You will hear a lot of talk about inflation in the financial media. Here are some thoughts about it. I don’t think inflation will rise or if it does that it will be protracted. But I am keeping my interest rate sensitivity low and keeping a keen eye on inflation data. Asset markets have either recovered most of their declines or are even higher than they were before the COVID lockdowns. Given that many countries and industries will not recover their level of economic output until 2022 or 2023, this seems strange.

1. Central banks have been supporting markets, not just the economy. Central banks are not only buying their own debt, they are buying private debt as well.
2. Governments have implemented emergency spending, sending checks to people. Significant portions of this money are being saved which leads to investment in stocks and bonds.
3. Some industries like tech, stay-at-home industries like e-commerce, Cloud and media streaming, logistics and industrial real estate are flourishing. Some are rebounding such as the auto industry and banks. Retail and hospitality and other old economy industries continue to languish.

Item 3 gives us hope that human ingenuity will overcome whatever nature throws our way. This is true to a great extent.

Items 1 and 2 are very important to asset values. Governments can continue to pursue such policies with one caveat. Inflation must not rise out of hand. If it does, central banks will have to raise rates or stop buying bonds. Governments will have to be more fiscally prudent. Either of these will throw the current trend of rising asset prices into reverse.

Inflation snippets:

• Human ingenuity leads to lower inflation. A bet on higher inflation is a bet against human ingenuity, a risky bet.
• Efficiency X Robustness = Constant. Efficiency is disinflationary and robustness is inflationary. De-globalization (whether in the form of trade wars, re-shoring, self-sufficiency,) decreases efficiency and increases robustness.
• Monetary policy cannot influence the real rate of interest. This is determined by the efficiency of the economy. This is the natural real rate of interest.
• Cutting rates can weaken inflation. Cutting interest rates leads to immediately lower real interest rates. However, real interest rates then return to their natural rate. For this to happen, inflation must fall. Conversely, raising interest rates can increase inflation.
• QE is relatively disinflationary. QE is printing money pro rata to assets which is a net relative transfer from poor to rich, increasing the savings rate and decreasing the propensity to consume. This depresses inflation and interest rates.
• Where the national debt is high relative to GDP, countries need low interest rates to maintain manageable debt service. Central banks may take into account national debt service in monetary policy. If so, central banks will maintain low interest rates for the foreseeable future.
• US bond issuers tend to focus on funding up to 5 years, with 10 year and longer maturity issuance tapering off. It is important that the Fed keeps interest rates low up to 5 to 7 years. Maturities beyond that are less important.
• There is an excess of money supply for assets. This has resulted in asset inflation. There is a shortage of money supply for goods and services. This has resulted in low inflation. The Fed cannot differentiate between money for assets and money for goods and services; this is a distinction made by consumers and investors.
• Fiscal policy is marginally inflationary. If fiscal policy involves the net transfer of wealth from rich to poor, it will increase the propensity to consume, encouraging higher inflation. If policy is financed with increased progressive taxation, it could lower aggregate savings leading to weaker demand for assets.
• 24% of the US consumer price index basket is shelter: owners’ equivalent rent. This quantity is flatlining even as other items are rising.
• Governments who have borrowed heavily should welcome inflation to erode the real value of their debts. Goods and services inflation is political risky, but asset inflation is mostly welcome by the people.
• Investors try to hedge against inflation by a) investing in commodities, b) investing in TIPS (inflation linked bonds), c) investing in stocks (tomorrow’s output bought today), d) shorting long maturity bonds while buying short-dated bonds or e) buying floating rate debt.

Why is inflation so low? Why is economic growth so slow despite the efforts of central banks and governments?

One possible view of the world:

The identity MV = PQ is, precisely that, an identity. So as central banks inflate the money supply, why does growth not accelerate, and prices not rise? It must be because the speed of circulation of money slows to compensate for the rise in the stock of money. That is one way of looking at the problem. Another way of looking at it is to divide the money supply into money destined to buy stuff, and money destined to buy assets. In fact, the M in the equation above is not a scalar but a 1X2 vector with elements Ms and Ma. Similarly, V is the 2X1 vector with elements Vs and Va, where the subscripts refer to stuff and assets respectively. The right-hand side is even more complicated as P is a vector of all the assets and stuff one could spend money on, and Q is the vector of all the quantities of such assets and stuff available for purchase.

Looking purely at the market for stuff, one might conclude that the lack of inflation is due to insufficient money supply. Let me repeat that because it is an important distinction: if there isn’t enough money in the market for stuff then the result will be moribund prices and output growth. Looking at the market for assets, however, one might conclude that there too much money in the market for assets and that this is causing asset price inflation. With this distinction the problem facing central banks becomes clearer, even if it may not be any easier to solve. The difficulty is that we do not distinguish between money in the markets for stuff and money in the markets of assets. But can we?

There is one way. Each individual or household privately allocates their holdings of money between money-for-stuff and money-for-assets (cash being a zero excess return asset.) If money was directed or transferred from individuals who allocate more to money-for-stuff and less to money-for-assets then it would mitigate some of the oversupply of money-for-assets and undersupply of money-for-stuff. Since individuals tend to allocate money in a waterfall fashion, satisfying first their need for stuff before turning to their need for assets, simply directing money from those who have more of it to those who have less of it would be a move in the right direction.

