In 1996, the Boskin Commission was tasked with saving the US government $1 trillion over 10 years. The commission recognized that if CPI, the US government’s preferred measure of inflation, was lowered by around 1%, then the government could save massively on Social Security and Medicare costs while simultaneously raising effective taxes, simply due to the fact that these are pegged to the CPI.

Meanwhile, economists Pia Malaney and Eric Weinstein, upon hearing that the economics profession was presented an opportunity to change the government’s measure of inflation, proposed using gauge theory as a way of incorporating changing preferences into neoclassical economic theory, a truly revolutionary idea that has been understudied to date.

One might hope that the economists would have listened to Malaney and Weinstein, ushering in a new era of mathematical economics, but instead, the Boskin Commission recalculated CPI such that it would come out 1% lower, transferring trillions in wealth away from social programs.

The dismal science? More like the dismal art of serving the powerful.

While the details of Malaney/Weinstein’s work are beyond the scope of this article, suffice it to say that inflation is still not measured properly. Inflation is currently measured as a single value (scalar) when in reality it is a field (vector), and there is no valid way to account for changing bundles/preferences over time using standard neoclassical theory.

In this week’s DDIntel, we take a deep dive into inflation; it’s causes, consequences, and how to invest accordingly. In particular, we consider war, energy, Covid, monetary policy, supply and demand, and greed, their effects on inflation, and how investors should treat the macro-landscape given an increased probability of recession.

To begin with our study of inflation, we must first understand the different theories for what money is and where it originated from. As economic historian Robert Skidelsky writes in Money and Government, “no one knows exactly where, how, or why money started, so people are free to invent stories.”

Skidelsky hones in on two prominent theories of money- the metallist theory and the credit theory. In short, the metallist theory claims that the origin of money comes from barter, while the credit theory claims that the origin of money comes from credit.

There is a grain of truth in each theory. For example, it cannot be denied that there has been centuries of trust build around storing gold as a safe haven. At the same time, it is also true that credit fluctuations are responsible for many if not all macroeconomic movements.

Under the money illusion theory (barter), real economic transactions are effectively barter transactions, and money is simply the medium of exchange upon which said transactions occur. This is oversimplified, as even David Hume recognized that in the short term inflation can result in a sugar high.

Nevertheless, Keynes undermined the remaining money illusion theories with his Theory of Employment, Interest, and Money. Without getting overly complex, Keynes developed what he called The Paradox of Thrift. He argued that money can be stored instead of spent, so in the short term there is the possibility that everyone individually becomes thrifty (storing money), lowering the overall demand in the economy to the point where everyone is worse off (recession).

It is not the goal of the authors to claim which theory is correct here. Instead, we are attempting to inform readers on the different schools of thought. For more information on the origins of money and macroeconomic theory more broadly, we highly recommend Money and Government, by Robert Skidelsky.

M*V = P*Q, where M is the money supply, V is the velocity of money (the number of times an average dollar exchanges hands in a given time period), P is the average price level and Q is the quantity of goods sold.

This equation was popularized by the monetarists; however, it is an accounting identity and therefore true by definition. The controversy surrounding this equation arises from the monetarists’ assumption that the velocity of money is constant in their analysis.

As can be seen in the above chart, not only is the velocity of money not constant, it is declining in recent history, and decelerates further during recessions. In other words, during a recession, it is possible for V to decline so sharply that even though M increases significantly due to accommodative policies by the central bank, the price level P declines.

So, central banks only have to worry about inflation when V stabilizes but M continues to grow, a situation we currently find ourselves in.

Nevertheless, while the monetarists are only half right, they correctly point out that increase the money supply too quickly for too long, and inflation is inevitable.

The monetary base has nearly doubled in the past 2 years, and the Fed spent this time buying $120 billion per month in bond purchases- $80 billion per month buying US backed Treasuries, and $40 billion per month in mortgage backed securities.

The Fed began tapering its buy back program in December of 2021; however, many have criticized the Fed for taking too long to raise interest rates and decrease liquidity to calm an over heated market. At the end of April when the Fed began decreasing its assets under control, the Fed’s balance sheet totaled nearly $9 trillion.

