The Inflation Cycle

The first thing to appreciate is that financial assets have no intrinsic value. You can’t eat or wear a bond or stock, and it won’t heat your home or move your car. Its worth derives entirely from its utility as a claim ticket for things you can eat or wear etcetera.

The same is true of currency. A currency is a financial security like a bond or stock, fundamentally no different than any other security. The differences are actually pretty superficial … currencies pay no interest or dividends, but some bonds and stocks don’t either. The outstanding distinguishing feature is how we use them … especially as a unit with which we measure value of other things.

It should be clear that this isn’t as fundamental as it may seem … it’s primarily a function of convention and habit. There’s nothing preventing you or I from using other units in our accounting, say euros, yen, ounces of gold, silver, or even shares of GM stock. Of course whenever we interact with others, say at the grocery store cash register, or notably the Internal Revenue Service, we will have to acknowledge the unit system they use. Even then, however, it’s still a matter of units conversion. The owner of the grocery store or the vendor whose product we’re buying could very well exchange the securities they receive from us into another form, even shares of GM stock.

This is a key insight into understanding the inflation cycle. When the currency changes value, for instance because it’s issuer floods the market with it, inflation happens immediately. There is no lag. The exchange rate between the currency and other securities in real-time, tick-by-tick markets reflects the reduced value of the currency now. By convention, because our habit is to use the currency as a unit of value, we refer to this change in the rate of exchange between the currency and other securities as an increase in the “price” of the latter.

This creates the illusion that these other securities have increased in value. But in fact it is the currency that has declined in value.

How can I make such a claim? Logic. Go back to our original characterization of securities as claim checks on real goods and services. The total value of goods and services has not changed as a result of the currency’s issuer flooding the market … so the total real value of the entire body of securities cannot have changed. So the increase in prices of these securities can only be one thing – inflation.

We don’t want to believe that though. It’s much more fun to imagine that we, through our ownership of securities like stocks and bonds, have become wealthier. We don’t want to apply a perjorative like “inflation” to it, as it would force us to recognize that we aren’t any richer than we were yesterday. It’s just no fun.

So we don’t. We prefer to pretend we’re richer because our stocks “went up”.

But of course fantasy must eventually be reconciled with reality. As we collectively go to spend our newfound wealth, we discover that it won’t buy any more than it did yesterday. But because it’s not just a day, but a long time that may have elapsed between the time the currency devaluation took place and when we try to redeem our claim checks, we don’t see the connection.

In the interim, there are a multitude of lags between the time the currency was devalued and the time its reduced value shows up in prices at the grocery store or in our rent. Unlike the securities we use as investments, groceries and rents don’t trade in real-time, tick-by-tick auction markets. Our rent may be renegotiated once a year or less. Our wages, which are a large component of the prices we pay for goods and services, may be renegotiated in multi-year contracts. As a result, the devaluation of the currency that took place a year ago, or even a decade ago, may now be just beginning to affect the prices of consumer goods and services. This makes it easy and natural for us to sustain our fantasy of increased wealth due to the currency devaluation. Even highly educated economists don’t realize this, claiming that “some” inflation is “good” for “the economy”.

Let’s take a look at this process in action. In March 2020, the issuer of the US dollar began flooding the market with these securities. They plunged in value. As a result, the exchange rate between these securities and others plunged, resulting in the prices of bonds and stocks soaring. This was widely hailed as a rescue operation that “stimulated” the economy out of its Covid-induced coma. But barely a year later, goods and services appeared to be in a rash of shortages relative to the demand for them. Prices began to take off. This ultimately prompted the issuer of the currency to take action to reduce its supply and restore its value. The “rescue” operation went into reverse, and the currency began to appreciate, reflected first in widespread declines in the “prices” of other securities. As the price effects of this upvaluation work their way through the system, the effects begin to filter into consumer prices and consumer price inflation begins to wane.

We admit to indulging in a bit of oversimplification, however. The currency devaluation that began in March 2020 was hardly the first. Rather it was the explosive grand finale to eleven years of currency depreciation that began in March 2009.  So there remains a much bigger reservoir of inflation that had for over a decade accumulated in securities prices. It will not all be worked off soon, and ultimately not all of it will … some of it will remain in the form of a permanently lower currency and permanently higher prices.

