Inflation?! And Why You're Being Lied To

You will definitely have experienced by now, that as the Sun rises in the East and sets in the West, inflation is a going concern all of us mortals. Well, yes and no! In this article, I will present a compelling thesis that puts this continuum to rest, for now.


So what exactly is inflation?

This is a question I ask every client I meet. The results aren't as what you might you've expected. The average Joe on the street thinks he understands what inflation is, and that is true to a large extent. But may I kindly correct that; the average Joe doesn't "understand" inflation, he experiences the effects of inflation. If you studied economics, you will know that there are many schools that one might subscribe to.

The Keynesian school posits that inflation is a general rise in price levels in the real, tangible economy; and a general decline in the purchasing power of the currency. The Austrian school posits to the contrary, that inflation is in and of itself always a monetary phenomenon. Most people can relate to the former, and that's exactly what is keeping the age old conundrum buzzing in modern times.

Rising or falling prices is not inflation. It is a consequence, a manifestation of the effects of inflation. Inflation by detonation relates to quantity, not price. However, if we were taught in school to measure inflation through a quantity measure, it would prove to be impossible. Try ascertaining the amount of fresh apples available for purchase in Singapore. Try ascertained the price of an apple in Singapore. The latter is the obvious choice to "measure" inflation.

I once read an article a few years back about an economist's lament on the sheer hubris humanity exhibits when the topic of inflation is mentioned. He reckons that inflation can never be quantified in absolute terms; meaning the current measure of inflation using the CPI (consumer price index) only does so in Singapore Dollars per se, or Euros in Germany, or Yuan in China but let's just use Singapore for now. This precisely why the PPP (purchasing power parity) is used in economics because it provides a more holistic benchmark of prices in a local currency adjusted for past inflation.

When the money supply within an economy rises, there is inflation. This is the inherent nature of the term inflation: to inflate the amount of currency in circulation, or to inflate the amount of credit available in the system. All else equal, when the amount of currency increases, there will be an upward pressure on prices of goods and services in that economy because more dollars are chasing that fixed amounts of goods and services. But we know all else is never equal, so there are myriad of other dynamics that feed into this price discovery process.

We're not going to delve into the topic of money supply and credit now because that would only open multiple Pandora Boxes. Readers need to appreciate just how immensely complex the actual science of economic is. Yes, the layperson would be able to see the concept of the art, but the since is very much beyond what I can claim to profess. All you need to know is inflation by all technicalities refers to the increase in the amount of available money; and everything that follows is a result of the endless series combinations and permutations.

For the rest if this article, and for the sake of commonality, I will refer to prices and similar references as to inflation.


Gross Misconceptions About QE

For a primer about QE, read my article written in 2011 to address flawed theories

A major misconception about about the various QE (quantitative easing) programs where central banks allegedly "print trillions of newly minted cash into existence" is that they cause inflation. Nothing could be further from the truth. Although I want to reserve this topic for a rant in the future, I will merely question the thousands of so called "experts" who have publicly stated that QE is money printing and that it causes hyperinflation.

My question to them is so simple even a first grader can answer: "for the last 5 years when global QE programs have been active, list down the examples where we have seen a high inflationary or hyperinflationary environment in the countries that said QE programs have been occurring."

The simple answer is, there is no hyperinflation as a consequence of QE, and contrary to popular belief, QE is not money printing. If it were, we would be seeing the values of the US dollar, the pound sterling, the Japanese yen collapse. We haven't seen that. So these folks who so daringly proclaim the grandest of nonsense, those who have very irresponsibly misinformed the innocent and oblivious public with pure chicanery, and those fellas who have been absolutely dead wrong for the past 5 years and counting, all of them have lost credibility in my eyes. And it should in yours too.


Should We Fear Inflation?

So back to the topic at hand, should we fear rising prices? Some would hasten to mock at this seemingly obvious question, but I can tell you there is a lot more to it than meets the eye. The short answer is no. But the longer and more complete response would be to define the level of inflation in question, and then take that in light of other factors to arrive at a definitive answer.

Of course the consensus amongst the person on the street is "inflation is bad because it makes everything more expensive", or "inflation erodes the value of my hard earned savings". While such memes make practical sense, they are incorrect in many aspects.

