Inflation: Making the Complex Simple
The quarterback signals for the Y receiver in the trips formation to shift left toward the right tackle. At the same time, the running back moves to the quarterback’s right. The slot Z receiver runs a fake jet sweep and doubles back. The left tackle and guard are ready to pull to the right, and the center will counter to the left. A safety creeps toward the line and the Sam yells to the strong-side linebacker to shadow the tight end.

The quarterback drops back and throws a pass up the middle for a 20 yard gain. What looks like a simple football play on television, is a complex choreography of 22 football players, coaches, and numerous strategies.

Humans constantly digest massive amounts of data. To make sense of our surroundings, we summarize data into simple packages. This survival skill is necessary, but it often results in a failure to appreciate life’s complexity.

Like a passing play, the price of a Big Mac may appear to be a simple number. However, the market forces determining its price are complex and often misunderstood. In fact, the most vital force has nothing to do with McDonald’s or its customers. It’s all about the supply and demand for money.

Upon reading this article, and its conclusion, you will understand what drives inflation. Whether we are approaching an inflationary or deflationary environment, being a step ahead of the markets thinking is critical to investment success.

The best-returning trades are those occurring when the market is proven wrong and offsides. we will share some market-based inflation measures to understand the market’s inflation view.

Who Remembers the ’70s?

Ask any investment professional what it was like to manage money in an inflationary environment, and you are likely to get a blank stare. The reason is an investment professional that worked through a period of high inflation in the U.S. is at least 65 years old. As such, experience managing wealth in such a volatile environment is hard to come by. The lack of real inflation era experience may increase price volatility if such an environment emerges. Accordingly, a trying investment environment will be even more challenging to navigate.

While we think the odds of sustained inflation are small, we must be prepared nonetheless. If inflation proves temporary and fades within months, assets being shunned today like long-term bonds and possibly gold offer sizeable returns. If we are wrong, investments that benefit from inflation like miners and energy companies should do well. Regardless, we are on guard for either scenario.

Preparation, first and foremost, involves understanding the drivers of inflation.

The Price of a Big Mac

The price of a McDonalds Big Mac is always expressed in relation to a currency. For instance, in the United States, the price is $4.25.

Like a football play, $4.25 is a simple summary of something more complex. To raise the complexity, we can fractionalize the price to 4.25/1. Whereas 4.25 represents the number of dollars required to purchase 1 Big Mac.

We can further expand on the numerator (dollars) and denominator (1 Big Mac) with the following formula: SD($)/SD(BM). The supply and demand for dollars over the supply and demand of Big Macs.

Now consider, regardless of the supply or demand for dollars and Big Macs, the denominator is always one. A dollar is always worth 1.00. Accordingly, the numerator (dollar price) changes to reflect fluctuations in the supply/demand functions of the dollar and/or the Big Mac.

What happens to the price of a Big Mac if the dollar is devalued by 50%? Despite the cheaper dollar, it is still worth $1. Therefore, only the numerator can change to reflect a price change. In this case, we would expect the price of a Big Mac to double.

In Aggregate

We could devote pages to the multitude of factors affecting the supply, demand, and pricing of a Big Mac. The exercise would explain why the Big Mac price rises or falls versus Burger King Whoppers and every other good and service available. Such analysis is critical to McDonalds, but often overemphasized from a macroeconomic perspective.

Economists cite increasing oil prices as a driver for inflation and stronger retail sales from time to time. They assume consumers will still buy everything they were consuming, yet pay an extra $20 at the pump each week. In reality, consumers often substitute goods and services based on their budgets and needs. Economists often fail to consider the extra $20 spent at the gas pump is $20 not spent elsewhere.

The price of oil may rise, but the price of oranges may fall as consumers spend less on oranges to compensate. What matters most from a macroeconomic perspective is the aggregate price change for oil, oranges, Big Macs, and every other good and service.

To correctly anticipate inflation, we must look beyond the supply and demand for goods and services. The truth lies in the supply and the demand for money. Unfortunately, the supply of money gets the headlines, while its demand is an afterthought.