But these many, overlapping and variable lags between the original inflationary impulse and their ultimate effect on consumer prices extend from nearly instantaneous to decades. In the 1950s & 1960s, a long period of dollar depreciation left its imprint primarily in prices of investment assets. In the 1970’s it finally spilled over into consumer prices. The resulting attempt to restrain the latter meant that securities prices were stagnant to down for a decade. The upvaluations that occurred in the early eighties finally washed most of the residual inflation out of goods and services prices. But then a new wave of inflationary dollar devaluations began driving securities prices up again. In the 1980s & 1990s, they again impacted primarily asset prices. Then in the 2000s, they began to filter into consumer goods and services prices, most notably in housing and energy. This prompted another wave of currency appreciation in 2007-2009, which then paved the way for another decade of currency depreciation in the 2010s, capped with the explosive depreciation we described above.

Rinse and repeat. It should be obvious by now, however, what the core economic fallacy is that underlies this entire boom and bust process … the refusal to recognize that asset price inflation is nothing more than the first manifestation of the same currency depreciation that ultimately becomes recognized as “inflation” when it finally, as it must, eventually spills over into consumer prices.

This is the Inflation Cycle.

7 thoughts on “The Inflation Cycle

  1. Bill Terrell says:

    As a coda to the 2007-2009 currency appreciation event we breezed right by, let’s ask why are such episodes so devastating? Why, despite the attempt to gradually reverse the acceleration of unwanted inflation, did it unwind so precipitously and violently?

    Again we return to our assertion that currencies are essentially securities like any other. When they decline in value, short positions accumulate. People shorted the currency against houses, for instance, hoping to profit from the depreciation of currency relative to real estate. These short positions were cascaded into further layers of leverage on Wall Street. When the decline of the currency began to decelerate and ultimately reverse, it triggered an epic short covering rally. This is what the deflationary crash of 2008 was … a short covering rally in the US dollar.

    This is one of the more insidious aspects of inflation and helps us understand why a 2% “inflation target” is doomed to fail. Any attempt to create a nice, smooth depreciation of the currency will invite an accumulation of shorts … taking on debt. Corporations pad their profits by shorting the currency. Government pad their revenue by shorting currency. Unless interest rates are carefully maintained above the rate of currency depreciation these short positions will accumulate. But not everybody can profit from the same short position … it’s a wealth transfer mechanism and if everyone is short there’s no one left to transfer it from. Once the inevitable effects begin to appear in accelerating consumer prices, the attempt to slow them can be like flicking a spark into a pile of tinder. The boom turns to bust.

    In light of all this, how to prevent it is obvious. Interest rates have to be competitive with the rates of return on other securities. Artificially maintaining rates near zero, for example, while the currency is depreciating at 20% annually against stocks or real estate for any length of time is to invite disaster. It is not supporting “financial stability” … it’s destroying it.

  2. Jk says:

    there are 2 arguments that I’ve seen advanced to support a goal of maintaining a low but positive rate of inflation. the irrational one is that our country was so freaked out by the decision of the ’30s that we need to hug the other shoulder of the road. the rational one is that prices, and especially wages are sticky. a little inflation allows them to change price in spite of their stickiness

    1. Bill Terrell says:

      Thanks JK. The irrational argument is plagued by the failure to consider how the 1930s resulted from the policies of the 1920s. My 35000-foot-view rebuttal to the rational one is how well has this been working out?

      Conventional economic thinking has brought the US repeated economic crises, an exploding wealth gap and stagnant to declining living standards for millions of ordinary working Americans it purports to benefit. Things have grown even worse just since the adoption of the 2% inflation target. Its pursuit over the last decade in particular has greatly enriched the already rich, not the average worker. And then there’s Exhibit A: 2022

      At a deeper level, what’s the premise behind the impulse to accommodate sticky wages (which btw I don’t dispute)? It apparently classifies everyone laterally at the same point in their careers, without regard for the fact that even stationary aggregate nominal wages nevertheless mean rising nominal wages for most individuals as their careers mature. Few expect for instance for a forty five year old manager to be earning the same wages he did when he was a seventeen year old burger flipper. Even if aggregate nominal wages are static.

      At an even more fundamental level, what is the justification for a society wide goal of having everyone employed? Strikes me that it’s more to sate the lust of corporations for as many serfs as possible. It can’t be for the benefit of individuals. All else being equal, most of us would rather not work. We spend our entire careers dreaming of retirement. Working “for the man” is not an end in itself, it’s a means to an end. What we really want economically is for our material wants and needs to be satisfied. In a perfect world, machines might provide all of this while unemployment is 100%. Policy is actually fighting progress.