As we discussed earlier, as an economy grows, its money supply would too increase. This is natural and logical. The pace of economy growth and money supply growth is a separate issue altogether. Usually, significant divergences between the two lead to problems. One of them is high inflation or in extreme cases hyperinflation. As a caveat, lots of folks use the term hyperinflation with reckless abandon. A 5% annual CPI inflation rate isn't hyperinflation. A 20% figure might be considered one but certainly not 5%.

5 year chart of the USDRUB. This is what hyperinflation looks like. RUB has weakened more than 50% against USD this year alone

5 year chart of the USDRUB. This is what hyperinflation looks like. RUB has weakened more than 50% against USD this year alone

Shift your attention to Russia just for a moment. Case in point, the Ruble has weakened against the greenback by 50% year to date. Prices of goods in its economy have sky rocketed in nominal terms. Without going into the reasons for the weakness in the Ruble, Russia is experiencing hyperinflation; not because its money supply is exploding, but because supply and demand dynamics of its currency and to a lesser extent the good and services of its economy. Hence in the parlance of the technical purists, Russia is merely seeing a severe period of rapidly rising prices, and not hyperinflation of its money supply. In fact, the Russian Central Bank just earlier today hiked its benchmark rate by 100bp (1%)

A moderate pace of inflation is the healthiest for most economies. This is why most central banks have stable prices as one of their mandates. A steady inflation rate is in the best interests of an economy.

The rationale behind this is when the there is deflation (negative rate of price change), personal consumption will generally decline. If this is counter intuitive to you, please allow me to explain. In a deflationary environment, consumers benefit on the surface because goods and services seem to be cheaper at first (lower prices). One will assume that demand in the form of consumption will increase and more than offset the decline in aggregate prices.

This is often not the case because it is part of human nature to anticipate; and in a deflationary environment, consumers and businesses will more likely shelve their purchases in anticipation of yet lower prices in the near future. If taken in isolation this would be a one-off reaction. We know it isn't: anticipatory behavior eventually creates feedback loop with negative consequences to economic output and growth.

Here's why. As consumption is held back to to our anticipatory nature, agree demand falls as a direct result. When aggregate demand declines, it puts further downward pressure on prices of those goods and services in questions; so this itself is a deflationary actor. Lower prices them feeds into the psychology of consumers and businesses, reinforcing a general sentiment of lower prices are still to come, and furthers the withholding of expenditures. I hope you get the picture now, on how by just the thought of lower prices in the future is itself sufficient to put an economy into a death spiral. Such is the reason why global central banks are extremely cautions when finding a balance between economic growth, the labor market, and prices.

If mass psychology and sentiment  drives market volatility, so does it drive an economy. Now you understand in better color why a moderate pace of rising prices is imperative for the healthy functioning of an economy. Too little is bad because it dampens consumption and to some extent investment. Too much is also bad because it destroyed wealth and can lead to hoarding of goods. A good way to succinct describe deflation and high inflation, both if which are not welcomed, would be death by a thousand cuts (deflation), and death by execution (high/hyperinflation). Japan is the prime example for the former, while Brazil exemplifies the latter albeit to a lesser degree.


The situation in Singapore

As a licensed financial adviser for one of the leading life insures globally, I interact with various other advisers and clients in my daily activities. I must say I'm shocked that financial advisers either knowingly or unknowingly misrepresent the real rate of inflation, or the rate of price increases in Singapore.

Some advisers confidently say the current level of inflation stands at 3%, some say 4%, and very few quote a figure below 2.5%. As an adviser that takes his job seriously, I am a little disgraced by this conduct. I have a feeling that the gross misrepresentation is a mix of oblivion and hoaxing. If you will, ask around for the current rate of inflation and you'll be surprised on the variety of wild guesses you'll receive.

I wrote this a week ago on my piece about the Singapore economy, presenting facts rather than subjective opinions. You decide for yourselves if we are facing disinflationary (decelerating inflation) or inflationary (accelerating inflation) risks on this current state.

