Transitory inflation means permanent purchasing power reduction
Lately I've been talking to a lot of people about the topic of inflation. I've noticed that almost nobody has a good understanding of the definition of the term, this is in part due to the huge spread of poor quality financial information that goes on in the general public. This is also in part due to people confusing the Consumer Price Index with Inflation. The Consumer Price Index is vaguely speaking an index that has a stated aim of attempting to track the purchasing power of each dollar year by year as it relates to quality of living, while this is related to inflation it is not a direct index to track inflation. Confusion between these two is actively promoted by people who have vested interests in systematically under-reporting inflation, see the footnote for how this works1. Inflation is actually a monetary phenomenon, inflation and deflation represent the amount of change to the total supply of money. The definition is remarkably simple, practically speaking the hard part in the modern world is actually tracking down how much money exists due to the proliferation of products that people in a practical sense will substitute for money.
Around about a year ago I started making calls that we would see massive inflation. This was in large part due to a huge growth in M2, huge quantitative easing programs and a number of other issues related to currency debasement. Almost no politicians seemed to want to do anything at all to slow down the expansion in the monetary base as they had huge fiscal stimulus programs they were attempting to roll out to deal with the pandemic. Those stimulus payments explicitly aimed to distribute money to people. Those programs do not come for free and were typically funded by the issuance of government bonds, bonds that are easier for the government to pay off if inflation continues to be high. The other thing I remember thinking is the idea that "there's no government program more permanent than a temporary measure" or in other words I strongly expected the fiscal programs to continue long past the worst of the pandemic and perhaps in some countries to completely outlive the pandemic. In 2020 much of the main stream media was pushing the narrative at the time that there was no inflation and because it was exceedingly hard to go spend any money due to widespread closures due to the pandemic many people didn't pay all that much attention. Many peoples entire focus was on the pandemic, in extreme cases leading to literal hypnosis. But what a difference a year makes, prices for almost everything have gone up so much that inflation has demanded the attention of the average person again. And because things have mostly reopened there's plenty of chances in daily life to see how everything is more expensive, well if it's available at all that is, and many things are not due to supply chain disruptions. For example 6 weeks ago I went to a pizza store and the order came to $35, 3 weeks ago it was $37 and the other day it was $40. This is a large percentage change in a small amount of time for the exact same order, the store was saying that the cost of ingredients was going up and that they had to pass these on. This is a highlight of why higher input costs can in the short term lead to rather extreme inflation2, if for example something widely needed like say grains go up in cost then things that use those grains can also go up in cost. And grains have gone up in cost, and gone up a lot:
Over the last few months I've once again been having a lot of conversations with people about inflation and the potential for hyperinflation in various places like Turkey and Canada (yes that's not a typo, hopefully I can explain why Canada is in such a precarious state in a future article). As a result of these conversations there's a common misconception about inflation that I've noticed a lot of people without economics or mathematics understanding have. They think that when the inflation is over their purchasing power will be retained. I think this misconception is extremely relevant for political reasons which I'll explain in a moment. Here's a classic example of this misconception as posted by someone on reddit about the inflation situation in Canada:
All you have to really ask yourself is: if inflation is this legit then how come when inflation goes down, prices of typical goods don't go down? Idk about y'all but everything in my life has only gotten more expensive NEVER has it gotten cheaper.
Unfortunately the way inflation works is that if you have one year of 10% inflation then a second year of no inflation at the end of the second year your money still buys 10% less than it did earlier (all other things being equal) even though inflation went down in that second year. The crucial conceptual step to be able to fully understand inflation is that inflation represents a rate of change of how much money exists now as compared to the year before. Every year with positive inflation is a year where more money enters the system as a whole, which in turn means purchasing power of each dollar declines. A year with 10% inflation means that at the end of the year 10% more currency exists, a year with 2% inflation means that 2% more currency exists. Even when the inflation rate drops more money is still in existence than the year before as long as the inflation rate stays positive. The other part of the misconception is that when inflation goes down prices won't go down, you need technological deflation to outpace monetary inflation for consumer prices to drop. Monetary deflation is not something that's happened in a long time in much of the western world, in the majority of the century since the great depression almost every single year has had positive inflation rates. This is in part because government have mostly decided as a matter of policy that deflation is to be avoided at all costs. Many people confuse disinflation which is the idea that inflation rates are dropping with deflation, the media doesn't tend to help people get more clarity on this either as a nuanced discussion of this is lacking.
Many people are under the mistaken impression that when inflation stops running so hot they will be able to purchase the same amount of goods and services for each hour of their labor as they did before. However this is only the case if wages go up by the same amount as inflation. Unfortunately for a whole lot of reasons wages have been mostly stagnant and are most certainly not keeping up with inflation. This is a situation that's been broadly speaking been taking place since 1971, which has led to many economists putting compelling arguments that the stagnation in wages is actually hurting the economy.
The reason I think this is so important politically is that this persistently high inflation is devastating for anyone who wishes to save money to spend later, but the impacts go far beyond that as inflation can be a form of wealth transfer that goes unnoticed. This is in part because we are in an era of financial repression where interest rates are now negative in real terms, or in other words the interest you can get on your money in the bank is far lower than inflation. High inflation in the cost of living is a very politically charged topic as persistently high inflation has historically been a destabilizing factor due to the way in which it reduces the approval ratings of leaders and in extreme cases destroys economies. History shows that spikes in the prices of food and fuel can cause massive political instability. Even in less extreme periods due to compounding interest a few years of high inflation can steadily remove a huge chunk of the purchasing power of each dollar. If you aren't able to work or have inflation-protected investments (actual inflation not indexed against CPI1) then you are going to end up having a worse quality of living for each hour of work you do. It is precisely because of this that high inflation is so much worse for poorer people than wealthier people, wealthier people just have so many more options to invest their excess money in ways that are less impacted by inflation (eg Precious metals, certain stocks, etc) but poorer people don't have excess money to invest at all when inflationary periods get bad.
