Currency - (CC image by Taki Steve on Flickr)

(CC image by Taki Steve on Flickr)

 

“Inflation” and “deflation”: These are two of the most commonly used terms in the world of investing, but what do they really mean?

And, why is it so crucial to understand these concepts before making any long-term forecasts?

 

Why Inflation Matters

In an earlier post, I introduced a framework for building wealth entitled “The Five Components of Successful Investing”.

The five components are the blue boxes in this flowchart, taken from that post:

activemgtplan

Long-term forecasts, the second component of the plan, are the most impacted by inflationary or deflationary forces in the economy.  The stronger and more persistent the inflation, the higher will be the expected returns across most asset classes.  Of course, the cost of living will rise at the same time, limiting the purchasing power of those investment gains.

The rate at which we expect inflation to expand or moderate in the future will also have a major impact on our preferences for certain asset classes over others.  Assets with a fixed stream of cash flows, like bonds, will be badly hurt by rising inflation, whereas gold will shine.  In mild deflation, when prices are gently falling or nearly constant, cash is king.  In that scenario, a wise investor will maintain a large cash reserve and consider writing options or shorting stocks to generate returns.

For these reasons, all long-term forecasting must start with an assessment of whether we expect inflationary or deflationary forces to be operating, and to what extent.

Before I go further down that path, it’s important to define what “inflation” really means.

What is Inflation?

Most people define inflation as the rate at which prices are increasing in an economy.  This is a good definition, but let’s dig deeper into it to avoid some important pitfalls.

Inflation is controlled by three factors, broadly speaking:

  • The supply and demand for goods and services in an economy;
  • The amount of liquid assets circulating in the economy, and;
  • How rapidly money circulates in the economy.

I’ll refer back to these towards the end of this post.

Goods and services are anything that is produced and available for sale to consumers.  This includes physical products, digital goods, and all kinds of services.  It even includes the underground economy or “black market”.  For simplicity, we’ll assume a closed economy, like a country that does not trade with other nations, so we can ignore the impact of cross-border flows of goods, services, and currency.

The second factor includes money, defined as any item that is serves as both a store of value and a medium of exchange.  Today, the vast majority of money in circulation is in the form of bank notes issued by central banks (paper currency, notes, and digital entries), but this category also includes gold, silver, and digital currencies like bitcoin.  A follower of the Austrian school of economics would simply define inflation as the rate of growth of the money supply, but this ignores all forms of credit and other liquid assets besides money.  It also ignores the rate at which money circulates in the economy.  Thus, the money supply by itself is useless for measuring inflation.

By “liquid assets”, I mean anything that can be converted to money in a reasonably efficient and fast way.  This includes far more than the supply of money and credit in the economy, and rightfully so.  For instance, let’s say you are considering the purchase of a new car for $30,000.  If you have $30,000 in your checking account, clearly this is money.  But if you instead have $30,000 of stocks in your online trading account, and all you have to do to get that money into your checking account is to: (1) click “Sell” and (2) request a check from your broker, how is this any different than money?

I’ve also included credit in my definition of “liquid assets”.  There are many types of credit.  As a simple illustration, let’s stay with the car-buying scenario.  Instead of using any money at all for the car, you could get a zero-down loan from your local bank.  That bank will then create the money out of “thin air” and use it to purchase the car on your behalf.  This puts new money into circulation, which will be taken out of circulation as you repay your loan.

The third factor, often forgotten, is arguably the most critical one when trying to predict future inflation rates.  It is the velocity of money – the rate at which all that money, credit, and liquid assets are circulating.  It generally follows a well-defined trend over long periods of time:

Prior to the start of this graph, money velocity also exhibited stable trends (down 1900-1932, up 1932-1960), when removing the impact of the two world wars.

Prior to the start of this graph, money velocity also exhibited stable trends (down 1900-1932, up 1932-1960), when removing the impact of the two world wars.

