Part 1: Inflation – Tall Tales And True Causes

Executive Summary

Inflation is often a poorly understood concept, with monotheistic explanations abounding. Money supply or fiscal deficits are oft-blamed suspects in the conventional wisdom. In reality, history teaches us that inflation is frequently more complex than such simple-minded explanations allow. Inflation is invariably, as Wicksell put it, a “cumulative process” in that it involves a feedback loop between prices and costs. Labour costs are particularly important in the production process, and thus a sustained inflation requires wages to rise significantly faster than productivity (as we have noted before, we have actually been witnessing the opposite situation for a long period of time now – a phenomenon known as wage repression). Without a radical shift in labour’s bargaining power (of which there is yet no sign) it is unlikely that inflation will be able to embed itself in the system. Thus, we believe the upsurge in inflationary angst is likely much ado about nothing.

Fears of inflation often make themselves felt at the strangest times. During the 2008-09 recession many were warning of inflation and even hyperinflation due to the government and central bank policies being enacted in response to the crisis. We have repeatedly pushed back on these ideas and pointed out that crude monetarist stories about quantitative easing, much less hyperventilating about becoming Zimbabwe, were deeply misguided.1 Economic predictions are often hard to prove or disprove, but we think we have been vindicated on this one. What followed quantitative easing and government stimulus was not accelerating inflation, but economic stagnation and low inflation.

However, times have changed. The nature of the present economic shock is entirely different from the last one. Whereas 2008-09 was a classic debt deflation demand shock, this time large parts of our economies have been shuttered; this has led to a supply shock that has generated a demand shock.2 Businesses are closed to consumers whilst staff are laid off and lose income. The consumers that have kept their jobs have fewer places to spend their money, while those laid off from closed businesses have less income to engage in consumption.

Whilst the times have changed, the stories of the inflationistas have not (see Exhibit 1). They continue to resemble the little boy who cried wolf. This is problematic because this time around there are risks of short-term inflation, but not the ones that the inflationistas are discussing. Understanding the underlying causes of inflation is vital in determining how to hedge them.3


As of 6/30/2021 | Source: BofA Global Fund Manager Survey

According to the consensus view, the two leading culprits of inflation risk today are the fiscal deficit and the money supply. To illustrate, take this CNBC headline, “The ballooning money supply may be the key to unlocking inflation in the US,” which precedes the quote that “the Fed may not be in control of Money Supply growth, which means they won’t have control of inflation either, if it gets going.” News flash: the Fed hasn’t controlled the money supply for years (ever since the Volcker experiment in the very early 1980s). The Fed sets the interest rate (the price of money), not the quantity of money. On the fiscal front we need only look to the always opinionated Larry Summers who suggested recently, “These are the least responsible macroeconomic policies for 40 years.” It is true that today both the fiscal deficit and money supply are at record levels not seen since the Second World War. But they are not risky in and of themselves.