There are other ways. Distinguishing between money-for-stuff and money-for-assets is another way. This could be administratively burdensome. An exchange rate would arise between the two forms of money giving rise to other issues. In order for money-for-stuff to be only for stuff, it must be ineligible for purchasing any type of asset, even cash. Excess money-for-stuff will seek to convert some stuff into stores of value (hoarding) thus distorting those markets and creating allocative inefficiencies. It creates the problem of distinguishing between stuff and assets. An object could derive value from being both an asset and a good or service. The scope for parallel financial systems arises which would create both risks and opportunities. One interesting development is central bank cryptocurrency which could provide the basis of the fork in the road between money-for-assets and money-for-stuff. Establishing a correspondence between proof of work and proof of value added could be an interesting way to manage the money-for-stuff supply.

As some individuals accumulate money-for-stuff, from their talent, enterprise or diligence, they may end up with more money-for-stuff relative to money-for-assets than they desire. They will need to convert their money-for-stuff to money-for-assets at an exchange rate, such exchange rate fluctuating relative to demand and supply. In an unequal world, any build up in money-for-stuff will result in an excess supply and the exchange rate moving so that the value of money-for-stuff falls relative to the value of money-for-assets. As money for assets is thence invested in assets, asset prices rise. This obtains the same result as an economy which does not distinguish between the two types of money. In other words, we are back to square one. The markets for stuff will be undersupplied for money relative to the markets for assets. One could fix the exchange rate between the two types of money but then a grey market would arise, among other distortions such as hoarding of quasi stores of value. A tax on assets would reduce the excess demand for assets. Given the waterfall priority of resource allocation, a wealth tax would perform the same function.

I give without proof:

1. All factors of production face diminishing marginal returns to scale except for knowledge.
2. In a knowledge economy, owners of institutional claims on knowledge (equity stakes in businesses) will accumulate wealth faster than suppliers of labour.
3. Increasing inequality is the natural consequence of free markets.
4. Inequality eventually leads to secular stagnation and stuff disinflation.
5. 3 and 4 together imply relative wealth transfers from poor to rich.

I propose without validation:

1. A budget neutral solution to disinflation and secular stagnation is to effect wealth transfer from rich to poor in the form of wealth taxes and living wages.
2. Politically, the probability of this happening is pretty small.

A detailed discussion is too long to fit in the margin, so without justification or validation, here are some forecasts. 

During the COVID lockdowns, schools have been shut and are struggling to reopen. This cohort of students face disruptions to their education which could lead to a future shortage of skilled labour. Labour costs may rise. The wage gap between skilled and unskilled labour will widen. Artificial Intelligence may be drafted to mitigate the shortage. 

Liquid public markets ability to ignore poor fundamentals will encourage more companies to go public. The IPO market will be revived, share buybacks will slow and market capitalisation rise. 

SMEs face credit discrimination as bond markets shrug off difficult times while bank credit gets rationed. Banks may find it good business to securitize SME loans and convert a credit business into a fee business. This will reduce the efficacy of interest rates as a monetary policy tool. 

Supply chains will seek robustness over disruptions arising from natural disasters and geopolitics. There will be a frictional cost to efficiency. 

The most important force of history is likely going to be the China US rivalry. However, just as 1400 years ago when Judaism and Christianity were wrong-footed by a new entrant, Islam, the future may be dominated by a player yet to emerge.

ESG and Impact investing are gaining momentum and will become mainstream. There will be some confusion and evolution before a common framework is accepted. In the transition investment returns could face frictional costs.

Population growth will take a hit due to social distancing. Developed countries already face ageing populations but developing countries may now join them. There will be implications for demographics and long term economic growth. 

The basic and easy stuff

USD will be strong for the foreseeable future.

• USD is a haven currency and as the economic crisis persists or matures, preference for USD will remain.
• USD remains the settlement currency of choice for the vast majority of international trade.
• The US economy is the strongest and is expected to be strong on the rebound, supporting USD.

USD will remain the primary reserve currency for the foreseeable future. RMB will rise to become the number 2 reserve currency over time. EUR has structural issues that threaten its role as current number 2 reserve currency.

• US has deep capital markets to absorb investor demand, satisfying store of value role.
• US has open capital account.
• RMB has semi-open capital account.
• China capital markets not as deep.
• EUR suffers from not having a fiscal union, and thus has break-up risk.

Gold likely to remain strong or strengthen in the near term.

• Record growth in national debts across the world effectively debase currency.

There is always a ‘however’ and these are mine:

I agree that USD will be strong, but consider additional factors. In the final analysis I expect the dollar to be strong.

• Japan’s stimulus is the largest at 20% of GDP, US is currently 11% of GDP and China is 2.5% of GDP. Based on marginal impact on budget, RMB should be stronger than USD. I discount this as I think there are other overriding factors.
• If de-globalization and the regression in international trade continues, and I am pretty confident it will, the largest net trade debtor nation, that is the US, will shrink its trade deficit. This implies a reduction in export of USD increasing its scarcity and creating upward pressure.

