The Flow Of Inflation

Veteran readers know it’s always been a part of the Financology canon that inflation is a decline in currency value that affects asset prices first, consumer prices later. As far as I recall however, we’ve never really dug into why that is or how it happens. It’s not particularly complex, but it does call on one’s powers of abstraction.

First let’s talk about securities in general. The most important are stocks, bonds, and currencies. Each is something that has no utility by itself. You can’t eat them, live in them, or even make them into jewelry to delight your sweetie. Their only use to you is as claim tickets on things that do have intrinsic utility.

They have much more in common with each other than they differ. Stocks and bonds are both obligations of someone else, essentially debts that are owed to the holder. In the case of bonds, the amounts are contractually fixed in advance, with stocks, they are contingent on the financial success and integrity of the issuer. They typically, but not universally, pay the holder some periodic consideration for the use of his capital. In the case of bonds it’s called interest and in the case of stocks it’s called dividends.

Currencies are issued by banks. They too are debt obligations. Like stocks, they may not be obligations to pay anything specific, but historically they may have been backed by silver or gold, and increasingly by government debt … essentially whatever the bank holds on its balance sheet. They don’t usually pay any interest or dividends.

For our purposes here though, it’s what they all have in common that is of primary interest. And that is that their use to the holder is as claim tickets on things that have intrinsic utility. And that their value to the holder ultimately depends on the latter.

This is not merely a theoretical abstraction, but has very practical implications to our axiom about asset and consumer prices.

At any given moment, there is a fixed amount of these things of intrinsic utility available in exchange for these claim tickets. This body of goods and services does not fluctuate with asset prices. There exists tomorrow for instance a certain amount of stuff in the world. The purchasing power of the sum total of all the securities … stocks, bonds, currencies … is equal to the amount of stuff available for purchase.

If for example the price of stocks increases by 5% between today and tomorrow, the value of this total is unchanged. This means the purchasing power of bonds+currencies must have declined. If the prices of stocks and bonds have both increased, the purchasing power of currencies must have decreased.

Now let’s turn to the differences between these types of securities. When we go to redeem our claim tickets, we don’t ordinarily exchange stocks or bonds directly for these things of intrinsic utility. We first exchange them for currency, then exchange the currency for the latter. The distinguishing characteristic of currency is hinted at by the name we give it … it is the asset we use for current consumption.

Stocks and bonds, on the other hand, are used almost exclusively to store purchasing power for future use.

At this point it may begin to become clear why declines in the value of currency show up first there, and how stocks and bonds in effect can serve as a reservoir to store inflation only to later become apparent in consumer prices.

When the purchasing power of a currency first declines, prices of stocks and bonds rise. For starters, consumer goods and services don’t trade in real time auction markets, where prices adjust instantly, tick by tick, to changes in the value of currency. And people’s consumption needs aren’t instantaneously affected by them either. If you were going to buy a ham sandwich today or a washing machine tomorrow, your plans aren’t going to change just because the central bank created a billion new dollars overnight. And chances are you didn’t receive any of those dollars either. Instead, what you will notice, if you have them, that the prices of your stocks and bonds rose. This is purchasing power that you will use later.

But all the while, the total purchasing power of all the world’s securities is unaffected by their relative values. It is affected only by the body of goods and services available for purchase. So increases in the value of stocks and bonds equate to decreases in the value of currencies. So long as this purchasing power is stored for later use, however, the decreases are not obvious.

So the initial effect of a decrease in the value of currency – inflation – is to create the appearance of an increase in prosperity. As long as you’re not trying to spend it, you are able to assume that you have gained wealth. This is an economy-wide effect. Society believes its wealth has increased. Yet aggregate wealth is unchanged.

We’ve seen this effect empirically in broad cycles over economic history. First asset prices rise, then consumer prices. Asset prices may then fall as policymakers belatedly attempt to counter the rise in consumer prices. Asset prices rose strongly in the 1950s-1960s. In the 1970’s, consumer prices surged, while asset prices fell. Asset prices rose in the 1980s-1990s. In the 2000’s, consumer prices rose and asset prices fell. In extreme cases, the effect can be seen over shorter time frames. In 2020-2021, asset prices soared. In 2022, consumer prices followed suit, as asset prices fell. In all cases large increases in asset prices are either reversed or consumer prices rise to meet them. Or some messy combination of both.

In sum, broad increases in asset prices represent the first obvious sign of inflation. They are perceived as a sign of prosperity, but in fact reflect a decrease in the value of the currency, which will later either be reversed or show up in consumer prices.

Or some messy combination of both.

10 thoughts on “The Flow Of Inflation

  1. jk says:

    from luke gromen:

    For the near-term at least, our high conviction in the impossibility of the Fed engineering a soft landing was tempered dramatically last week when we first learned of CPI methodology changes that go into effect beginning next month. We simply had not considered that, when given the choice between “Let UST markets become dysfunctional” or “Resume QE despite elevated inflation,” US policymakers could create a third option: “Change the way CPI inflation is calculated.”