      Then of course we still have the problem of inciting players to game the depreciating currency with the attendant results I’ve just outlined … it creates the very deflation the ads claim it will avoid. Not to mention economists apparently don’t have a clue how to even measure inflation, let alone produce a given rate. It’s a theory that sounds good on the surface, but on both empirical evidence and critical analysis turns out to be erected with shaky logic on dubious premises.

  3. shiny! says:

    “In light of all this, how to prevent it is obvious. Interest rates have to be competitive with the rates of return on other securities.”

    Perhaps less obvious but the elephant in the living room as far as I’m concerned, is the intrinsic flaw of fiat currency itself: that it can be printed at will with nothing backing it. As you have said so often, Bill, it’s an elastic ruler. So I would think the *best* way to prevent inflation would be to return to sound money that’s based on scarcity. It would be incredibly hard and painful, but how much harder and more painful than the mess we’re in now?

    The current global fiat system has been around since 1971. It’s time to step back and look at the results, both good and bad. Some countries are already doing that.

    The BRICS+ are beginning to form a commodities-based method of currency valuation. Perhaps we’ll soon start to see how that works.

    1. Bill Terrell says:

      No argument there, Shiny! You are right. What we’ve done is give a lot of power to a small group of people … given them “tools” that if used honestly, intelligently and responsibly, could be used to help keep the playing field level. The catch of course is in the “if”. Such concentration of power is an invitation to use it to the benefit of the powerful.

      It depends on leadership of the highest integrity and intelligence. We’ve been fortunate on some occasions to have such leadership. But it’s the exception and not the rule.

      So where does my prescription fit in? On the premise of the existing system of unbacked money, because we’re likely stuck with it for the time being. Even when we had a gold standard, we were headed toward it being abandoned. One of the least appreciated disadvantages of a gold standard is that that the rug can be pulled out from under it at any time. It’s likely to be abandoned just when it’s needed most … when it begins to constrain the actions of those who would exploit the financial system.

      It’s not so clear where that leaves us. If the current system is sufficiently abused for sufficiently long it will collapse and a gold standard might again become politically feasible. And it might last for a while … until it got in the way, at which point in time we’d be back in pure fiat mode.

      So I doubt we will ever see a lasting commodity backed currency. That being the case, it’s still to our benefit to try and learn how to live with fiat.

      What’s more, on theoretical grounds we can imagine a monetary unit even better than gold. Even gold is subject to the vagaries of supply and demand and is itself not constant in value. Something even more fundamental is … human time. Gold itself can even be thought of as a way to store the value of human time.

      More to the point though, some of the assumptions of current thinking are so fundamentally flawed they beg for scrutiny, regardless of what monetary system is in use. The notion that limiting our field of prices to domestic consumer goods and services as a reference of currency value, arbitrarily excluding vast swathes of the first responders, is patently absurd. This is something potentially fixable even within the system as it now exists, so worth the effort to explore.

      The passage you quote is calculated to expose just how out of whack current thinking is … that if interest rates are orders of magnitude different than rates of return on competing forms of capital, something is seriously wrong. Regardless of how the system is structured, when we as investors see something this far out of kilter for this long, we can at least be on the alert for the inevitable consequences and take steps to protect ourselves.

      The observation that cash itself is a security not unlike stocks or bonds is of practical value to investors. Once we appreciate that so much of what we see in the prices of everything else is in fact fluctuations in the value of this security, we can use it to our advantage. We can see through the fallacies of financial reporting and gain deeper insight into what’s moving markets. This would apply no matter what monetary system were in use, whether a gold standard, pure fiat, or anything else.

  4. Bill Terrell says:

    An interesting article by Niels Jensen at Advisor Perspectives looks at another angle of this issue.
    Jensen frames it in terms of a wealth-to-GDP ratio. I believe that Jensen is looking at the same thing as we do here, except would argue that the “wealth” he cites is not real … it’s the notional value of aggregate assets.

    The long run ratio of 380% he cites represents the rate at which assets can be converted into real goods and services. To the extent it exceeds this norm, the purchasing power stored in assets (wealth) is illusory … it is due to inflation being manifested in asset prices.

    Jensen’s point about mean reversion translates as our dictum that this gap will be reconciled … either by asset prices coming down or consumer prices rising to meet them … or some messy combination of both.