Inflation - The Corrupted Thief
Lamar Schoell LLC
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Inflation - The Corrupted Thief
Inflation
The Corrupted Thief
Lamar Schoell LLC
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Inflation - The Corrupted Thief
TABLE OF CONTENTS
Table of Contents
Executive Summary


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4
Introduction


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5
What Is Inflation?


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5
Causes of Inflation


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5
The Triangle Model


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7
Demand-Pull Inflation


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7
Cost-Push Inflation


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7
Built-In Inflation


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8
Lowest Common Denominator


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8
What Are the Effects of Inflation?


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9
What Happens When Inflation Gets Out of Control?


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13
Monetary Policy: Keeping Inflation Under Control


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15
Modifying the Discount Rate


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16
Bank Reserve Requirement


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17
Open Market Operations


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19
Quantitative Easing/Tightening


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20
Repurchase Agreement (Repo) Operations


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22
How Is Inflation Measured?


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22
The Common Criticisms of How Inflation Is Calculated


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26
Hedging: Learn to Protect Your Wealth


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28
Gold


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28
Bitcoin


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29
Stocks & Bonds


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30
Real Estate


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31
Inflation-Linked Bonds


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32
Conclusion


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33
Disclaimer


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34
Recommended Resources


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35
Discover How To Build & Protect Your Wealth With Gold & Silver Even If You're On a
Budget!


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35
Struggling To Get Your Emails To Convert Hot Leads Into Sales


