3 Types Of Inflation, And How They Impact Your Portfolio | Seeking Alpha

Summary

Inflation comes in three main forms: monetary inflation, asset price inflation, and consumer price inflation.

A look into the forces that can cause the various types of inflation.

Tying the current economic climate into sociopolitical risks and changes, as it relates to an investment portfolio.

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This article focuses on the topic of inflation.

It’s often described as though it’s binary- either inflation is rising or its falling. However, there are multiple types of inflation, and they have different causes and different outcomes on asset classes, so this newsletter walks through some of the nuances.

Having an idea about forward inflation or deflation potential is critical for establishing which asset classes are likely to outperform in the 2020’s decade.

Three Types of Inflation

How economists define inflation in part depends on what school of economics they come from. For the sake of this piece, I’m going to break it down into three different types: monetary inflation, asset price inflation, and consumer price inflation.

1) Monetary Inflation

Monetary inflation generally refers to an increase in the broad money supply, known as M2. In other words, it’s not about prices going up; it’s about the amount of money itself going up.

Broad money supply, M2, refers to all of the various bank deposits that exist in the system, like checking accounts and savings accounts, as well as physical currency in circulation. The official broad money supply in the United States is currently about $18.8 trillion.

This chart shows the broad money supply over time in blue on the left axis, and the year-over-year percent change in that broad money supply in red on the right axis:

Chart Source: St. Louis Fed

There are two main forces that drive the broad money supply up over time: either banks make more private loans and thus create new deposits, or the government runs large fiscal deficits and has the central bank create new bank reserves to buy large portions of the bond issuance for those deficits. I walked through this process in my article on banks, QE, and money-printing, so if you haven’t read it, that’s a key resource.

Monetary inflation is generally a starting point for the next two forms of inflation: asset price inflation and consumer price inflation, which we feel more directly.

2) Asset Price Inflation

Asset price inflation refers to the prices and valuations of financial assets, like stocks, bonds, real estate, gold, fine art, and fine wine, increasing over time. These are things that can be held for long periods of time and tend to appreciate in price.

There are multiple ways to measure asset valuation, and I use several of them throughout my newsletters and articles. None of them are perfect, which is why I use several to see if they agree or don’t agree. Pretty much any valuation metric for U.S. equities suggests significant overvaluation this year and for the past few years, with the exception of the equity risk premium vs Treasuries. In other words, stocks are historically expensive, but bonds are historically even more expensive.

Collectively, asset prices have never been higher than they are now, compared to GDP. Here is U.S. household net worth as a percentage of GDP in blue, and short-term interest rates in red:

Chart Source: St. Louis Fed

Household net worth includes stocks, bonds, cash, real estate, and other assets, minus liabilities like mortgages and other debts. That chart goes through Q2 (the latest z.1 financial accounts release, which comes with a lag), so we’ll see a bit of a pullback in the blue line for Q3 numbers because GDP rebounded in Q3. Household net worth reached nearly 550% of GDP before the pandemic, briefly shot up over 600% in Q2, and should return to somewhere around 550%-575% in the Q3 report, because GDP partially normalized.

Another broad valuation indicator that I don’t cite frequently is Tobin’s Q Ratio, which compares the broad equity market value to the replacement value of the companies. This excellent chart from Advisor Perspectives shows Tobin’s Q on the bottom, and shows the inflation-adjusted S&P 500 on the top:

Chart Source: Advisor Perspectives

Here’s another chart that shows asset price inflation. It has the gold price in red (asset price inflation), the median house price in purple (asset price inflation), the money supply per capita in blue (monetary inflation), and the consumer price index in green (consumer price inflation), all indexed to 100 in 1995:

Chart Source: St. Louis Fed

As we can see from that chart, gold has kept pace with monetary inflation, which has greatly outpaced the official consumer price index. Housing has also greatly outpaced the consumer price index, but not by quite as much as monetary inflation. If I were to put stocks on that chart, even with dividends excluded, they would also have greatly outperformed consumer price inflation, due to major increases in average stock valuations over this time period.

3) Consumer Price Inflation

Consumer price inflation refers to the prices of everyday goods and services going up in price, for things ranging from food to medical costs. It overlaps a little bit with asset price inflation in the housing sector, but for the most part, refers to non-financial items.

Consumer price inflation is challenging to measure, because you have to define a basket of goods and services to measure as an average. No household has an identical basket of expenses; my household expenses have a different percentage of housing, transportation, food, travel, clothing, healthcare, electronics, and automobiles, than yours does.

