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Inflation, Yes, but How High?

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I have been asked what has happened to my weekly blogs. The thing is, although I enjoy writing, I only do so when I have something to say, and this is, after all, a site devoted to things relating to real estate, although I don't mind going off at a tangent now and again. But it so happens that one of the arguments I have looked at and digested over the past week has been an interesting article about the coming inflation by a guy I always find interesting; Nick Hubble. Maybe you should check him out. He is definitely worth a read.

In this blog I will attempt to paraphrase his argument on inflation. Like most articles on the future, the best anyone can do is put forward a hypothesis. But the article I want to discuss at least gives us a few ground rules from which to base any thoughts about where we are headed.

He starts by reminding us of the basic equation that governs the way we look at the financial aspects of an economy. When I was studying this stuff at university I was much taken by the methodology of one of my fellow students. He invariably started his essays with the phrase "Take the product of an economy to be a can of baked beans..." I am assuming MV=PY is arguably a more useful point of departure, but what the heck is this equation?

M stands for the money supply, V is the velocity of that money. P stands for Prices, while Y is real GDP.

The problem with all of this is that we can define the amount of money in the system in many ways. Does it include reserves, credit, the unused amount on your credit card, or something else entirely?

There are also some strange implications when talking about the velocity of money, which basically refers to the speed at which money is used in the system. If the same five pound note goes from being used once a day to being used twice a day, it feels as if there is twice as much money sloshing around the system.

Let's use another example. Quantitive Easing (QE) has undoubtedly increased the money supply, but it was used as reserves instead of being used in daily transactions, so its velocity was low.

P is simply a way of representing inflation (rising prices), or deflation (falling prices). This also is a difficult figure to asses as some prices go up and some prices go down, but the current indices take an average of a whole basket of items. There are also some tricks of the trade such as hedonics, but I dont want to get too technical here. Let's just accept that we are talking about the price of a basket of basic items used by most people in their daily life.

There are even problems with defining GDP. If instead of mowing my lawn I pay someone else to do it, how has that increased the country's GDP? The state is no more well off the day after my lawn has been mowed, but money has changed hands.

Quite. Economics is a very inexact science. And we are supposed to be using this stuff to try and chart a way into the future. No wonder this subject is difficult, and prone to disastrous assumptions. But let's struggle on.

Okay, we've defined our terms as best we can, but what does the equation really mean?

Let's do a translation. "In an economy, the amount of money (M) times the speed with which it is spent (V) is equal to the price of stuff (P) times the amount of stuff (Y)."

I always maintain that the most important indicator in maths is the equals sign, and the whole point of this equation is that if you double the money supply, the other side of the equation has to double as well.

The real problem with that assumption is that if you double the money supply (QE), but the velocity of that money halves, nothing changes on the other side of the equation. In other words, there is no inflation.

There is a nasty corollary to that observation. If the government introduces a digital currency, that currency can be programmed to expire if not used. Expiring money encourages people to spend it faster, which increases V (velocity). This would have a stimulus effect on prices or a stimulus effect on spending to spur on GDP. That's precisely what the governments of the world want in order to get inflation to eat away at their deficits.

During the pandemic the lockdowns meant that the economy (Y) crashed. Apparently it was the biggest drop in GDP in the UK for 300 years. On the other side of the equation, the velocity of money (V) plunged too. People saved instead of spending. In fact they were prevented from doing quite a lot of spending. Central bankers responded to this drop in V by creating insane amounts of money (M) to try and pump up the economy (Y) and keep prices stable (P).

I hope you are all on top of this, or do you need a rest and a brandy?

Okay, it's Consequences time. As economies around the world come back to some semblance of normality, spending is going to return. All that increase in M is going to circulate faster, triggering a spike in inflation.

This is starting to happen right now. But how much higher is inflation likely to rise?

Sadly, there are too many variables in the equation to work that out. But Nick has a try. "If V returns to its pre-pandemic level, that would equal a rise of 27%. The Federal Reserve is anticipating economic growth of 6.5% in 2021 in the USA." If you assume no more QE, which is probably an unrealistic assumption, but let's do the sums, then the left-hand side of the equation has increased by 27% so the other side must equal that, which means that 27 - 6.5 (GDP) = 20.5% worth of inflation. That's nasty.

If M increases with more QE, and V increases because in an inflationary environment people spend money faster before it loses more value, then the figures are going to show inflation far higher than 20%.

What likelihoods are there? Inflation rises, so interest rates rise to help damp down the problem. Rates ought to rise to compensate for holding debt, but governments want inflation to eat away at their debts, so that is going to be resisted as much as possible. The only way I can see they can do that is by cutting down on their spending, or by refraining from borrowing to finance their obligations. There is, I believe, something like eight trillion dollars that will need refinancing at the end of this year in the USA alone. The only way out of that problem is to print the money to pay off the debt. If they dont have to borrow, that will take the pressure off a rate rise.

An interest rate rise would trigger a deflationary debt crisis like the one in 2008-9, but with far higher levels of debt today any crash would have more far reaching consequences.

Then there is the risk of stagflation. In the USA there is a disappointing jobs number, and there are rather a lot of supply shortages.

In short, it looks as though there is more money printing to come. Expect the dollar to fall against other currencies.

On this side of the pond an inflation spike might force the ECB into raising interest rates on heavily indebted South European countries, and inflation has already risen above the ECB's mandate. Not that that little inconvenience will bother Christine Lagarde.

The bottom line is that no-one knows where this mess is headed, but the signs are not good. For the moment I am tentatively suspecting inflation to rise at least to the levels last seen in the seventies. 25% - 30% is perfectly feasible on the current figures. Let's hope it doesn't get that bad, but it would be sensible to be prepared. And those inflation figures will screw the housing market, as price rises in that range would seriously impact on disposable income.

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