The chart below shows the forthcoming evidence of inflation used by most inflationists.

The following graph captures monetary velocity for an appropriate view of inflation.

Inflation is a function of money supply but equally critical, the demand for money (velocity).

Supply Demand Curves

Economists use supply-demand curves to visualize how a shift in the supply and/or demand for a good affects prices. As shown below, reducing the production of goods shifts the supply curve to the left. Since demand remains constant in this case, the price rises (P1 to P2). The example is Econo-speak for “the less of something there is, the more its worth.”

The cost of beef, factory capacity, labor prices, and thousands of other factors influence the supply of Big Macs. Its demand curve shifts with the prices of other goods, wages, tastes, and many other factors.

Federal Reserve actions and, equally important, the demand for debt and the banks’ willingness and ability to lend greatly impact the supply of money. All money starts as debt. As such, new debt increases the money supply while debt defaulted upon decreases the supply.

The demand for dollars, also known as velocity, is driven by the aggregate desire to save or spend money. Velocity is essential in determining prices and yet is most often neglected. To better understand velocity, we recommend reading: The Fed’s Inconvenient Truth: Inflation is M.I.A.

How the Dollar Affects the Price of a Big Mac

We present the diagrams below to show the interaction of a Big Mac’s price to shifts in the supply and demand for money. As noted in Part 1, from a macroeconomic view we only care about prices in aggregate. Big Macs in the charts below represent the aggregate price change for all goods and services.  

As shown below, the supply and demand for Big Macs are influenced by many factors. Any change in supply or demand will shift either or both curves, resulting in a new price (black dot).

The supply and demand curve for money, shown below, is not the more common “X” pattern. First of all, the y-axis, or value of money, is always 1. Also, the supply of money is a vertical line, meaning it is inelastic. Supply is not swayed by price, but instead, it shifts on the Fed and banks’ actions. Shifts in the demand line (monetary velocity) are based on interest rates and the change in spending and saving habits.

The following graph shows how supply (blue) shifts right when the money supply increases. This should result in a lower price for money. However, the price of money does not change, so any change is reflected in higher aggregate prices for all goods and services.  Remember, “cheapening” of the dollar does not mean it has a lower price. Instead, it shows up as higher prices of goods and services.  To repeat, a dollar is always worth a dollar.

Since a dollar is always worth a dollar, a Big Mac’s price adjusts for the change in the graph above. The Big Mac (all goods) supply/demand lines shift upwards in a similar fashion. The result is inflation. If demand fell due to higher prices, the orange curve would shift left, resulting in a lower price.

Today’s Money Curves

The following graph illustrates what is happening today. As shown below, a decline in demand (orange-velocity) is offsetting the increase in the money supply (blue). With less money circulating through the economy, it is as if the quantity of money never changed.  

Velocity Matters

On its own, an increase in the money supply is inflationary. However, an equal decline in the demand (velocity) for money completely offsets it, resulting in no change in aggregate prices

The media and those hyping inflation tend to solely focus on the supply of money. Rarely do we hear mention of monetary velocity. We revisit the graph below to show the surge in money supply is nearly perfectly offset by the decline in velocity.

The velocity of money has been in a downturn for the past 25 years. It is occurring due to excessive debt levels, low productivity growth, and poor demographics. The result is declining economic growth.

Looking forward, the surge in unproductive COVID-related debt and more leverage in the system will further impede monetary velocity. Temporary blips higher in inflation are possible due to supply line problems and fiscal stimulus, but the long-term outlook remains disinflationary for the time being.

Summary

Inflation, measured as the aggregate prices of all goods and services, is a function of the supply of money and its velocity. Productivity growth, demographics, and debt trends lead us to believe velocity will continue to counterbalance increases in the money supply. Unless the Fed changes its operations and truly prints money, we must assume prior price trends will extend forward.

Supply line problems and bouts of strong demand due to fiscal stimulus can and will create very short-term bursts of higher prices. However, there is little from a macro perspective to persuade us that long-term inflation is in our future. If our opinion changes, we will promptly inform you.