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36
Lamar Schoell LLC
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Inflation - The Corrupted Thief
Executive Summary
In today’s global economy, fears of inflation are front and center for many. This fear is
driven by massive government stimulus in response to the COVID-19 pandemic.
However, many market participants nowadays haven’t experienced truly unhealthy
levels of inflation and therefore aren’t prepared to protect themselves against it. In order
to understand where this fear originates from and how one can better protect
themselves from unhealthy levels of inflation, it is paramount that market participants
and everyday individuals understand the ins-and-outs of inflation. In this report we break
down inflation, elaborate on its causes and effects, discuss how central banks manage
it, explain what it means for society, and lend insight into how anyone can protect
themselves against it.
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Inflation - The Corrupted Thief
Introduction
What Is Inflation?
Inflation is an economic term that refers to a general rise in the price of goods and
services in an economy. A rise in prices causes fiat currencies to lose purchasing
power.
Central banks measure inflation by calculating the rise in the average price of a basket
of goods and services. Because prices are a function of supply and demand, all else
being constant, an increase in the money supply (i.e., greater demand) can increase the
general prices of goods and services.
The inflation rate is a proxy for understanding how much the average household’s cost
of living rises per year. Inflation attempts to quantify how much more it costs to buy
everyday goods, such as gas, groceries, hygiene products, and other common
consumer goods costs relative to how much they cost in the past.
Inflation seems harmless when under control. However, it causes an insidious drain on
the wealth of the consumer and is catastrophic to an economy when unmanaged.
Former US President Ronald Reagan once famously said, "Inflation is as violent as a
mugger, as frightening as an armed robber, and as deadly as a hitman."
Causes of Inflation
In times of uncertainty or hardship, like an economic recession, consumers don’t spend
like they usually do and instead opt to save. This behavioral shift is because they expect
a potential loss in consumption-ability (e.g., losing a job or falling real wages).
However, there are knock-on effects: if consumers aren’t spending, business production
declines, employees are laid off, and people make fewer investments. These effects
can create a vicious cycle that central banks often try to mitigate by increasing the
money supply to stimulate consumption and investment. By pumping more money into
the economy, consumers will have the confidence to spend more in businesses that, in
turn, can invest in new or existing products and services. Thus, central banks
reinvigorate economic activity to attempt to jumpstart economic growth. Central banks
measure this growth in Gross Domestic Product (GDP), or the total value of all goods
and services a country produces in a given year.
Inflation is usually a direct result of central banks creating money faster than GDP
growth. However, this imbalance doesn't always lead to inflation: money can enter
circulation without causing inflation. For example, increased investment enables
technical innovations that are generally deflationary (i.e., causes prices of goods and
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Inflation - The Corrupted Thief
services to fall); when businesses can produce goods and services at a lower cost and
faster than consumers can demand them, prices fall. In other words, new money is not
always frivolously spent. Some may save or pay down debt. Even though the money
supply is greater than before, the velocity of money fell (i.e., the rate at which money is
exchanged within an economy).
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Inflation - The Corrupted Thief
The Triangle Model
The three root causes of inflation, or what the Keynesian economist Robert J. Gordon
termed the "triangle model," are demand-pull inflation, cost-push inflation, and built-in
inflation.
Demand-Pull Inflation
When the demand for goods and services rises faster than productive capacity,
demand-pull inflation occurs. This type of inflation is due to an increase in the supply of
fiat currency and cheap credit. As more money is put into circulation and is easily
accessible, both demand and prices rise.
For instance, if demand rises by 5% while productive capacity is only growing by 3%,
demand will outpace supply by 2%. With more money chasing fewer goods and
services, prices will naturally rise.
Demand-pull inflation has occurred many times throughout history. An infamous
example took place in the UK from 1986–1991 when inflation hiked 4.6 percentage
points to a nine-year high of 7.6%, caused by demand-related factors including lower
interest rates, rising house prices, decreased income tax rates, and high consumer
confidence.
Cost-Push Inflation
When input costs for goods and services increase, such as wages or raw materials,
costpush inflation occurs. As the cost of production rises, supply decreases because
fewer goods and services are available. Because supply-side factors (e.g., higher
wages and higher lumber prices) have changed and demand hasn’t, the producer will
pass on the additional cost to consumers.
A notorious example of cost-push inflation took place in the early 1970s when the
intergovernmental body known as the Organization of Petroleum Exporting Countries
(OPEC) imposed higher prices on the oil market without any increase in demand, now
known as the Oil Shock of 1973–1974. Though producers were earning higher profit
margins in the short term, all sectors of the economy that relied on oil saw increased
production costs. As a result, these parts of the economy that involve oil (e.g.,
transportation, plastics, construction) saw inflationary pressure on the prices of goods
and services.
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Inflation - The Corrupted Thief
Built-In Inflation
When consumers expect inflation to keep rising, they demand higher wages. This
demand results in an increase in the cost of production, which results in higher prices. A
circular dependency can emerge whereby inflation spirals out of control, known as built-
in inflation.
Lowest Common Denominator
Per figure 1, we can see changes in prices within various sectors in the US economy.
Over the past 20 years, sectors with government intervention (education, housing,
medicine) have seen prices soar.
Figure 1
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We can also see in figure 1 that competitive markets with low involvement by the