    Or, as Jean Claude Juncker said, “When it becomes serious, you have to lie.” We now believe that for the near term at least (the next 1-2 quarters?), the odds of the Fed engineering a soft landing may be higher than consensus believes. Why?

    US BLS methodology changes for CPI that were discussed but not implemented in 2021 (when inflation was still considered transitory) will now be implemented next month:

    In August 2021, the BLS announced interventions were considered to mitigate possible measurement errors caused by the COVID-19 pandemic during 2020, but the standard biennial update procedure was ultimately chosen.
    -US BLS, 2/25/22 (when US policymakers still believed “Inflation is transitory”)

    Starting with January 2023 data, the BLS plans to update weights annually for the Consumer Price Index based on a single calendar year of data, using consumer expenditure data from 2021. This reflects a change from prior practice of updating weights biennially using two years of expenditure data.
    -BLS, 5/24/22 (when US policymakers realized “Inflation is no longer transitory”)

    Beginning with January 2023 data, BLS plans to adjust the weighting method for Owner’s Equivalent Rent (OER) in the CPI. The new method will use neighborhood level information on housing structure types to weight OER’s unit sample observations.
    -BLS, 9/2/22 (when policymakers realized “Inflation is no longer transitory”)

    1. Bill Terrell says:

      So the definition of “soft landing” is changed by changing the definition of “2% inflation”. It’s comforting to know conventional economics jargon is just as clear and solid as the thinking behind it.

      We’ve talked before about the government’s incentive not only to inflate, but to inflate the gap between actual inflation and the CPI, so have been expecting another wave of alarming consumer inflation to prompt more statistical tinkering with the CPI. This would just be the latest in a long series of deception attempts dating back to the Boskin Commission. Many of the government’s obligations are indexed to the CPI, so from the government’s viewpoint the fiscal benefit of inflation is lost for this portion of its expenditures, where it works only to the extent inflation exceeds the CPI.

      But if Gromen is suggesting it will change economic outcomes, I disagree. Changing how much inflation is reported has no effect on how much inflation there is. It’s not even clear it would affect monetary policy. The Fed’s preferred gauge of inflation is the PCE deflator, and if he’s connecting the dots that far I’ve missed it. The Fed also looks directly at wages. And more to the point of this post, it’s even looking at asset prices.

      Also a newfound determination to rein in inflation is hardly unique to the US Fed. Of the “developed” world’s central banks, only Japan’s BoJ hasn’t yet joined in, and it’s showing signs of cracking.

      The public of course looks at gas prices, grocery prices, utilities, rents, medicine, etcetera, without benefit of a bureaucratic filter.

      This of course doesn’t mean the Fed isn’t under under tremendous pressure from both the financial and political establishment for easier money. We can even add to Wall Street and Washington the powerful Silicon Valley lobby. The average American doesn’t have much of a voice unless the Fed decides it wants to hear it.

      Although it’s possible the Fed is more keen on saving the bond market, which depends on maintaining a modicum of confidence in the US dollar.

      Fortunately in light of the above post we can not only know how much inflation there really is, but we can know it well before it registers in consumer prices, regardless of how honestly or dishonestly the government reports them.

      Finally, this is not a “soft landing” yield curve. And the much balleyhooed UST market dysfunction is a tempest in a teapot. UST have been in a bull market since October. The most visible risk to UST is the administration’s threatened refusal to negotiate over the debt ceiling.

      I continue to believe the Fed will hike 25 bp February 1 and maintain QT at the current pace. It’s quite possible that‘s it for this cycle, but if so it will because stock prices hit new lows, giving it the tightening of financial conditions it’s been seeking.

      Meanwhile the stress on the government’s fiscal weal from higher rates is greatly exaggerated:

  2. Llanlad2 says:

    Thanks for the clear explanation on drawing a line from asset price inflation to consumer inflation.
    Regarding the debt service problem, can a line be drawn from inflation (excess money creation) to increases in taxes?
    Looking at the 1940s , money was created to fight a war but taxes were increased massively and stayed high for decades.
    There always seems to be an argument that taxes fund govt spending. Is it possible that excess govt spending funds taxes and taxation is an inflation control tool? Can we expect higher taxes especially on capital gains?

    1. Bill Terrell says:

      Thanks Llanlad; great question. I’ve never really thought about that. But we can use the same framework to sort it out.

      The basic principle is the aggregate purchasing power of all securities is equal to the body of goods and services available for purchase.

      The latter changes very little compared to the relative value of each of the kinds of securities (stocks, bonds, currencies), so changes in the value of any of these are offset by an equal and opposite change in the value of the others.