 

In the extreme case, the Treasury could print warehouses full of cash and drop it by helicopter, but if everyone stuffs it under their mattresses then it will have no impact on prices today.  Yet we can be certain that as soon as velocity begins to rise again, pent-up inflation will be released.   It is just a matter of time until it occurs.  We’re seeing this same phenomenon today in all the world’s leading economies, just not to such a dramatic level.  Central banks continue to stimulate growth by pumping money into the banking system, but its effect remains limited because it is not being deployed into the broader economy.

Now that we’ve defined inflation, let’s consider the factors that cause the inflation rate to go up or down (all other factors held equal).

Inflation increases when:

  • The supply of goods contracts (e.g. production quotas or natural disasters);
  • The supply of liquid assets increases (e.g. growth in money supply, financial asset values);
  • Liquid assets begin to circulate more rapidly.  For instance, when people expect rapid inflation, they spend their money more quickly.

Inflation decreases when:

  • The supply of goods expands;
  • The supply of liquid assets decreases (e.g. banks pull back on lending);
  • Liquid assets begin to circulate more slowly.  For instance, when people worry about the economy, they tend to hold onto their money longer.

(Which scenario fits today’s economy?  More the second scenario than the first, I’d say!  We see this in the inability of inflation to hit the Federal Reserve’s 2% target level, despite massive money-printing.)

If the rate of inflation is negative, i.e. price levels are dropping, we say that “deflation” is happening.

 

How is Inflation Measured?

It’s easy to measure inflation if you’re only interested in past or present values of the inflation rate.  Government agencies regularly publish inflation data, often labeled as a Consumer Price Index (CPI).  These series measure the rate at which prices are increasing for consumers in the economy.  Price levels at the producer level, like commodities and raw materials used by manufacturers to produce consumer goods, are measured by a Producer Price Index (PPI).  A more obscure measure of price levels, yet one that is arguably more valuable for investors, is the GDP (Gross Domestic Product) deflator.  The GDP deflator is the inflation series used to convert the GDP of a nation (a measure of its annual production of goods and services) into today’s prices.  I prefer to use the GDP deflator when running analyses because it aggregates all transactions in the economy, including those at the consumer and producer levels.

PriceStats and State Street have collaborated to develop their own inflation series, giving an alternate view that in many ways is more comprehensive than official series.

The tougher task is determining how much inflation to expect in the future.  The prices of gold and silver offer some insight into how much inflation investors are expecting, but these markets are small and subject to many forces beyond just inflation expectations.  Tracking gold and silver prices isn’t enough.

Without a good forecast of inflation, all our long-term forecasts will be too high or too low, and we won’t be adequately protected against distastrous outcomes.

 

Forecasting Inflation

It’s a whole lot easier to predict future inflation once you break it down into the three factors that I listed earlier.  Here is each one, with a list of questions to ask yourself when assessing each:

Supply vs. demand of goods & services

  1. How rapidly will technology advance?
  2. Will energy become more abundant, or more scarce?
  3. How rapidly will governments increase their spending?  Will some pull back?
  4. Will the population expand rapidly, or level off?

Amount of liquid assets circulating in the economy

  1. Will central banks follow loose (expansionary) or tight (contractionary) policies?
  2. Will government policies cause banks to hold on to reserves, or incentivize them to lend to the public?
  3. How will investors preferences change between non-liquid assets, like privately owned businesses, and liquid ones, like publicly traded companies?

The velocity of money

  1. Which will be stronger, fear or greed?
  2. How likely is it that a major war will break out, pulling money off the sidelines into the war effort?
  3. Has velocity been trending downward or upward, and for how long?  Is it due for a reversal?

 

After reflecting on these questions, you’ll be able to make more confident long-term forecasts.

Think of a swimmer going along with the current, or fighting against it – this is the difference between a forecast that starts with a good understanding of inflation, and one that does not.  Whether you’re a long-term investor or a frequent trader, you’ll want the current on your side.