government (e.g., cell phone services, toys, and TVs) have seen prices fall over the
past 21 years. Net-net, it appears there is a strong correlation between governmental
intervention on markets and inflationary impacts.
What Are the Effects of Inflation?
Economists from the Austrian school, such as Murray N. Rothbard or Ludwig Von
Mises, contend that inflation is not a rise in the general price level but rather an increase
in the supply of money and bank credit relative to the volume of goods and services. As
such, they argue that inflation is outright harmful because it depreciates the value of
currency, raises the cost of living, imposes an implicit tax on the poorest class of people
at a relatively higher rate than the tax on the richest class of people, devalues savings
and thus disincentivizes future savings, redistributes wealth and income asymmetrically,
incentivizes speculation and gambling, underestimates the antifragile mechanisms of a
free market system, and corrupts the morals of both the public and private sectors.
Meanwhile, the Keynesian school defines inflation as an increase in the general price
level caused by an increased money supply. Keynesian thinkers assert that inflation can
yield a variety of positive and negative effects, including:
•
[Positive] Increase in labor supply —An economy operating below its production
capacity has more unused labor and resources than can be used to increase
business production (i.e., economic growth). With a surplus of readily available
workers, hiring competition increases, and thus it becomes unnecessary for
employers to "bid" for employees by offering higher wages. In times of high
unemployment, wages typically remain stagnant, and no wage inflation (i.e., the
rate of change in wages) occurs. When there's low unemployment, the demand
for labor exceeds the supply, and employers may need to pay higher wages to
attract employees. Increasing wages forces employers to raise prices, causing
further inflation.
•
[Positive] Increase in aggregate demand —Because more money in circulation
may lead to more spending, it can positively impact the economy by increasing
demand for goods and services. This rise in aggregate demand thereby triggers
more production.
•
[Positive & Negative] Increase in value of scarce asset holdings / decline in value
of fiat savings— Because a currency’s purchasing power falls when inflation
rises, so will an individual's wealth if it’s parked in cash. Therefore, demand for
scarce assets (e.g., bitcoin, gold, real estate) will rise.
By way of example, gold prices grew +24% in 2009 on the back of the worst financial
crisis since the Great Depression, as inflationary concerns caused investors to seek
safe haven assets. However, the S&P 500 rallied +26% during the same period,
outpacing gold by 2%.
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Though it may seem like the ETF for the S&P 500 (SPX) was the better investment
choice at the time, this does not account for the amount of risk involved with investing in
either asset.7 Considering the S&P 500's risk (volatility) relative to gold, it's clear that
gold offered a better risk-adjusted return (i.e., less prone to a sudden drop in value while
having relatively large upside potential).
Figure 2 below provides a more contemporary example on the performance of fiat
currencies and scarce assets in the face of inflation by displaying the real (inflation-
adjusted) purchasing power of the USD, EUR, and GBP in contrast with USD-
denominated bitcoin price. Though there are some immaterial exceptions, it’s clear that
major fiat currencies have steadily declined throughout the last 11 and a half years
while bitcoin has inversely posted significant returns.
Figure 2
•
[Positive & Negative] Gains/losses for debtors/creditors —Unhealthy inflation
levels can weigh on creditors because the money they lend out will be worth less
upon repayment. On the other hand, high inflation is a boon for debtors because
the money they pay back gradually becomes less valuable. For example, if Bob
borrowed $100 from the bank with a 3% annual interest rate and suddenly the
economy experiences 10% inflation, Bob would pay his debts at a 7% discount in
terms of purchasing power. Inflation effectively rewards borrowing and
disincentivizes lending. When inflation expectations are high, assuming no
central bank intervention, nominal rates will rise to offset the long-term decline in
currency value for lenders.
Under the right conditions, governments are beneficiaries of inflation and will use it to
their advantage when possible. Governments do so by transmitting monetary policies
that increase tax revenues for the government, such as implementing tax hikes or
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selling bonds to issue debt. These initiatives allow central banks to effectively cause
more inflation, leading to the devaluation of the debt the government owes to investors
while simultaneously collecting more taxes that will help it pay off debts.
The debt-to-GDP ratio is a helpful metric for assessing a country’s ability to pay off its
debts. To calculate debt-to-GDP, divide government debt by the country’s GDP.
Figure 3
GDP corresponds to the amount of taxable revenue a government has to help pay down
debt. When debt-to-GDP is low, it means that the country is in an excellent position to
pay back its debt, and when high, the government has a greater risk of defaulting.
For reference, a study conducted by the World Bank states that a ratio exceeding 77%
for an extended period may result in an adverse economic impact on a country.8 At the
time of writing, data from the US Bureau of Public Debt showed that the US debt-to-
GDP ratio stands at a whopping 107.6% and is nearing levels last seen in 1946
following World War II (WWII) when the metric hit an all-time high of 118.9%. This is
notable as the majority of that debt value was inflated away in the decades that ensued
until the Debt-to-GDP hit 31.7% in 1974. Because most interest payments are fixed in
nominal terms, inflation makes the current debt value diminish in real terms.
Figure 4
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At least three factors contributed to the government’s debt being inflated away following the
war:
1. The economy rapidly expanded at an average pace of +3.75% per year from the
late 1940s to the late 1950s, which translated to massive tax revenues. Also, US
manufacturers saw little international competition as the war destroyed German,
UK, and Japanese factories.
2. After the war, the US government rolled back price controls, causing inflation to
soar and thus bringing in more tax revenue to pay down depreciating debt.10
