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We cherish independent and rational analysis. 

BFI Perspectives 

  • Dirk Steinhoff

Inflation Could Be Arriving Sooner Than We Thought

Bubbles, from east to west. Even the coronavirus lockdowns could not stop the world’s asset bubbles from growing bigger and bigger. From the stock markets in the west to the real estate markets in China, assets are all feeding off a never-ending supply of “cheap money”. While the general consensus expects the disinflationary status quo (low interest and low inflation) to continue for some time, we might actually see the return of rising inflation sooner than expected. Summertime used to be a time for reflection. In ancient Greece, you were seen as virtuous if you were spotted lying underneath an olive tree, reading in peace or looking leisurely at the clear blue sky, and simply thinking or reading. Those were seen as the moments that instilled creativity and ideas. Those were the moments that fed your philosopher’s mind and fuelled the discussions and truth-seeking debates with other “olive tree aficionados”.

Today, this practice has become rare. In fact, if you dare come up with an original but unconventional, or non-consensus, thought and share it on social media, there’s a good chance your life will never be the same again…and not in a good way! Nevertheless, I still think we should all endeavor to seek the truth as best we can, understanding always, in all humility, that none of us know for sure.

So, dear Reader, I don’t care much about the thoughts and opinions of the masses. In fact, I think the consensus is generally wrong. And, although quiet reflection and independent thinking may be shunned these days, I dare say I have been doing precisely that. And, contrary to the consensus, I think inflation may be with us sooner than the majority expects.

Just when we thought inflation was dead...

We thought history had ended when the Berlin wall came down. We thought communism was dead. We thought socialism had proven to be doomed to fail. We just “recently” witnessed the disasters of the 20th century – Mao, Stalin, Hitler – all of which were based on collectivist dogmatism and stark, coercive, violent, centralistic power. And yet, here we are!


Similarly, until just a few weeks ago, we – well, most! – thought central bankers had it all under control. After they had proven to be capable of “saving the world” during the 2008 crisis, it was clear to all that nothing bad would ever happen again. The mountains of debt were not an issue for industrialized countries. Central bankers were able to create money out of thin air, in unimaginable quantities. And yet, price inflation is nowhere to be seen. We only experienced asset inflation. What a wonderful thing: “Stock markets ONLY GO UP!”. This sentiment dominates Wall Street and now it’s Main Street’s slogan too: Check out Dave Portnoy, the latest YouTube superstar investor.


Mr. Portnoy has a huge and growing following on Twitter. He’s a well-known sport commentator and has made millions with sports-betting. During the corona-lockdowns, he switched to stocks and became a day trader. Why is this relevant? Because now “the masses” are following his advice. We have entered a period where stock markets are again increasingly driven more by pure speculation than by rational investments. Profitability? Who cares! Huge debt, huge leverage? No, problem. Some of you might remember the dot.com era, with its great beginning and its outcome.


And now, just when we thought central bankers would keep interest rates low and inflation had been declared dead for the coming years, the danger of its resurrection, and the rising interest rates that likely comes with it, is back.


Yes, I know the consensus disagrees. However - and this is a big HOWEVER - I strongly suggest we do some olive-tree-thinking together and walk our own path, apart from the masses.

No inflation after the financial crisis of 2008 – therefore, none this time either?

During the years after the financial crisis in 2008, the economists and talking heads who forecasted a rise in inflation (consumer price inflation) as a result of unprecedented monetary inflation by central banks were wrong, time and time again. Instead, we witnessed a period of deflation, or more precisely, dis-inflation. It became the dominant theme. We (I included) have become accustomed to monetary inflation, accompanied by asset price inflation AND consumer price dis-inflation. A wonderful world indeed, at least for investors.

However, just when we get complacent is when the market “kicks us in the butt”. I admit, it might be counter intuitive. We have just seen one of the worst economic disruptions. As a result of the global COVID-19 lockdown, we have seen GDP drop like never before in such a short timeframe. That does not support the case for inflation.

Moreover, while GDP has dropped, and while money supply has gone somewhat hyperbolic, money velocity continues to be at historic lows. Increased liquidity has long ago stopped helping to prop up GDP. It has mostly supported the price of financial assets, faithfully propping up stock markets and real estate markets, and financing debt at a continuously lower price tag (interest rates). M2 Money Supply (in billions of US$)

Source: fred.stlouisfed.org, Federal Reserve Bank of St. Louis Velocity of M2 Money Stock (Money Velocity)

Source: fred.stlouisfed.org, Federal Reserve Bank of St. Louis And, as discussed in depth in the post written by Frank Suess, titled “Deflation or Inflation? Take Your Pick…”, at BFI, we have operated on the basis of the following assumption: “Until money velocity picks up, or other factors result in higher interest rates, we doubt that we will see an end of a deflationary scenario. Chances are quite high that deflation will reign supreme for some time. That does not mean that inflation should be ruled out. We know for sure that literally the entire developed and much of the emerging world is going through a monetary and fiscal expansion like never before. In a way, it is like a universal basic income, financed by Modern Monetary Theory. Ultimately, that is inflationary by nature.”