I also expect that USD will remain primary reserve currency, however, I also think that the role of RMB as reserve currency will rise more quickly than many expect.

• If currencies are claims on goods denominated in that currency then demand for RMB is under-represented. I think this is a choice by China as much as inertia from the rest of the world. The US economy is roughly 20 trillion dollars nominal and the Chinese economy is 13.6 trillion dollars nominal, trade being 12% of the US economy and 19% of the Chinese economy.

I am less certain about the outlook for gold.

• The gold price has risen sharply this year, precisely in response to the large scale fiscal and monetary policies. However, gold is like an insurance policy and the cost of insurance has already risen in response to the event which has already occurred. Therefore I think gold has become an inefficient hedge for future currency debasement.

Other tangential thoughts.

• As every country expands fiscal deficits, instantaneously to deal with the shutdowns of the economy and more deliberately in a Keynesian reflationary effort, the impact on purchasing power internally (inflation) and externally (exchange rate) will become more acute. The risk to the exchange rate may be addressed through temporary currency pegs very much like Bretton Woods. An anchor currency will need to be identified. Even if there is no agreement, any attempt at a Bretton Woods style system will have implications on FX volatility in the interim.
• Inflation is a serious risk. This is a contrarian view. The immediate consequence of the shut downs is deficient demand and thus deflation. This can very quickly reverse.
  • Supply chains may not be restored quickly leading to shortages.
  • In the longer term, more robust supply chains may lead to longer lasting rising costs and thus inflation.
  • More money for a given level of output is inflationary.
  • The deficits will want financing and taxes are almost certain to rise. If the tax codes are more progressive, and I think they will be, this will be more expansionary and thus inflationary.
  • Finally, when national debt to GDP levels rise to acute levels, the risk of loss of confidence in the sovereign and its central bank rises. This type of inflation is the most dangerous, hyperinflation.

Politicization or weaponization of currencies.

• President Trump’s administration has contemplated the weaponization of the USD. US influence over SWIFT has been used against Iran. Most recently, the US has contemplated selective default against China as sanctions for its culpability in spreading COVID19. The weaponization of the USD would accelerate the search for an alternative reserve currency.
• The EUR is the second largest reserve currency. However, the break up risk is not zero and handicaps its potential role as lead reserve currency. RMB is 3^rd largest in the IMF’s SDR and is also a potential candidate.

RMB as a viable primary reserve currency.

• RMB is gradually being internationalized. RMB was officially de-pegged from USD in 2005. CNH (offshore RMB) was introduced 2009. Market forces were introduced in the daily rate setting of RMB in 2016, the same time that RMB was introduced into the IMF’s SDR basket. China is a long term player and has been gradually and systematically inserting the RMB into the global financial system.
• The RMB as primary reserve currency is also a choice. To achieve primacy China would have to fully open its capital account, and be fully transparent about its money market and PBOC open market policies and actions. China would lose some control over its currency, just as the US has handed control over the USD entirely to market forces (Plaza Accord excepting).
• The primacy of USD as reserve currency was determined at Bretton Woods. For RMB to achieve the same status as the USD, international and institutional support is necessary. If the COVID19 crisis induces such conditions, and the US flubs its hand, Europe and the rest of the world might rally around the RMB as the new anchor.

I think that USD will remain supported but now have signposts that might herald a change, swift or slow, to a new regime and what that regime might be.

At this time of COVID19 pandemic, social and economic disruption and recession, I can see instantaneous deflation due to the demand shock, but I also see a longer term trend of rising prices. This could present investment opportunities, and risks, and would certainly complicate monetary policy.

Given the acute reduction in demand, deflation is the more visible risk. With total and partial lockdowns, people cannot move about to spend, and unemployment is rising so people may have their purchasing power severely impaired. Overlay this with pessimistic sentiment and demand is further reduced. Deflation or at the very least disinflation should occur.

There is always, a however. Prices have been weak for the past two decades mainly from innovation, trade and globalization. Optimized supply chains and production plans mean that for a level of output, costs are constantly being minimized. For this to work, society must choose efficiency over robustness, be willing to trade freely, be happy for free markets to operate regardless of distribution of utility or welfare.

With the global trade war, incepted almost a decade ago but accelerated with the Trump Presidency, productive efficiency will suffer, raising costs.

With the COVID19 induced economic crisis, humans will raise robustness at the expense of efficiency, raising costs.

Governments have greatly increased their national debts to finance emergency fiscal support. These debts will take a long time to pay down. Governments will encourage inflation to erode the real value of their national debts. The high debt levels also risk disorderly devaluations and hyperinflation from loss of confidence.  

In order to finance fiscal stimulus, tax rates will rise and tax codes will become more progressive. The net transfer of wealth from rich to poor will increase the propensity to consume, encouraging higher inflation. A corollary to this is that governments will try to reduce the external purchasing power of their currencies (or improve their terms of trade), which could encourage currency devaluations, which could in turn trigger currency regimes such as Bretton Woods.