Because government bonds yielded significantly less than the +76% rise in
prices between 1941 and 1951, real government debt obligations fell sharply.
3. The average duration of debt in 1947 was more than ten years, about twice
today’s average time.
[Negative] Decline in purchasing power—The most blatant impact of inflation is
that necessities such as food and shelter become more expensive. Because
consumers will purchase goods or services in anticipation of higher prices, prices
rise further, and purchasing power falls. Those with lower socioeconomic status
are the ones most impacted and must undergo material lifestyle changes.
Figure 5
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What Happens When Inflation Gets Out of Control?
History has consistently shown that too much inflation is detrimental to an economy.
When the money supply expands too much, it causes rapid, excessive, and out-of-
control price increases of +50% or more per month—or hyperinflation. Hyperinflation
usually occurs when a central bank expands the money supply too much and too fast
during tough economic times.
Hyperinflation negatively impacts an economy in several ways, such as:
•
The native currency’s value falls relative to others and has significantly less
purchasing power.
• Consumers stockpile goods in anticipation of higher prices, causing supply
shortages.
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• Consumers withdraw deposits and stop depositing money at banks, thereby
limiting lenders’ ability to operate.
•
Less production and spending means less tax revenue, forcing governments to
run a budget deficit and limit social services.
Venezuela, Hungary, and Zimbabwe are some examples of countries that have
experienced periods of hyperinflation. Hungary experienced the worst case of
hyperinflation in human history following WWII in 1946. At the time, the daily inflation
rate was over 200%, meaning the average price of goods and services was doubling
every 8 hours. The government stopped collecting taxes altogether because just a few
hours of delay in paying taxes could decimate its value. Workers had to pay the price of
this hyperinflation as real wages fell −80%, forcing them and their families into abject
poverty amidst a devastating supply shock. Moreover, hyperinflation eradicated
creditors because loans lost their value before debtors repaid them.
Figure 6
Figure 7
Monetary Policy: Keeping Inflation Under Control
Central banks are known as “lenders of last resort” because they’re responsible for
providing financial capital to commercial banks for both day-to-day business operations
and during periods of financial turmoil. Specifically, they’re responsible for maintaining
full employment and managing reasonable rates of inflation.
Most central banks closely monitor the inflation rate and set an annual inflation target of
roughly 2–3%, which they believe promotes a certain level of spending while stimulating
sustainable economic growth.
Figure 8
Notably, central banks haven’t always set inflation targets. Germany and Switzerland
first used inflation targeting in the mid-1970s to revive the economy following the
collapse of Bretton Woods. Roughly 20 years later, Canada, the UK, Sweden, New
Zealand, and Australia followed suit in adopting the inflation targeting policy, along with
many emerging economies. The US didn't adopt inflation targeting until January 2012
after the fallout of the 2008–2009 financial crisis (the Great Recession).
A central bank also acts as the regulatory authority of a country's monetary policy and
controls the production, distribution, and reduction of the nation’s money supply. Put
simply, a country’s central bank maintains the integrity of the banking system and
prevents it from falling apart; this is done by either expanding or shrinking the money
supply and providing liquidity buffers as needed.
The process by which central banks control the money supply varies depending on the
central bank and the nation’s economic situation. Some of the most common methods
that central banks utilize to control the money supply include:
• Changing the central bank’s discount rate
(i.e., interest rate between the central bank and domestic banks)
• Setting reserve requirements
(i.e., the amount of money a bank is required to hold against customer deposits)
• Conducting open market operations
(i.e., buying/selling US treasuries, reverse repos, quantitative easing)
Modifying the Discount Rate
Central banks can’t directly set interest rates for loans such as mortgages, personal
loans, or auto loans, which is known as the “lending rate.” However, central banks do
have the power to influence the lending rate by modifying the discount rate. Central
banks change these rates to incentivize borrowing (monetary expansion) or lending
(monetary contraction) to control economic growth.
If the discount rate is low, borrowing from the central bank is less expensive, and thus
banks can lend to customers at a lower rate. Lower rates tend to increase borrowing
and consequently the quantity of money in circulation, which can stimulate economic
growth. However, central banks should theoretically refrain from keeping rates too low
for too long to avoid excessive inflation. If a central bank wants to decrease borrowing
and incentivize saving because an economy is growing too fast, it can increase the
discount rate.
Bank Reserve Requirement
Another common way central banks manage the money supply is by adjusting the bank
reserve requirement. Reducing the reserve requirement allows commercial banks to
use the surplus to lend out more money. On the other hand, the central bank can
reduce money in circulation by increasing the reserve requirement.
In the US, when a bank runs low on reserves and needs to meet the reserve
requirement, it will borrow funds from another bank overnight and pay the federal funds
rate. Notably, the federal funds rate impacts all lending markets because of the cost
associated with borrowing from other banks. For instance, if it is expensive for a bank to
borrow from another bank, financial institutions will logically charge its customers an
even higher interest rate. Alternatively, suppose it doesn't cost much for a bank to
borrow from one of its peers. In that case, financial institutions will offer their customers
loans at a lower interest rate to compete in a market where money is cheaply available.
As a result, the federal funds rate directly influences the lending rate.
Figure 9
This practice of banks creating loans in excess of customer deposits is known as
fractional-reserve banking. While the US reserve requirement tends to vary depending
on factors such as the type of financial institution and existing economic conditions, it is
usually somewhere between 5–10%.