      So what happens when the government spends? Each unit of purchasing power spent by the government has to come from somewhere else … someone else’s purchasing power must be reduced by a like amount. Taxes represent the direct route to transfer this purchasing power to the government.

      What about the rest? When the government spends more units of purchasing power than it takes in direct taxes, the remainder still has to come from somewhere. The total purchasing power of all securities must decline.

      If no new currency is created, the purchasing power of other securities (stocks+bonds) must be reduced. At the opposite extreme, if all the excess spending is funded by currency creation, it all comes from a reduction in the purchasing power of currency. We call that “inflation”.

      The bottom line is that all purchasing power spent by the government is offset by a reduction in purchasing power somewhere else. The net effect is that the purchasing power of labor is reduced. If it’s not taken in taxes, it must come from some combination of reduction in the purchasing power of securities.

      People resist having their purchasing power taken. Direct taxes are the most obvious route, so governments resort to more covert means via deficit spending. It may initially appear nearly cost free, but the longer it goes on and the greater the deficits, the more noticeable these other purchasing power losses become, and eventually there may be enough political pressure to resist those as well. So the government comes under pressure to constrain spending and increase direct taxes. The mix of each is politically determined.

    2. Milton Kuo says:

      >Is it possible that excess govt spending funds taxes and taxation is an inflation control tool?

      If I understand it correctly, Modern Monetary Theory directly expresses taxation as the primary means of controlling inflation.

      It makes sense from a certain perspective but one must consider what the government will do with the income from taxation. In all likelihood, government departments will spend any sort of windfall they have to prevent their budgets from being reduced in subsequent years. (“You didn’t spend all of the money in your budget so it’s obvious you don’t need that much money. We’ll give you a smaller budget next year.”) It takes a fairly disciplined and honest government to pay down debt with the extra tax money.

      1. Bill Terrell says:

        100% agreed, Milton. I want to point out that MMT’s take on taxes is equivalent to what I just said … whatever the government spends that is not taken in taxes is taken by inflation.

        MM theory is solid … it’s MM practice that’s the problem. If you’re looking for honest government, you won’t find it here. At least with direct taxes, politicians must confront voters with the bill for their programs, wars, etc. Inflation attempts to hide the cost as voters pay at the gas pump, grocery store, monthly rent, utilities, etcetera, with the vast majority having no clue where their lost purchasing power is going.

  3. Llanlad2 says:

    Thanks for the above. As if to prove how much we can trust the govt to be prudent
    I just read this regarding UK govt borrowing hitting a record.
    “The Office for National Statistics (ONS) said inflation was the main factor behind the rise in borrowing.”
    I’m guessing here at Financology the second half of that sentence would be the other way round. Crazy.

    1. Bill Terrell says:

      Haha yes … the other way around. Of course I’ve simplified things a bit to illustrate the general concept, but it’s practically tautological that real government spending must reduce real private spending by a like amount.

      Two particulars to note. First, this can come about through purchasing power reductions of any of the securities universe – mostly bonds, stocks and currencies – how these reductions are distributed can vary. If for example no new currency is produced and the value of the currency is maintained, it can come about though reductions in the purchasing power of stocks and bonds … prices decline and yields rise. If in contrast the banking system monetizes the borrowing (more common), it comes about through currency depreciation aka inflation. So failure of stock and bond prices to decline with government deficit spending is prima facie evidence of monetary inflation in the banking system.

      Second, it is exactly true only on a global level, because the global economy is a closed system. It is approximately true on a national level; national economies are open systems where there can be net inflows and outflows of goods and services. Global flows tend to keep national economies in equilibrium over time, but there can be limited departures for limited times for national economies.

      In general though it’s an iron law, almost like a law of physics. You can’t consume what hasn’t been produced, so aggregate purchasing power is exactly equal to the aggregate body of goods and services available for purchase. That changes remarkably little in comparison to changes in security values … population increase increases global GDP but there are proportionally more consumers too, so net per capita GDP is unchanged. The only variables are the per capita natural resources (which decline with population growth) and technological advance (which allows real production costs to decline). Factors commonly cited by conventional economics like monetary policy and fiscal policy have almost nothing to do with it … they only change the distribution of purchasing power between different types of claim tickets and move it around. Because of the lag before inflation is obvious in consumer prices, inflation at first looks like “growth”.

      Alas the more they do so, it tends to disconnect consuming power with producing activity for economic players and consequently disincentivize production and depress living standards in the aggregate. What’s more, because the wealthy have the most influence over monetary and fiscal policy the redistributing effect of these policies generally favors the wealthy and expands economic inequality. It’s no mere coincidence for example that the explosion in monetary activism by central banks after 2008 was accompanied by a like explosion in the wealth gap.

      The bottom line: Government’s take of purchasing power in the economy is not measured by how much it taxes, but by how much it spends.