In summary, there is a numerical relationship between money supply and price level. This may in fact be the single most important determinant of inflation. Nevertheless, the story is complicated by the fact that the velocity of money is constantly changing. Furthermore, today’s inflation is caused by a unique blend of monetary policy and supply side shocks ranging from the war in Ukraine to the Covid lockdown in China.

A perennial question is does greed cause inflation. Economists are quick to reject the idea that greed can cause price changes. Why? Because greed is allegedly a constant. In other words, companies were just as greedy 2 years ago as they are today, so we can’t blame current price increases on increased levels of greed.

It is true, however, that conditions have altered enough to allow greedy opportunists to take advantage and raise prices. The Covid pandemic and the war in Ukraine are just two examples of shocks that can be exploited by profit seeking corporations.

One piece of evidence that inflation is partially caused by greed is that over 50% of the total rise in prices can be attributed to the rise in corporate profits. So the answer is mixed. Economists would say no, greed does not cause inflation. Common sense would suggest otherwise.

Modern monetary theory is quite the interesting approach to macroeconomics and monetary policy. It is with both strong proponents and critics. Both sides of the isle seem to think that the other side doesn’t really understand their arguments.

We would like to avoid over-complications here and focus on the core of MMT and its arguments. Essentially, MMT argues that as long as debt is denominated in one’s own currency, government deficits are much less important than neoclassical economics implies.

This is because the government must first spend currency before it can tax it!

Nevertheless, the fundamental constraint on government spending, according to MMT, is the generation of inflation, which results from excessive demand in the economy. However, MMT suggests that central banks should not focus on inflation and should instead let fiscal policy take the lead on controlling inflation.

In this sense, MMT is more prescriptive than predictive. In other words, MMT suggests that governments should spend more during a recession, deficits are less important than initially thought, and inflation should be controlled by Congress, not the Fed.

As such, many have criticized MMT for not factoring in that inflation expectations are controlled by the Fed for a reason and limit the sustainability of long term government deficits.

In addition to monetary policy considerations such as the supply of money in circulation, the level of interest rates, bond purchases, and the like, there are considerations related to aggregate supply and demand.

Holding everything constant, if an economy experiences a negative supply shock, then average prices will rise. Additionally, if an economy experiences a boost in demand, say from increased government spending, then all things being equal, prices will rise.

Currently, we are in the midst of the perfect storm for inflation. In addition to accommodative policies by the Fed and increased government spending, Covid was a massive (negative) supply shock that distorted prices. While it did cause average prices to rise, this effect was highly asymmetric and unequal.

Moreover, after Russia invaded Ukraine, food and energy supplies were disrupted worldwide, certain to lead to continued inflation in the coming months. Interestingly, China’s recent Covid-related lockdown is having a negative impact on aggregate demand, which in theory should reduce prices.

So, while the Fed is raising rates to combat inflation, the supply side shocks from Covid and the war in Ukraine are partially countered by decreased aggregate demand from an extended lockdown in China. No one said being an investor was easy!

Inflation is a macro phenomenon, so here we focus on the big picture, not on individual stocks. While it is clear that the probability of a recession in the next 12 months is higher than it was 12 months ago, it is important to not invest as if the end of the world is coming tomorrow.

There will always be another recession, and at their peak stocks certainly seemed overvalued compared to historic norms, but to beat the market, an investor has to know when to sell while everyone else is getting greedy and buy when everyone is getting fearful.

After over 6 weeks of negative returns in the S&P 500 and Nasdaq, equities are looking more attractive than at the beginning of the year. Nevertheless, it is clear that we are in the middle of a tightening cycle, where the Fed is raising interest rates and decreasing liquidity in the market.

As such, it’s unclear as to whether or not the market has temporarily bottomed, but timing a market bottom is a fool’s errand for most. Instead, you should continue dollar cost averaging into markets. As markets dip, you find buying opportunities.

In terms of investing around inflation, in general, during periods of high inflation, commodities do well, but there are always confounding variables. If the Fed raises interest rates too quickly, then the market narrative will be one of recession.

Inflation is elevated, but dropping, interest rates are rising, but subject to change, and equities are approaching bear territories, but eager for a turn around. Until there is more clarity on medium term interest rates and the short term probability of recession, expect choppy trading ahead.