However, the Federal Reserve Board lowered reserve requirements ratios to a historic
low of 0% on March 15, 2020, in response to the first outbreak of the COVID-19
pandemic.
The tricky part about fractional-reserve banking is that it allows for the multiplication of
money created from nothing. For example, assume a bank starts with $0, and it
receives a $100 deposit. The bank now has $100 in reserves. At the current reserve
requirement in the US, the bank can lend out the full $100 to other individuals or
institutions and thus insert an additional $100 into the economy. The borrower then
might take their $100 to another bank to deposit, where it will be lent out once again and
increase the number of dollars in circulation even further in a feedback loop. This
economic phenomenon is known as the “multiplier effect.”
If a country’s financial stability is in question, depositors may seek to withdraw their
funds from a bank out of fear that the bank could become insolvent, known as a bank
run. Bank runs have occurred repeatedly since the advent of banking, including during
the Great Depression and the 2008–09 financial crisis. Bank runs create negative
feedback loops that can quickly bankrupt banks and contribute to a systemic financial
crisis or collapse. Though banks have significant safeguards in place to prevent bank
runs, they are still a genuine possibility; the last bank run occurred in May 2019 against
MetroBank.
Some economists argue that while fractional-reserve banking has its risks, it is not
definitively inflationary and can stimulate economic growth. This scenario is especially
true when lending fuels technological innovation, which is deflationary.
Open Market Operations
Central banks, such as the US Federal Reserve (“the Fed”), also influence interest rates
by conducting open market operations where they buy and sell government or
privatelyissued securities (e.g., corporate bonds) on the open market. These operations
create artificial supply or demand that drives interest rates towards its target. When the
Fed wants to increase the money supply and drive economic growth, it credits its
member banks’ balance sheet with funds in exchange for US Treasuries and other
securities sold in the open market. However, the Fed doesn't physically exchange
capital with its member banks. The ECB similarly controls interest rates through the
European Overnight Index Average (Eonia), the average overnight reference rate for
which European banks lend to one another in euros. These purchases and balance
sheet credits mean that banks now have more money on hand to lend out to customers
at a low interest rate, thus increasing the circulating money supply. Most importantly,
this new money provides cheap credit to individuals and businesses who can use this
newly acquired debt to make purchases or investments.
If the economy is expanding at an unsustainable rate, the Fed will reduce the money
supply by selling Treasury bonds from its account on the open market and will raise
interest rates. Fewer dollars and higher interest rates means it’s more costly to borrow,
and the incentive to save is greater. In both instances, the Fed has in-house traders
who constantly adjust the bank's securities and credit daily to keep the federal funds
rate in line with its target.
Quantitative Easing/Tightening
When open market operations fail, central banks will specifically purchase long-term
government bonds from member banks and reinvest proceeds back into the same
securities—or what is known as Quantitative Easing (QE). This unconventional
monetary policy tool spurs economic growth by injecting money into the economy
through asset purchases. Conversely, central banks conduct Quantitative Tightening
(QT) to reduce the central bank’s balance sheet by slowing the pace of reinvestment of
proceeds from maturing bonds. In both cases, the goal is to influence economic growth
by altering the money supply.
The Fed recently took unprecedented stimulus relief action in response to COVID-19 via
aggressive open market operations and QE, among other stimulus efforts. The Fed’s
QE strategy in March 2020 was to buy at least $500B in Treasury securities and $200B
in government-guaranteed, mortgage-backed securities over “the coming months.” The
Fed indefinitely expanded the QE strategy a week later, noting that it would buy long-
term securities “in the amounts needed to support smooth market functioning and
effective transmission of monetary policy to broader financial conditions.” Though the
operations were successful through May, the central bank announced it would begin
buying $80M per month in Treasury bonds and $40B in residential and commercial
mortgage-backed securities in early June 2020.20 Since March 2020, the Fed’s balance
sheet has exploded nearly 2x its size to around $8T due to its massive purchasing
efforts on the open market.
Figure 10
When it comes to QE, the ECB lends money to governments and commercial banks in
the eurozone on a short-term basis (usually three months). This method is different from
how the Federal Reserve purchases long-dated treasury bonds. For example, the Fed
implemented aggressive QE in the 2008 recession while the ECB incrementally
increased the maturity of its bank loans from three months to three years. The ECB also
eased requirements on its loan collateral multiple times, giving European banks easier
access to the ECB's reserve money as they were made available on a full-allotment
basis (i.e., banks have unlimited access to the central bank’s liquidity). However, it
appears the central banks are starting to converge on their crisis management
strategies as the ECB introduced QE in March 2015.
Repurchase Agreement (Repo) Operations
A repurchase agreement (repo) is where a central bank sells short-term securities to
investors, typically overnight, and repurchases them the following day or week at a
slight premium (i.e., the implicit overnight interest rate). The central bank effectively
borrows, and the other party is lending at the implicit overnight interest rate. This
operation is known as a repo to the seller and a reverse repo for the buyer.
The most recent example of repo operations was in response to the COVID-19
pandemic; the ECB set up a Eurosystem repo facility in June 2020 to provide euro
liquidity to no-neurozone central banks (EUREP). This system allowed the ECB to
arrange repo lines with several non-eurozone central banks, including Hungary,
Albania, and Serbia, to conduct more repos. These repo lines allow the ECB to better
address euro liquidity shortages in non-eurozone countries by lending euros to these
foreign central banks. As a result, the ECB mitigates downward pressure on eurozone
markets and economies that might adversely impact the implementation of monetary