And then, there are methodological differences, including how substitutions are calculated. Many people argue that official measures of CPI somewhat understate the real inflation rate, and I agree.

As an exercise, I calculated that my household inflation rate averaged about 3% over the past two years, from summer 2018 to summer 2020, which is above the official CPI, but lower than some of the other measurements out there.

It’s starting to get interesting this year, though. As an anecdotal data point, my husband and I bought a mattress in December 2019, and due to some damage, we had it replaced in November 2020, 11 months later. We liked the mattress, so we got the identical version, except now it’s 20% more expensive than our original purchase. On the other hand, things like gasoline are cheaper.

This chart shows the consumer price index going back to 1913, with a notable period marked:

Chart Source: St. Louis Fed

What that chart shows, is that something that cost $100 in 1982, would cost $260 today, and would cost about $10 in 1913. The price of a basket of goods, in other words, has risen by about 26x from 1913 to today in dollar terms. Breaking that down further, it rose by about 4x from 1913-1971 when Nixon took the U.S. off the gold standard, and about 6.5x from 1971 to the present.

It also shows that the CPI trend turned up prior to the gold standard being undone; the monetary system began having major issues under the surface prior to the official devaluation.

To give a bit more granularity, this chart shows the year-over-year percent change in the consumer price index, which is what we generally refer to as “inflation”.

Chart Source: St. Louis Fed

Prior to 1971, there were both periods of inflation and deflation. Since 1971, there have been periods of inflation, but barely any periods of deflation.

Inflation Relationships

Now that we’ve defined the three main types of inflation, we can move into why sometimes one goes up but another does not. A rapid increase in the broad money supply usually comes with either asset price inflation or consumer price inflation, and a few variables can affect which of those two it mostly causes to go up.

This is because when money supply goes up rapidly, it only causes an increase in the price of assets or goods if there is a situation with too much money chasing too few assets and goods, resulting in a supply-vs-demand imbalance.

On the other hand, if the quantity of those assets and goods goes up rapidly as well, then there is no supply-vs-demand imbalance, and thus no reason for prices to go up at any substantial rate, even though the amount of currency units is going up.

Asset Price Inflation vs Consumer Price Inflation

Substantial asset price inflation often occurs when monetary inflation is substantial, interest rates are also quite low, and labor and commodity costs are controlled at relatively low levels.

Or, a blunt way to think about asset price inflation, is that it’s consumer price inflation for the wealthy and upper middle class who own most of the financial assets.

If the broad money supply is going up quickly, and the top few percent of the population have their incomes going up quickly, then they will be flush with cash, and they have to put it somewhere. Most people don’t want to hold their net worth in cash, especially if interest rates are low. And when interest rates are low, it means the discount rate that we use to value various financial assets is low, and so the subsequent valuation calculation can result in rather high prices for financial assets.

For example, if interest rates for bank savings accounts and Treasury bonds are 5% per year, then a dividend stock that pays a 4% dividend yield and grows at 4% per year is only moderately attractive; its annual returns will be slightly better (about 8% total) but with more volatility and risk. However, if interest rates for banks and Treasury bonds are only 1%, then suddenly that dividend stock looks a lot more attractive, and we would pay higher prices for it, drive the valuation ratio up, the dividend yield down, and thus drive the forward returns down.

So, when the money supply is going up and interest rates are low, folks with plenty of cash start buying financial assets, such as stocks, bonds, real estate, private equity, gold, fine wine, and fine art. These assets have inherent scarcity, and so as money supply goes up while interest rates stay low, the prices of financial assets tend to do very well.

There is an age-old battle between labor and capital; the working class vs the wealthy. Over the very long run in a given society, the pendulum tends to swing strongly in one direction to the point where it causes societal issues, and then society pushes it back in the other direction where it tends to overshoot in that direction instead, until society pushes it back the other way again.

A healthy society finds a balance somewhere where both sides are reasonably satisfied, resulting in high productivity and social cohesion. A pendulum that is too far in one direction or the other tends to cause discontent, economic stagnation, and/or unsustainable bubbles.

Periods of substantial wealth concentration, like the 1920’s and 2010’s, have generally been environments of high asset price inflation but relatively low consumer price inflation. These are periods where capital interests have a lot more political power than labor interests, whereas the 1960’s and 1970’s were times when labor unions had a lot more political power.