In October 2014, annual inflation fell a staggering 0.5% from 0.6% to 0.1% and saw a further deceleration in the sequential print, declining from -0.1% to -0.4% marking the second consecutive MoM deflation; core inflation (ex. energy) fell from 1.9% to 1.7%; the GDP deflator has been suppressed since 4Q13; food inflation remains the only outlier. printing a 2.8% vs. 2.9% in September and remains the only component preventing the main metric from sliding into deflationary territory

In October 2014, annual inflation fell a staggering 0.5% from 0.6% to 0.1% and saw a further deceleration in the sequential print, declining from -0.1% to -0.4% marking the second consecutive MoM deflation; core inflation (ex. energy) fell from 1.9% to 1.7%; the GDP deflator has been suppressed since 4Q13; food inflation remains the only outlier. printing a 2.8% vs. 2.9% in September and remains the only component preventing the main metric from sliding into deflationary territory

Prices remain my second foremost concern and this is not exclusive to Singapore; Europe is facing serious disinflationary (core) and deflationary (periphery) headwinds, while America never seems to be able to get its core figure above the Federal Reserve mandated 2%. There is a multitude of factors that are causing a wave of declining prices across the globe; crashing energy prices (Texas and North Sea crude oil and other petroleum cracks), falling prices of industrial metals (copper, iron ore, aluminum), a broadly strengthening US Dollar, and tepid inflation expectations (mainly in Europe, America, and Japan as indicated by their respective forward breakeven rates).

The result of lower prices will be felt globally. Singapore is a major importer of energy and consumers will directly benefit from lower energy prices at the pump. Electricity prices are unlikely to fall because the natural gas Singapore imports (similar to that of what Japan imports) are of a different origin than the shale gas in America, and should not be affected significantly by cheaper crude oil.

A fairly controlled pace of inflation is generally deemed healthy because it balanced the scale of savings, anticipating expenditures, and current expenditures. One doesn’t have to look beyond Japan to appreciate the effects of a deflationary spiral; many central bankers are pinning their monetary policies to prices primarily on this fear of deflation. It will be interesting to see how cheaper oil prices filter down to the down streams, and its effect on real disposable income.
— Business of Finance

Slumping inflation expectations
 

In this chart from ZeroHedge, it is evident that the even the markets see inflation as a diminishing concern. The chart plots the various breakeven rates on US treasury bonds, German Bunds, and Japanese government bonds. The breakeven rate is derived by subtracting the real yield of an inflation-linked bond (like TIPS in the US) from the nominal yield of a conventional government bond, both of the same credit quality and tenure. In this case we use the 5 year measure of breakeven, and all 3 are trending down

In this chart from ZeroHedge, it is evident that the even the markets see inflation as a diminishing concern. The chart plots the various breakeven rates on US treasury bonds, German Bunds, and Japanese government bonds. The breakeven rate is derived by subtracting the real yield of an inflation-linked bond (like TIPS in the US) from the nominal yield of a conventional government bond, both of the same credit quality and tenure. In this case we use the 5 year measure of breakeven, and all 3 are trending down

It is one thing to rely on polls and surveys to gather consensus on something as subjective as price levels, and it is another thing altogether to quantify future expectations using freely traded securities in the markets as an objective approach. Many people rely solely on "word on the street" as an indicator of reality. I regret to tell you that now that most people are wrong. As I said, to truly understand something requires years of study and experience. Most folks clearly don't have that.

For much of 2014, the market expectations of forward inflation has waned rather drastically. There have been growth concerns (see my article on Singapore's economy). Although I would be hard pressed to expect lower global energy prices to filter down to our utility bills and at the pump, we can at least be well assured that they aren't going up anytime soon. Public transportation costs are another aspect which isn't the focus now.

I have yet to talk about property prices, but to those who still think residential home prices are in a boom, please kindly head to the URA and conduct some fact finding. Ever wonder why real estate agents get so worked up whenever people mention that home prices are in a slump? You don't have to think far; we're going to see some blood in that industry. Whatever goes up, has to come down eventually.

Then again, Singaporeans just hate it when they can't get a real return on their deposits earning quarter-pennies on the dollar. But this is a topic for another discussion.


In short...

  1. Understand what inflation really means, and understand what prices really mean
     
  2. The current environment we're in should beckon concerns about growth and stagnation, rather than acceleration of price increases
     
  3. Beware of gift bearing Greeks who scapegoat high inflation to stoke unnecessary fear
     
  4. Understand that QE isn't money printing and does not lead to a surge in general price levels
     
  5. Know your facts!

Enough said!