policy.
How Is Inflation Measured?
United States
Consumer Price Index (CPI)
The Bureau of Labor Statistics’ (BLS) Consumer Price Index (CPI) is the most commonly used
measure of inflation. It tracks the change in the cost of living by calculating the weighted
average of price changes in a basket of consumer goods and services. This basket attempts to
reflect common consumer spending behaviors by mimicking the usual products and services
purchased. The US CPI rose 5% year-over-year as of the time of press, the fastest pace since
August 2008.
Figure 11
To calculate the CPI, the BLS will contact service establishments, doctors offices, retail
stores, and rental units, among others, to record the prices of roughly 80,000 goods and
services and compare its findings to 1984; a CPI of 100 implies inflation is at levels last
seen in 1984.
Figure 12
Personal Consumption Expenditures (PCE)
Like CPI, the Bureau of Economic Analysis has a Personal Consumption Expenditures
(PCE) index that seeks to measure inflation by gauging the change in price of business
goods and services.
Because the government and central bank focus on different inflation measures, they
utilize other price indexes. For instance, the government uses the CPI to make inflation
adjustments to certain benefits (e.g., Social Security), while the Fed focuses on the
PCE. Historically, PCE has come in lower than CPI. The US PCE increased by 1.2
percentage points month-over-month to 3.6% at the time of press, up from 1.4% in
January 2021.
Figure 13
The Fed previously used the CPI to measure inflation before January 2012 but switched
to the PCE index. The index responds dynamically to changing consumer preferences
because expenditure weights can vary as people substitute goods and services for
others, it includes a more comprehensive list of goods and services, and the Fed can
revise historical data to reflect new data.
Figure 14
Eurozone
Harmonized Index of Consumer Prices (HICP)
The ECB’s Harmonized Index of Consumer Prices (HICP) measures the change in the
prices of consumer goods and services acquired over time, used or paid for by
eurozone households. The HICP includes most consumer goods and services
purchased (e.g., food, newspapers, petrol, durable goods such as clothing, PCs,
washing machines, and services such as hairdressing, insurance, and rented housing).
The biggest difference between the HICP and the US CPI is that the HICP doesn’t
cover expenditure on owner-occupied housing. The US CPI calculates "rental-
equivalent" costs for owner-occupied housing, while the HICP considers such
expenditure as investment and excludes it from the index. Also, the HICP differs from
the US CPI in that it attempts to incorporate rural consumers, while the US focuses on
the urban population. However, the HICP does not accurately include rural consumers
in its index since it only uses rural samples for creating scalable weights. The HICP
reading rose +0.4% month-over-month to 2% at the time of press, its highest level in
over two years.
China
Consumer Price Index (CPI)
China measures inflation via its own CPI, which focuses on often-consumed goods and
services, such as groceries, clothes, rent, power, phone services, recreational activities,
and raw materials (e.g., gas, oil, lumber), as well as federal fees and taxes. Though the
country has never disclosed the index’s exact weightings, estimates suggest that food,
tobacco, and alcohol account for roughly 30%. China’s CPI rose from -0.3% at the start
of the year to
1.3% at the time of writing, its biggest year-over-year increase in eight months.
Producer Price Index (PPI)
Although CPI measures price changes from the consumer’s perspective, China’s
producer price index (PPI) measures price movements from the seller’s perspective.
The PPI does this by tracking changes in the prices that manufacturers charge
wholesalers (i.e., factory gate prices). China’s PPI is typically a leading indicator of
changes in the nation’s CPI because it foreshadows the potential price levels of many
goods and services before they reach the market. In essence, the PPI is a gauge of
industrial profitability. The nation’s PPI rose 2.2 percentage points month-over-month to
9% at the time of press, the highest level in over 12 years due to rising commodity
prices.
The Common Criticisms of How Inflation Is Calculated
United States
Skeptics have long argued that calculations for the CPI and other measures of inflation
are flawed. These arguments range from questionable economic incentives to outdated
methodologies. In particular, skeptics believe that the inflation figures that the US
government and Fed throw around are incorrect for the following reasons:
•
The government has incentives to suggest inflation is lower because it affects
public programs that use inflation as a benchmark to set policy. Because the CPI
determines the incomes of tens of millions of Americans living off government
programs (e.g., food stamp recipients, Social Security beneficiaries, military and
federal Civil Service retirees, and children on school lunch programs), the
inflation reading directly affects the amount of money the government must
spend on these income payments to keep pace with the cost of living. Therefore,
a higher CPI is more costly and less manageable to the government than a lower
CPI, especially when a government is deeply indebted.
• Consumer spending habits may change with the economy, but the CPI doesn’t
account for substitution. Therefore, the government may overestimate inflation;
even the BLS freely admits the flaws of the substitution effect.
•
The CPI doesn’t capture the regional price differences and variations in buying
patterns across different groups, e.g., citizens living in expensive areas such as
San Francisco will have different spending habits than those living in cheaper
locations such as Wyoming.36 Not accounting for this difference can result in a
lower inflation reading.
Figure 15
•
The CPI inadequately represents certain expenditures, e.g., the index includes
outof-pocket medical expenses but not the portion of medical costs sent by
insurance companies and government healthcare programs.
•
The omission of productive investment assets (e.g., stocks, bonds, and real
estate) conceals declines in an essential component of purchasing power. CPI
may measure increases in the price of consumption assets, but it doesn’t
account for reductions in the dollar’s purchasing power against productive capital
assets. For example, the total market capitalization of the US stock market since
the start of 2020 has increased by +30%, driven by aggressive money creation
efforts.
Eurozone
Much like the US, skeptics have long claimed that the HICP isn’t entirely accurate. The