Over the past four decades, the capital side has gained most of the political power, so that’s where the pendulum is at the moment. This is because things like labor offshoring and technological advancements put downward pressure on wages for many people, while shareholders, executives, and highly-paid professionals with in-demand skillsets can prosper within that system. Tax changes further supported this trend, where corporate tax rates and top income tax rates came down, while payroll taxes remained high, and per-capita healthcare costs and childcare costs skyrocketed:

Chart Source: St. Louis Fed

The reason the pendulum tends to swing too far is because when one group gets power, it becomes a self-reinforcing cycle into cronyism, where those with power and influence can further tilt politics in their favor and thus further entrench themselves, until it causes a breaking point and society unwinds that entrenchment.

In addition, periods of commodity abundance and thus low commodity prices can support periods of high asset prices and low consumer prices as well, because it helps keep input costs for finished goods low.

With that set of variables combined at the moment, the high end of the income spectrum does well and has plenty of money, while the lower and middle portions of the income spectrum remain cash-constrained. So, a lot of money starts chasing scarce goods among the wealthy (leading to a large increase in the price of financial assets and luxury goods), while money remains tight for everyday consumers (leading to a smaller increase in the price of everyday goods and services, particularly those that are non-essential). Essential costs like healthcare and childcare keep going up.

We can see over the past thirty years, for example, that the top 1% have gone from having 23% of the wealth to a little over 30% of the wealth, while the bottom 90% decreased from having about 40% of the wealth to a little over 30%. So, the top 1% combined now have the same amount of wealth as the bottom 90% combined:

Chart Source: St. Louis Fed

And if we split that into the top 10% and bottom 90%, it looks like this, where the top 10% have two-thirds of the wealth, and the bottom 90% have the remaining one-third:

Chart Source: St. Louis Fed

This relationship is positive for asset prices, because cheaper labor and cheaper input costs are beneficial for corporate profits, and as wealth concentrates into the top few percent of the population, it gets stored more and more in financial assets which drives the valuations up.

In addition, there has been a rapid increase in CEO pay over the past four decades. CEOs used to make 20x as much as the average worker in 1965, and that ratio moved up to 59x by 1989, 122x by 1995, and in recent decades has been well over 200x as much as the average worker.

Meanwhile, the median male worker has a lot more trouble covering key family expenses than he did back in the 1980’s and 1990’s, mainly due to health care inflation and education inflation rising more quickly than his wages:

Chart Source: Washington Post, Oren Cass

I explored other aspects of this situation in my article on tax policy as structured for the past few decades.

Trends like this generally lead to rising populist politics on both the right and the left of the political spectrum (cracks in the system emerging from the pendulum swinging very far), as people sense that something isn’t working right with the established system, due to a problematic mix of political and corporate interests merging together into cronyism, but differ in what they think the root of the problem is and how to address it.

So, we are in an environment of unusually strong political polarization, as well as political challengers to the established system.

We can think of it roughly as a political quadrant in the United States, with Populist Left, Established Left, Established Right, and Populist Right, rather than a simple Left-vs-Right spectrum. And then even within those four quadrants, there are multiple sub-groups.

Monetary Inflation vs Consumer Price Inflation

If we look back over a full century, there is a significant correlation between monetary inflation and consumer price inflation.

This chart shows the 5-year rolling percent change of the broad money supply per capita in blue and the consumer price index in orange:

Data Source: Federal Reserve

This chart shows the inflationary decades of the 1940’s and 1970’s, where both money supply and consumer prices rose quickly. 2020 is starting this decade out by reaching those historically high money supply 5-year percent growth levels, while official CPI remains low. Big expenses like housing, healthcare, education, childcare, and other non-outsourced expenses tend to be more in line with monetary inflation, giving people a sense that inflation is higher than the broad CPI reports that it is.

In some ways, 2020 looks like the mid-1960’s, where there was a pretty wide divide between money supply growth and official CPI growth. Back then, the result was that CPI started to catch up with broad money supply growth in the late 1960’s and then shot up quickly in the 1970’s. It remains to be seen if that will happen this time or not.

After the 1960’s which had moderately high asset prices, the 1970’s inflationary period saw rather low asset prices for most financial assets, except gold and silver which did very well. This was because interest rates became very high, which meant the discount rate when valuing stocks and other cashflow-producing assets led to rather low fair valuation estimates for those wishing to take on equity risk. That was, of course, ultimately a great time to buy financial assets, because as inflation was eventually brought under control, interest rates began a four-decade structural decline, which led to the massive boom in asset prices that we’ve enjoyed since then.