So, why am I writing now to alert you to the spectre of inflation?

I am writing now because a number of variables have changed. Most importantly, in the wake of the COVID-19 lockdowns and the wide acceptance - if not expectation - that “Thy Government Shalt Take Care of Thee AT ALL COSTS”, we have seen the emergence of a new kind of money creation. Now, it is the government, not central banks, that opened the liquidity faucets, and this time, that new money will be reaching “the streets”.

We are witnessing the worst recession since World War II. But we are also witnessing the fastest growth in broad money supply in over thirty years. In the US, M2, the broadest money aggregate available, has been growing at over 20%. I don’t know how far back you’d have to go to find that kind of money growth in the US. In the EU, M3 is currently growing at about 9% and rising. I expect it to be back to the previous high of 2007, at 11.5%, in very short period. Broad Money Aggregates Rising Sharply

Source: themarket.ch, Bloomberg So, the Trillion-Dollar Question is this: does the growth of broad money matter?

The market does not think so. After all, inflation rates on inflation-linked bonds are at historic lows. Most investors and experts believe the current level of broad money growth is a short-term phenomenon. But I beg to differ. I agree with the analysis made by Russel Napier and explained in an interview with TheMarket.ch this month:


“It’s a shift in the way that money is created that has changed the game fundamentally. Most investors just look at the narrow money aggregates and central bank balance sheets. But if you look at broad money, you notice that it has been growing very slowly by historical standards for the past 30 or so years. There were many factors pushing down the rate of inflation over that time, China being the most important, but I do believe that the low level of broad money growth was one of the factors that led to low inflation.


“…This broad money growth is created by governments intervening in the commercial banking system. Governments tell commercial banks to grant loans to companies, and they guarantee these loans to the banks. This is money creation in a way that is completely circumventing central banks. So I make two key calls: One, with broad money growth that high, we will get inflation. And more importantly, the control of money supply has moved from central bankers to politicians. Politicians have different goals and incentives than central bankers. They need inflation to get rid of high debt levels. They now have the mechanism to create it, so they will create it.“


So, as Mr. Napier points out, QE was a fiasco. All that central banks have achieved over the past ten years was the creation of a lot of non-bank debt. Their actions kept interest rates low, which inflated asset prices and allowed companies to borrow cheaply through the issuance of bonds. Not only did central banks fail to create money, but they created a lot of debt outside the banking system.


This led to the worst of two worlds: no growth in broad money, low nominal GDP growth and high growth in debt. Most money in the world is not created by central banks, but by commercial banks. In the past ten years, central banks have never succeeded in triggering commercial banks to create credit and therefore to create money.


Now, politicians have discovered the money faucet. They are guaranteeing loans, so that commercial banks are willing to make loans to business. Thus, this money will be impacting the economy and it will be hitting the streets.


That, in and of itself, could be considered good news. But, here’s the catch: governments will probably recognize this as their way out of debt. They will bypass central banks and, they are very unlikely to act with moderation and care. Chances are that, by the time they try to stop the tide they created, it will be too late. Inflation, and high inflation, will have taken hold.

The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation. ~ Vladimir Lenin

Governments will bypass central banks and will turn up the faucet. And, they will find scapegoats to blame for the debt and the deficits.


As we know well from Rogoff and Reinhart, at this point, the level of debt cannot be dealt with through GDP growth, austerity or repayment. That only leaves painful options as debt restructuring, public insolvency, or currency reform. None of this looks good for politicians. Therefore, they will opt for inflation and taxation instead. In the current environment, that certainly looks like the ideal policy combination to go for.


Conclusion


In conclusion, investors should not rule out high inflation as a factor to plan for now. It may be upon us faster than we all thought. Central bankers will soon be taking a backseat, as politicians take the wheel. And, with governments leaning towards all kinds of leftist policies and money-spending ideas, you can be assured of the following scenarios:

  • Higher Inflation, possibly runaway inflation

  • Higher taxation for the wealthy

  • Increased financial repression, aka all kinds of creative ways to get rid of debt

On the back of inflation, we will automatically see interest rates rise too. Central banks will not be able to stave that off. Once interest rates start moving up in earnest from where they stand today, we are in for a very rough ride, or for an unbelievably attractive time for investing, depending on one’s risk appetite.


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