Inflation – Central Banker’s Gordian Knot Tightens

Written by James Sellon, CFA, CFP™

Inflation is something that investors (and arguably central bankers) have not had to worry about since the global financial crisis, however inflation, the silent enemy of the long-term investor, is back. One cannot escape the evidence of inflation today – the lack of restaurant staff, reduced number of UK truck drivers, commodity prices increasing, the supposed lack of turkeys for Thanksgiving/Christmas and evidence of supply chain disruption (record number of ships parked off the busiest port in the Western Hemisphere – Los Angeles).

This supply-crunch inflation has given central bankers an unenviable task. Inflation is appearing around every corner, yet controlling it could be beyond their reach. The quandary is what proportion of inflation is the result of elevated demand as we exit lockdown and what proportion has been caused by shortages of materials, workers and jammed supply chains.

What is wrong with a little bit of inflation?

Before we look at how central bankers untangle the knot it is worth asking the question: What is wrong with a little bit of inflation? In short – inflation (prices rising) at 2% per year is healthy.

Inflation (prices rising) at more than double that can create imbalances in the economy and a lack of predictability about the future price of everything. For Chief Financial Officer’s globally this increases the risk of investment/capital allocation decisions and thus makes these decisions more challenging.

A good yardstick is the ‘Rule of 72’. The ‘Rule of 72’ estimates how quickly prices will double; all we have to do is to divide 72 by the rate of inflation. If the Bank of England is successful at meeting the 2% per year inflation target set for it by the UK government, prices will double every 36 years (72/2).  If inflation is higher, then the time to double will be quicker. For example, at 6% inflation prices double every 12 years. The chart below provides an insight into the impact of inflation on spending power in the UK.  It shows how much £100 of goods or services bought at some point in the past would cost today. Even since 2010, things now cost around 30% more than they did.

Figure 1: How much £100 of goods and services in the past would cost today.

 
Source: Bank of England- November 2021

Without turning this short note into an economics lecture, a simple model that explores the balance between buyers and sellers of goods and services can be useful when thinking about inflationary pressures:

• On the buyers’ side we have the amount of money in supply (M) and the number of times this money is used to buy goods and service in a year (the ‘velocity’ of money or V).  
• On the sellers’ side we have the price of goods (P) and the amount of goods and services produced (Y).  
• As everyone knows an equation needs to balance; so, MV=PY.

Since the Covid-19 crisis began, governments around the world have pumped huge amounts of money into the economy, via both quantitative easing and huge stimulus packages, not least the US $1.9 trillion package being touted by the Democrats in the US. The money supply in the US has grown dramatically in the past 24 months.

So far, because people were restrained from buying goods and services during the lockdown, savings increased and the velocity of money has been low, as a result the spare capacity that existed in the economy resulted in little pressure on prices. Yet, as the vaccine program rolled out and we emerged from the lockdown constraints, people have begun to satisfy their pent-up demand using accumulated savings to buy goods and services. Such activity is expected to raise the velocity of money back to more normal levels. On the supply side, economic output should grow as the recovery takes hold, utilising spare capacity and creating new jobs. But if the money chasing goods and services (MV) outstrips the output of the economy (Y), then prices (P) will rise. The bond markets have responded to this, pushing yields up in compensation and, as a consequence, bond prices down.

The Central Bank’s Dilemma

Central Bankers are being foxed by the difficult tightrope as to how to deal with this up-tick in inflation. The buzzword today is whether this pick-up in inflation is ‘transitory’ or whether it is more permanent. Covid-19 has caused the most unnatural bump in the road and these supply side disruptions (mentioned earlier) have lead to higher inflation. Moreover, the new spending program from Congress looks increasingly challenging to push through.

The traditional solution to rising inflation would be to raise interest rates but higher interest rates will do nothing to ease the supply bottlenecks. If these shortages ease and trade returns to historical levels then higher interest rates could choke the recovery.

On the flip-side if central banks adopt dovish policies and keep rates low and the supply shortages prevail then inflation expectations could become permanently entrenched causing companies to increase wages and prices. This is likely to cause central banks to raise rates harder and faster in the future.

Threading the Needle

Trying to untangle this Gordian Knot is virtually impossible. The Federal Reserve is powerless in fixing these supply issues and so the debate is really around whether they can convince the market that these supply constraints are indeed temporary, but also that they are ready to raise rates if necessary. The question is whether the pandemic has caused supply chains to become permanently stressed or will they fix themselves in short order. The game for the central bankers seems to be to talk up the likelihood of rate rises in the future to keep a lid on everyone’s inflation expectations until these supply issues are worked through (which are unlikely to happen overnight as workers need re-hiring and crumbled supply chains need rebuilding).

Inflation is the story of the day but like everything is unlikely to be the story of tomorrow. As we work through the ripple effects of Covid-19 it is likely these ‘transitory’ base effects will be gone – like all matters it just depends on an investors time horizon. It is worth remembering that until a year ago the conversation was around negative interest rates and deflation as a result of:

1. Over indebted economies 
2. The ageing of the baby boomers and worsening demographics (working aged population)
3. Rapid technology development – keeping a lid on prices
4. Globalisation
5. Continued reduction in unions/workers power 

Whether the Covid-19 jolt to the economy and the resulting supply shocks causes inflationary expectations to be permanently entrenched remains to be seen. The good news is that the central banks are on the same side of the table as the rest of us – we want the Goldilocks sort of inflation – the inflation that runs not too hot and not too cold.

What this means for portfolios?

So, what would this mean for your portfolio? Over the medium to longer-term, equities do a good job of delivering investors returns above inflation. In the shorter term it is hard to know what the impact on equities will be – on the one hand higher bond yields may undercut equity valuations, whilst on the other, growing optimism and economic growth of a post-lockdown world may improve prospects for company earnings. No-one knows.

At MASECO we do not allocate our equity exposure based on attempting to ‘Nowcast’ or ‘Forecast’ the macro economic landscape. This is inherently difficult as so much is random. We focus on the sources of economic return and tilt our portfolios towards companies that are inexpensive from a fundamental perspective, those that are posting high profits and we allocate to a wider selection of securities than simply the largest firms in the world.

On the bond side, the threat of inflation tends to drive yields higher and bond prices lower. Fortunately, the bulk of bonds owned in MASECO portfolios are shorter-dated, where price changes are much smaller than longer-dated bonds and the time it takes for one to benefit from this rise in yields will be much quicker. Also, MASECO portfolios have a decent slug of inflation protected bonds that were allocated into the portfolios at the beginning of 2021.

The key to the MASECO portfolios is diversification – one never knows what is around every corner and as such it is best to be prepared for multiple uncertainties.

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