Monetary Inflation Outlook

My base case is for continued fast growth of the broad money supply per capita over the next 3-5 years, perhaps at 8-12% or more per year on average.

This is because federal fiscal deficits continue to be very large for structural reasons even without further large stimulus, and big portions of those deficits are being monetized by the Federal Reserve rather than extracted from existing pools of capital, which is generally what happens when sovereign debt as a percentage of GDP gets this high.

This widening fiscal deficit began happening pre-pandemic, and the pandemic sharply blew it out, much like a war:

Chart Source: St. Louis Fed

Here’s the single-month October 2020 U.S. fiscal situation:

Chart Source: U.S. Treasury Department

As of now, the deficit is structurally impaired for years, and thus will likely continue growing the broad money supply at an eyebrow-raising pace. The question becomes whether that money will spill mostly into financial assets, or into consumer prices.

3 Catalysts For Consumer Price Inflation

As previously shown, monetary inflation and asset price inflation have been pretty high over the past several years, while official CPI measures remain low.

Technological advancements, high debt levels, labor offshoring, wealth concentration, low median wage growth, no commodity shortages, and other forces all affect that divide.

However, inflation of domestic services, like healthcare and childcare, have skyrocketed along with monetary inflation and asset price inflation, so the disinflationary trend has mostly been from manufactured goods.

So, we have a handful of key things to watch to see to what extent, if any, this trend will shift towards higher consumer prices of goods as well, which are generally the only thing not going up.

1) Labor Onshoring

We have had a multi-decade trend of increasing globalization, and specifically offshoring jobs to other countries, which basically exports inflation. It puts downward pressure on local wages and on prices of many types of goods like electronics, clothing, and various items. Globalization particularly accelerated during the 1990’s and 2000’s.

This trend may have peaked, though. Global trade as a percentage of global GDP hit a local top in 2008 at about 60% of global GDP, and has been in a choppy sideways period ever since:

Chart Source: World Bank

If we start to see more of a period of labor onshoring in various developed countries, it would end this period of exporting inflation, and thus could result in higher prices of manufactured goods, i.e. consumer price inflation. Having more resilient supply chains is one incentive for this, as is the political tension between China and the United States.

However, that trend still has to face off against technological advancements in the area of industrial automation, which should continue to exert downward pressure on prices of manufactured goods and compete with human labor in the long run. There could certainly be a period in this decade, however, where labor onshoring could temporarily happen faster than advancements in automation, and push up some prices for a period of time.

2) Commodity Scarcity

During most of the 1990’s, 2000’s, and 2010’s, we had commodity abundance.

Oil abundance started to get a bit tight by the end of the 2000’s decade, but improving shale technologies combined with low interest rates and a willingness among companies and investors to drill while being consistently free cash flow negative (and thus persistently destroy their capital), significantly boosted American oil supply and resulted in a long-term supply glut and low oil prices.

Chart Source: EIA

However, there has been less over-abundance of metals, like copper. Annual deposit discoveries have been weak during the 2010’s decade, despite big money put into the space a decade ago. We have some degree of abundance at the moment, but no structural over-abundance:

Chart Source: S&P Global World Exploration Report 2019

So, gold and copper prices held up a lot better than oil prices in recent years.

In 2020, there have been massive capex cuts by oil and gas producers, and the U.S. shale oil industry has faced a number of bankruptcies. Investors might be more cautious with financing shale drilling going forward, after a decade of brutal losses. The growing movement towards ESG investing also generally results in less investment capital for oil and gas. Supply can stagnate for a while until demand catches up and results in more oil and gas tightness, and higher prices.

Some producers for commodities like uranium and copper also cut costs this year as well, even though these industries have less oversupply to begin with, and are looking rather tight as we head deeper into the 2020’s decade.

If commodities in general start to enter a period of relative scarcity deeper into the 2020’s decade in conjunction with high monetary inflation, it would exert upward pressure on consumer prices.

3) Political Changes

Fiscal policy changes can affect wealth concentration. Whether it’s higher taxes on the wealthy, or payroll tax cuts for the middle class, or partial student loan forgiveness by executive action, or some type of universal basic income or one-time stimulus injections, there are various policies that can get more money into the hands of everyday consumers, which can put upward pressure on consumer prices.