Boskin Commission identified problems with the HICP in 1996, including product
substitution, the treatment of new products, and quality adjustment. This issue is likely
because the HICP methodology does not ensure standardization (i.e., harmony) of the
quality adjustment process, the entry of new products, or the analysis of missing prices.
Critics argue these issues cause significant price differences across countries. While
the most considerable criticism of the HICP is likely in its exclusion of the cost of owner-
occupied housing, ECB president Christine Lagarde hinted in early 2020 that the central
bank might soon include it in the HICP calculation.
China
Though the National Bureau of Statistics of China has defended its CPI as a reliable
metric for gauging the change in prices, the most frequently discussed concern is the
indicator's drastic underestimation of overall price pressures in China’s economy. This
problem is due to the government not giving enough weight to housing prices and has
caused great concern as China’s housing market has surged for years to a whopping
$52T market. Additionally, some critics argue that the basket does not always reflect
changes in consumer preferences as the basket is only adjusted every five years (last
updated in 2020). Much of the remaining criticisms about China’s CPI measurement
have unsurprisingly pointed to a lack of trust in the government.
Hedging: Learn to Protect Your Wealth
To protect against inflation-driven loss of purchasing power, investors look to own
assets that appreciate with inflation. These assets include gold, stocks, real estate, and,
more recently, bitcoin. Assets purchased to protect wealth against rising inflation are
referred to as “inflation hedges” and have been part of many individuals’ portfolios for
many reasons.
Gold
Gold has a rich history of price stability and a proven track record of resilience during
economic downturns. Additionally, gold has been praised for its sound monetary
properties, including its scarcity, cost of production (i.e., difficult to inflate supply),
durability, divisibility, and fungibility—making it an attractive store of value and a “safe
haven” asset.
For example, the bullion outperformed virtually all other assets when inflation was high
under the Carter and Nixon administrations. Pundits contend that Richard Nixon, the
37th US president (1969– 1974), nearly destroyed the US economy via his poor
attempts to remedy mild inflation with wage and price controls, as well as removing the
US gold standard. By the end of his tenure, inflation hit double digits, and gold was up
+350% since the start of his first term.
Under Jimmy Carter, the 39th US President (1977–1981), inflation got as high as
roughly 18% following the naming of Paul Volcker as Chairman of the Federal Reserve
Board. Volcker attempted to end double-digit inflation by raising the federal funds rate to
unprecedented levels. This extensive period of extremely high interest rates is now
known as the “Volcker Shock” and was the primary driver of the 1981 recession.
Between Carter’s inauguration and the end of his tenure, gold prices rose +148% as
people flocked to the safe haven asset to protect their wealth.
Between major economic downturns, gold prices have historically trended lower before
consolidating and then rallying higher as the next economic downturn begins to surface.
Figure 16 describes how gold rapidly appreciates ahead of significant downturns before
retracing lower and consolidating.
Figure 16
Bitcoin
Bitcoin is often referred to as digital gold because its underlying computer code ensures
many of the same properties of gold. Like gold, bitcoin is also highly scarce, supply
inflation-resistant, divisible, durable, and highly fungible. Bitcoin is hailed as an inflation
hedge because it isn’t subject to the uncertainty of a central bank’s monetary policy.
Instead, Bitcoin creator Satoshi Nakamoto determined the crypto asset's supply inflation
schedule at the time of inception, and any changes to it would have to be voted in by
the community rather than a centralized authority.
Moreover, it seems that the "smart money" is buying up bitcoin in troves since late last
year, including legendary investor Paul Tudor Jones, MicroStrategy's Michael Saylor,
and Tesla's Elon Musk. These billionaires, among others, have added billions of dollars
worth of bitcoin to their company's Treasury reserves and personal investment portfolios
to hedge against impending inflation. Institutions and renowned investors have
historically stayed away from investing in bitcoin, citing claims that it is a risky and
speculative asset. Though before the COVID-19 pandemic, bitcoin was too
inexperienced to be an inflation hedge, its rapidly growing reputation—as evidenced by
“smart money” buying into the asset— will likely solidify its spot as one of the best
inflation hedges for the foreseeable future.
Stocks & Bonds
The relationship between inflation and equity prices is not uniform because stocks and
the companies issuing them differ. While every stock should be evaluated on its own
merits, many contend that value stocks (i.e., shares trading at a lower valuation relative
to the company's fundamentals, such as dividends, earnings, or sales) may do better
than growth stocks (i.e., stocks that are expected to outperform the market) when
inflation is high. This theory stems from investors assessing growth stocks based on
their present value of future earnings. When growth in inflation or interest rates starts
pacing faster than expected, it reduces the current value of future cash flows. Stocks
that can defend high dividend payments, including many value stocks, are likely to
outperform because their yield is relatively attractive.
Stocks can appreciate with inflation because it can stimulate job growth, investors may
seek to hedge by converting cash into stocks, and revenues increase with inflation
following an adjustment period.
Assuming high inflation is considered a rate greater than the average for post-gold
linked currency exchange in the US since 1971 (i.e., 4.4%), stocks have on average
fared significantly better than bonds during times of high inflation throughout history.
Figure 17
Out of these 20 years of high inflation, bonds have yielded a positive return for only six
years (30%) while stocks finished higher for 11 (55%). However, one should note that
the average return for stocks (+2.5%) was still less than the average inflation rate
(6.4%) during these 20 years. Although stocks are typically a better inflation hedge than
bonds and fiat currency, they have struggled to completely protect one’s wealth from
inflation in the past.
Inflation can also adversely affect stock prices because declining consumer spending
during general economic slowdowns leads to lower revenue and profits that weigh on
