by Paul Hoffmeister, Chief Economist
Inflation is always and everywhere a monetary phenomenon.
What could keep a lid on Inflation.
Energy prices are biggest inflation risk.
Historical View of Money and Inflation
Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon.” This is the fundamental idea behind the monetarist school of economics that focuses on controlling the money supply to control the price level.
If there is inflation, then there is an excess supply of money in the economy; and the central bank can extract that money (by selling bonds) to appropriately balance the supply and demand for money. If there is deflation, then there is too little supply of money; and the central bank can add money (by purchasing bonds) to appropriately balance the supply and demand for money.
Over thousands of years, civilization ultimately identified precious metals as the most stable store of value and unit of account. Prices of many goods and services would generally fluctuate around a specific ratio of gold. Rather than bartering and trading specific goods, humans could use gold or other precious metals as the means of exchange because the price in terms of precious metals did not significantly change. Commercial transactions were far easier to perform with precious metals.
When the concept of money or currency emerged, central banks sought to maintain a stable price of gold in their respective currency. If a British pound note or US dollar represented a fixed price of gold, then commercial transactions were even easier to perform than carrying gold coins. To keep its currency value stable, the central bank would add or subtract currency on a regular basis by keeping its eye on the gold price of the currency. If the gold price rose (indicating inflation), then the bank would reduce money supply, and vice versa. By keeping the currency value stable with respect to gold, then prices of goods and services should generally be stable in that currency as well.
The objective of central banks of maintaining a fixed gold price and the basic operations to meet that objective is the spirit of the idea that inflation is always and everywhere a monetary phenomenon.
Inflation Since 1971
Unfortunately, things have gotten a little more complicated with the advent of the modern monetary system. In August 1971, President Nixon abandoned the gold standard, and for the first time in history, humans began to transact within a fiat monetary system where not one major currency was tied to something real. Since then, no central banks have officially managed their money supplies with the objective of keeping a stable currency price in terms of gold. This has led to violent currency swings and extreme inflations and deflations (see chart 1). And it has made the inflation discussion more complex.
Under successfully run fixed monetary regimes where the currencies were stable with respect to gold, prices for goods and services would change relative to gold. But when they did, it was typically not a monetary phenomenon. Instead, it was a signal to the market that there was too much or too little of that good or service. As a result, producers would then respond accordingly to properly align supply and demand. For the most part, the price changes under fixed monetary regimes were tame, in comparison to periods when there was no monetary standard.
Today, unfortunately, price swings can occur because of monetary error as well as specific supply and demand effects for a given good or service. Price signals are much more complicated or distorted. A rise or fall in prices might be due to too much or too little money supply, supply disruptions or sudden changes in demand.
Thinking about Inflation Today
The global economy is currently experiencing a surge in prices. For example, as of last month, the CPI was rising 6.8% year-over-year; whereas in June 2020, the US CPI had risen 0.1% year-over-year. How much of this increase is monetary, economic, or product-specific? And, are we on the verge of a breakout in inflation, or even hyperinflation?
In our view, it’s more the latter than the former. Indeed, gold has risen from $1200 per ounce in 2018 to just nearly $1800 today (see chart 2). This indicates inflationary monetary error and will contribute to a broad price level rise in coming years. However, the prospect of, let’s say, 15% inflation is highly unlikely today. Between 1976 and 1980, gold sky-rocketed from nearly $100 to more than $850; at which time, year-over-year growth in CPI had jumped from approximately 5% to 15% (see chart 3). This is why we’ve been saying that we’re not concerned about a major outbreak of inflation, unless gold were to start exploding higher past $2000-$3000 per ounce.
This leads to focus on supply and demand for goods and services in the economy. With the nearly sudden shutdown of the global economy in 2020, the demand for goods and services plummeted, causing the year-over-year growth in CPI to fall from 2.1% (in December 2019) to 0.1% (in June 2020). Demand collapsed and producers were forced to slash prices.
With the resurgence in demand thanks to the relatively quick reopening of the global economy as well as supply chain constraints and supply shortages, prices have surged, which is reflected in the 6.8% year-over-year growth in CPI.
What Could Keep a Lid on Inflation
A few things are working in favor of CPI now.
First, some of the pressure on port operators and logistics providers appear to be improving. Drewry’s global benchmark freight rate is down about 11% since its September high. According to Freightos, the cost of shipping goods from China to the West Coast is down nearly 30% from its high. According to the Port of Los Angeles, the number of container ships waiting to dock has fallen by nearly 50% in recent months. And, railroads are now picking up shipments within 2 days, compared to almost 13 days during the summer.
Second, the reality of the CPI statistic is starting to favor slower growth. The bottom in the CPI Index data was the second half of 2020. As a result, the year-over-year comparisons in the coming year will be more favorable, and no longer compared to the low prices during the period of inventory liquidation of 2020.
For the most part, the inflation outlook is not great, and as it naturally tends to do, hurts the most vulnerable members of the economy whose wages are not keeping pace with their cost of living. But the CPI data will unlikely misbehave as it has during the last 12 months.
Biggest Concern about Inflation Outlook
My biggest concern, however, is the continued rise in energy prices, and this goes back to earlier comments about prices keeping their historical ratio with gold over the long-term. Since 2001, the oil-gold ratio has generally traded around 17.1; meaning that 17.1 barrels of oil traded per ounce of gold, on average. With gold at nearly $1800 and oil near $70, recently, the ratio trades at approximately 26 (see chart 4). If oil traded at a more normal ratio with gold, then this would translate to $100+ oil. This would lead to a significantly higher CPI and hurt the most vulnerable even more.
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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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