Based on current election results, major fiscal changes appear unlikely for the next 2 years, although there can be changes around the edges, including with executive action. As we look out further than that, we need to be aware of potential changes in fiscal policy that could shift the capital/labor pendulum and affect asset classes in various ways.

In this current environment, due to the severity of the pandemic against a backdrop of a very financially vulnerable society, personal income went *up* this year rather than down, despite massive unemployment, due to big government transfer payments that took the form of stimulus checks, extra unemployment benefits, and PPP loans that turn into grants:

Chart Source: St. Louis Fed

This fiscal injection pushed back against the deflationary crunch that occurred in spring 2020 during the pandemic shutdown, resulting in a rebound of reported inflation and forward-looking inflation expectations. This began to level off as we entered the autumn, because there was no second round of stimulus, and unemployment remained rather high.

Chart Source: St. Louis Fed

We should keep in mind that the two consumer price inflationary decades of the past century, the 1940’s and 1970’s, both saw rapid declines in wealth concentration, as the bottom 90% gained wealth share against the top 0.1%:

Source: Ray Dalio, Changing World Order

In the 1940’s, the government ran large deficits which were monetized by the Fed and commercial banking system for World War II, which resulted in a massive increase in the industrial base that benefited blue collar workers, and when soldiers came home from the war, the government passed bills to get 8 million of them educated or trained at government expense. Massive money supply increases, along with periods of supply shortages, led to three big inflationary spikes in 1942-43, 1947-48, and 1951. Interest rates were held low, and stocks and real estate did well in this environment from a starting point of low valuations, benefiting the wealthy, but even so, the bottom 90% did better. Taxes on the wealthy were quite high in this environment, and folks who were overweight in cash and bonds did rather poorly, as those paper assets failed to keep up with inflation.

In the mid-1960’s, the pendulum of power swung increasingly in favor of labor unions, and Lyndon B. Johnson oversaw a set of domestic programs referred to as The Great Society. These various forces contributed to an increase in the wealth share of the bottom 90%, but also contributed to moderately high consumer price inflation in the late 1960’s. By the 1970’s, budget deficits from the Vietnam War, along with problems supporting the gold standard, resulted in the dollar going off the gold standard and experiencing a period of rapid devaluation. Oil scarcity relating to geopolitical issues then further exacerbated this, leading to a period of very high inflation. Rising interest rates to control inflation put severe downward pressure on stocks and bonds and many financial assets, other than gold and silver which did extraordinarily well, until Fed Chair Volcker finally broke the back of inflation in the early 1980’s with sky-high inflation-adjusted interest rates.

Summary Conclusions

As a recap, there are some important relationships to keep in mind for inflation in its various forms.

Monetary inflation, meaning a rapid increase in the broad money supply, is driven either by an increase in bank lending or large fiscal deficits that are monetized by the central bank. Whether this leads more to asset price inflation or consumer price inflation depends on a few variables.

Interest rates: When interest rates rise, it puts downward pressure on most asset prices, as we saw in the inflationary decade of the 1970’s. When interest rates remain low, then monetary inflation remains a good environment for asset prices, as we saw in the inflationary decade of the 1940’s. Some financial assets, like gold and silver, tend to do well in either environment, as long as inflation-adjusted interest rates remain low, whereas stocks and bonds are more tied to nominal interest rates. Some stock industries can also go against the trend by benefiting from higher rates, like banks.

Pendulum swings: Whenever the balance of power favors the wealthy, due to some combination of offshoring, automation, and the political consensus as we’ve had for a while, then monetary inflation is more likely to translate into asset price inflation. Whenever the balance of power shifts towards labor, due to labor onshoring, labor organization, and/or a change in the political consensus, then monetary inflation is more likely to translate into consumer price inflation. This is largely connected to wage increases or lack thereof, as well as the size and scope of government transfer payments and tax policy.

Commodity scarcity: When commodities are abundant, with supply outpacing demand, it keeps input costs low and puts downward pressure on consumer price inflation. When commodities are scarce, with demand outpacing supply, input costs start to rise and it puts upward pressure on consumer price inflation. In recent decades, we’ve spent most of the time in a period of commodity abundance.

As monetary inflation likely continues, navigating the next 5 years in terms of portfolio management will depend in part on analyzing these variables to see where that money will end up.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long domestic stocks, foreign stocks, bonds, precious metals, and other alternatives, as part of a diversified portfolio.