Even transitory inflation creates permanent damage to the purchasing power of each dollar. The price levels tend to get higher with supply shocks and not come down as far as they went up. But in all honesty what we are seeing now is anything but transitory, monetary creation is running hot to try to reduce all the debts of the world in real terms. Keep this in mind the next time some spokesperson tells you that "inflation is transitory and not something for you to worry about". If you get told this enough its actually a fairly strong sign that inflation will be bad since "jawboning" is an early step used to try to control the markets. Take for example the recent events in Turkey, where as far as I understand it's a very risky move to comment on the way in which inflation is contributing to the deteriorating financial situation as just the act of commenting on the countries financial affairs could very likely land you in jail. Most of the smart money at the moment is starting to invest at least some of their money into hard assets that perform well against inflation and as always it is always far more instructive to see what people are doing with their money compared to what they say they are doing with their money.
The methodology behind the CPI calculations are far more complex (in a Kolmogorov complexity sense) and are far more intellectually dishonest than most people realize. This is due to the way in which "hedonic adjustments" are made to prices. The idea goes like this, say you bought a smartphone 10 years ago for $100 and now you buy a smartphone for $500 this line of reasoning says that the newer smartphone is much better than the older one and so we have to adjust the price to take into account changes in quality to do a comparison with the older worse product. When making an index to track some representation of what change in money is required to maintain some fixed quality of life it does make some sense to adjust for quality of items. Where the intellectual corruption occurs is that adjustments are never made in the other direction when the quality of products get worse over time. Take for example the fridge my grandfather got in 1986 for $100, that fridge is working just fine today and could even last a few more years. The better fridges of that era were built to last and you'd have trouble finding anything at all on the market today that has the same durability without getting into vastly more expensive commercial options. Perhaps today you have the great misfortune of having to buy a "smart" fridge for $1000 that is designed with cheap parts that have an average life of 5 years each and requires an always on internet connection to get firmware updates from a server that might not even be there in 5 years time to control the thermostat, are you getting a better deal? As an added bonus many of these modern appliances are not easily repairable due to deliberately consumer hostile decisions from manufacturers like not supplying spare parts and making design decisions that make repairs deliberately harder to do. All this comes about due to a lack of right-to-repair legislation to force the manufacturers to not build in planned obsolescence as the manufacturers want to force you to have to keep purchasing the same sorts of products from them on an ever shorter timeframe than is natural even considering the crap quality of parts. So given this we really should be doing the opposite adjustment here, the old fridge was far better value than the new one and any pricing changes should definitely adjust for this decline in quality. But yet this is the nature of the intellectual corruption of the CPI index, hedonic quality adjustments are only ever made in one direction of improving quality over time. This was always problematic but in this new distinctly consumer hostile world we live in with consumer goods this problem with the CPI calculation has greatly grown. As a result of the deliberately corrupt methodology CPI will always underestimate the true rate of monetary inflation. Of course if you follow the money you'll see extremely strong entrenched interests that like to see inflation figures consistently under-reported so the CPI is often deliberately misrepresented as being the true inflation rate. There's significantly monetary incentives at play for this intellectual dishonesty too as many "inflation protected" securities are actually indexed against CPI and not the real inflation rate. If you can actually set up a trade where you get the real inflation rate in returns and pay out the lower CPI rate then you'll make a lot of money. Then on the political side CPI is often aggressively pushed onto people via the mainstream media by those who have agendas that benefit from claiming inflation is low. ↩↩
Supply shocks tend to make things more expensive but they aren't quite the same as monetary inflation. The reason is because of a variety of factors like wages not going up at the same rate as input costs you often have situations where if the input costs go up too much then nobody really has any money left over to buy things. If nobody can afford to buy anything then the demand drops which starts putting downwards pressure on prices. When nobody is able to buy anything then natural monetary base growth tends to stop. Part of the reason this happens is that business aren't always able to pass on increased prices to their customers for a variety of reasons, if you make something that people can afford to buy for $100 and the material costs are $50 then you have $50 of room to pay your staff and costs. If those material costs rise to $100 but the customers aren't able to pay that extra $50 then you are screwed. The reason that inflationary shocks are so nasty is because inflation is never felt uniformly across society, in part this is due to the Cantillon Effect and in part due to the way in which money circulates unevenly in society. A spike in inflation will mean some businesses go under because their costs go up but the money available to their customers does not go up quickly enough for the business to survive even if eventually the customers end up with more money in nominal terms eventually. ↩
This post is part 10 of the "MonetaryPolicy" series:
- Finally getting around to publishing some monetary policy articles
- Fast things happen slowly then quickly
- Politics of unproductive debt
- Futures markets lower prices, both in good and bad ways
- Why do stable coins matter
- Why is so much financial advice bullshit
- Bank bail ins
- Where is money created
- Bastiat on legal systems and morality
- Transitory inflation means permanent purchasing power reduction *
- Problems with Celsius
- Crypto's Lehman moment
- Crypto crash update May 2022
- The myth of the unbalanced government budget