see us going back to the gold standard any time soon.

So to close, we are of the opinion that the current inflation we are experiencing is “transitory” and the result of coming out of a global pandemic. That is not to say greater inflation fears should be dismissed. There is no doubt we are printing a ton of money and racking up a lot of debt. How and when that becomes a problem however is difficult to predict.