The inflation beast is bigger than you think it is

Inflation is on the rise. For instance, in the US, consumer goods prices rose by 7.5 per cent in January 2022 compared to the previous year. In the euro area, annual consumer goods price inflation was 5.1 per cent in December last year. In many countries, the prices of, e.g., producer and wholesale goods, as well as food prices, are rising even more. In particular, energy prices are skyrocketing. As always in times of price inflation, people are debating two questions. The first question: Is rising price inflation temporary or permanent? A few months ago, many people thought elevated price inflation would be temporary, that it would return to normal soon. At the time of writing, the consensus is that price inflation will remain elevated longer than previously expected but will eventually return to acceptable levels around 2 per cent. Is that a reasonable expectation?

This brings us to the second question: What is the cause of price inflation? Mainstream economists usually point to the impact of the politically dictated lockdown crisis (production halts, logistical bottlenecks, etc.) and ‘green policies’, which, they argue, have been driving goods prices up. While this is undoubtedly true, an important inflation driver is overlooked: the excessive increase in the quantity of money. For instance, the US Federal Reserve (Fed) has increased the money stock M2 by 40 per cent since the end of 2019. In the euro area, the European Central Bank (ECB) has raised the M3 money stock by around 20 per cent. This, in turn, has created an enormous ‘monetary overhang’ that is now translating into higher goods prices – both consumer and asset prices. To cloud the inflation outlook further, money growth rates have remained high. 

But wait: Central banks have announced that they will take their foot off the monetary accelerator. The Fed is now expected to start raising interest rates in March, followed by quite a few more rate hikes later this year. The ECB is also expected to change course, ending its hyper-expansive monetary policy in the coming quarters. Will it be enough to dampen price inflation? Probably not. Because central banks are faced with a delicate trade-off: bringing down price inflation would require substantially high(er) real interest rates to rein in credit and money supply growth. This, however, would presumably cause the debt pyramid in the global financial system to collapse. This is, of course, politically highly undesirable.  

Central banks will likely be less harsh when it comes to curbing price inflation. In other words, price inflation will most likely be higher for longer, while real interest rates will remain lower for longer. In fact, what seems to unfold is a textbook example: Financially overstretched governments are resorting to raising the ‘inflation tax’ to lower their debt load in real terms. Of course, governments probably would not want price inflation to spin out of control. However, they can be expected to favour increased price inflation of 4 to 6 per cent for some time. For this ‘financial repression’ to work, nominal interest rates must be kept low. Governments and their central banks will likely get away with this policy for the time being.

However, playing with higher price inflation is playing with fire. It can get out of control. If people recognize the scam, they adjust their inflation expectations upwards, pricing higher inflation into their wages, rent, and credit agreements. When this happens, the political incentives to take recourse in an even higher dose of ‘surprise inflation’ grow. It is not difficult to see that such a process could be devastating to the purchasing power of money. In fact, once an inflation process has started, it is relatively difficult to stop – for political reasons. And the longer the inflation process lasts, the greater the economic and socio-political costs to put an end to it will be. There is plenty of evidence in monetary history to support this concern.

The Austrian economist Friedrich August von Hayek (1899–1992) has put it succinctly (1960, pp. 332):

“The manner in which inflation operates explains why it is so difficult to resist when policy mainly concerns itself with particular situations rather than with general conditions and with short-term rather than with long-term problems. It is usually the easy way out of any temporary difficulties for both government and business – the path of least resistance and sometimes also the easiest way to help the economy get over all the obstacles that government policy has placed in its way. It is the inevitable result of a policy which regards all the other decisions as data to which the supply of money must be adapted so that the damage done by other measures will be as little noticed as possible.”

With this in mind, there is reason to conclude that ‘the inflation beast is bigger than you think’ and to remind the investor that protecting one’s capital from inflation-related losses is, and will remain, a key challenge in the years to come, a challenge that requires a lot of attention in everyone’s investment process.

Thorsten Polleit, chief economist of Degussa