share prices. Also, increases in input costs (cost-push inflation) can decrease profit
rates and force businesses to falter as it takes companies several quarters to pass
along input costs to consumers.
Real Estate
Investing in real estate or real estate investment trusts (REITs) is another popular
inflation hedge because property values tend to increase along with the cost of renting.
This property value rise occurs because input costs (e.g., raw construction material
such as lumber) rise with inflation, and higher interest rates brought by rising inflation
will push builders to demand higher home prices to offset borrowing costs. All these
dynamics create a positive feedback loop that acts as a tailwind for property owners.
However, real estate prices don’t always rise when inflation is high. Because rental
income generally grows less than inflation, there will likely be no material appreciation in
real estate prices if rising interest rates push up capitalization rates (i.e., the rate of
return expected to be generated on a real estate investment property). According to
MIT’s Department of Economics, only retail property incomes have historically kept up
with inflation. In contrast, industrial and apartment incomes have only partially offset the
increase in inflation and office property incomes have barely increased, if at all.
Figure 18
Property value has historically performed better as retail and apartment properties
proved to be complete inflation hedges, industrial property was a nearly complete
inflation hedge, and office properties only provided a partial inflation hedge.
Inflation-Linked Bonds
Inflation-linked bonds, such as the US Treasury inflation-protected securities (TIPS), are
bonds designed to increase in value with the pace of inflation. TIPS track the CPI, and
its principal amount will reset according to modifications in the index, meaning it will
increase with inflation and decrease with deflation. TIPS are often viewed as a "risk-
free" investment because the investors always receive at least the original principal at
maturity.
These securities won’t yield high returns but often outperform Treasuries during periods
of unexpectedly high inflation. For instance, following the 2008 financial crisis when
inflation was high, the iShares TIPS Bond exchange-traded fund (ETF) increased by
+33% through late 2012. Although they go by different names, many countries such as
India, Canada, and the US issue inflation-adjusted bonds like the TIPs.
Figure 19
Conclusion
As we have already alluded to, understanding the economic phenomenon that is
inflation isn’t just for economists, market participants, and the intellectually curious, but
for everyone. Inflation is paradoxically a silent friend and a silent foe; it can serve as a
financial tailwind for some and a painfully relentless wealth destroyer for many others.
Not only can inflation be devastating to businesses and individuals when it gets out of
hand, particularly when times are already tough, but it can be a powerful force of good
for governments.
In the past, we’ve seen governments and central banks attempt to control inflation by
employing contractionary monetary policy, such as modifying the central bank’s
discount rate, changing the bank reserve requirement, and conducting open market
operations. But, when governments and central banks fail to keep a tight leash on
inflation and rely on arguably inefficient measures of inflation, then businesses,
economies, and even livelihoods can be in great danger. Because of what seems to be
government and central bank’s innate tendency to push inflation to detrimentally
elevated levels, individuals have learned over time how to better store their wealth to
protect themselves against abnormally high levels of inflation. While assets like gold,
real estate, inflation-adjusted bonds, and some stocks have proven to be useful hedges
against inflation, the emergence of bitcoin and crypto assets has some market
participants questioning how to protect one’s wealth in today’s modern-day economy.
This shift in belief and thinking is evident by institutional investors, such as
MicroStrategy’s Michael Saylor, Bridgewater’s Ray Dalio, and legendary investor Paul
Tudor Jones, outright vocalizing support for bitcoin.
Needless to say, while there is no telling what lies ahead, fortune favors the bold. By
understanding the ins & outs of inflation and the multitude of tools one can use against
reckless monetary policies, one can better protect their wealth and truly be better off.
Disclaimer
The information in this report is provided by, and is the sole opinion of, Satoshi
Pioneers’s research desk. The information is provided as general market commentary
and should not be the basis for making investment decisions or be construed as
investment advice with respect to any digital asset or the issuers thereof. Trading digital
assets involves significant risk. Any person considering trading digital assets should
seek independent advice on the suitability of any particular digital asset. Satoshi
Pioneers does not guarantee the accuracy or completeness of the information provided
in this report, does not control, endorse or adopt any third party content, and accepts no
liability of any kind arising from the use of any information contained in the report,
including without limitation, any loss of profit. Satoshi Pioneers expressly disclaims all
warranties of accuracy, completeness, merchantability or fitness for a particular purpose
with respect to the information in this report. Satoshi Pioneers shall not be responsible
for any risks associated with accessing third party websites, including the use of
hyperlinks. All market prices, data and other information are based upon selected public
market data, reflect prevailing conditions, and research’s views as of this date, all of
which are subject to change without notice.
This report has not been prepared in accordance with the legal requirements designed
to promote the independence of investment research and is not subject to any
prohibition on dealing ahead of the dissemination of investment research. Satoshi
Pioneers and its affiliates hold positions in digital assets and may now or in the future
hold a position in the subject of this research. This report is not directed or intended for
distribution to, or use by, any person or entity who is a citizen or resident of, or located
in a jurisdiction where such distribution or use would be contrary to applicable law or
that would subject Satoshi Pioneers and/or its affiliates to any registration or licensing
requirement. The digital assets described herein may or may not be eligible for sale in
all jurisdictions.
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