Financial Literacy Series - Money & Inflation

What are the possible outcomes of the actions recently taken by government and central banks? How prevalent will inflation be moving forward? What will happen to the economy with all this debt? Should I be concerned about that picture? Generally speaking, people like answers that are clear and easy to understand. However, some answers cannot be achieved with simple understanding, and require a little extra brain power. One such area that needs that power is when people think about their financial future.

Financial courses talk about the government’s responsibility to manage the economic growth at a target rate of 2%. Central banks expand or contract the money supply, and adjust the interest rates to put the brakes on or accelerate the economy. These available education courses do not explain why that is necessary, do not question why it is inevitable, provide any information on how the central planning of an economy is impossible, or what the unintended consequences might be.

The basic myth of effective top-down control of the market is what F. A. Hayek called the “Knowledge Problem.” No one person or committee could ever have enough awareness and knowledge to be able to correctly allocate the supply of resources to an infinite number of options at any given time, let alone ALL the time. Even aided by complex algorithms, it’s empirically impossible that a small group of people has the omniscience required to coordinate all the collected actions of an entire society and especially so when markets are providing mixed and distorted signals. Government policies to manage an economy always uses old information; that is, it takes facts from the past and attempts to forecast the future using the same skill required for a blindfolded child to swat a pi?ata. The child knows where the pi?ata might be, but the odds of hitting it correctly are statistically improbable. Put another way, as Mark Yamada stated in his article The Precariousness of Low Interest Rates, government action is “monetary intervention whack-a-mole.”

Central Banks are interested in attempting to create a steady state of economic growth by adjusting interest rates by adjusting their balance sheet. When they buy a market security or government bond (as of 2018, almost 90% of their assets were government bonds and T-bills [1]), they aren’t sitting on billions of extra dollars to buy these instruments. They create new money by a few keystrokes on a computer and then use that money to deploy into the market. The act of central banks increasing the monetary supply and purchasing securities drops interest rates, and similarly the act of selling securities and reducing the monetary supply increases interest rates. Other actions taken by central banks might include paying higher interest on bank reserves, and additional issues arise with fractional reserve lending with banks multiplying that supply of money, but let’s stick to the basics of central bank monetary policy as the central issue.

It's really about inflation. Prior US FED chair Milton Friedman stated that “inflation is the increase in the monetary supply and deflation a decrease in the monetary supply.” Some economists will suggest that monetary supply has little to do with inflation, while others maintain it has a large impact on inflation; but in reality, it is basically impossible to predict. Not only have the official inflation measurement metrics shifted over time[2], but they don’t factor in some of the real costs consumers face on a daily basis. Food, fuel and housing have been eliminated from the official inflation numbers. There have been many calls to redefine inflation to include these costs, but what increased monetary supply has really done is inflated asset prices while still having a marginal effect on the prices of consumable goods. In an article posted in December 2014[3], four writers including Austrian economist Robert Murphy and Chairman of Euro Pacific Asset Management Peter Schiff commented about the apparent lack of inflation in the economy since the monetary expansion during the 2008 Financial Crisis, and the article predictably presented four separate points of view. Predicting inflation using theory is extremely challenging, and that is evident given the content of the article.

In his article published on mises.org on May 11 2020, Karl-Friedrich Israel PhD, Senior Researcher at Leipzig University, provided evidence that monetary inflation inflates asset prices more than it inflates consumer prices. Dr. Israel suggests that the likely place that inflation materializes is “outside of consumer goods industries, most notably in the markets for long-term assets, such as stocks and real estate.”[4] When overlaying charts of increasing financial markets and increasing Reserve Bank balance sheets, the correlation is striking. In his research, the evidence suggests that pumping extra money into the economy prevents asset prices and stated inflation rates from falling, but also soon moves to a boom in assets such as real estate and securities. Of course, these asset prices are not worth more or experiencing a staggering increase in demand, but rather because the money used to acquire them is worth less.

What cannot be accurately quantified is what might have happened to inflation rates if stimulus was not in place? It’s virtually impossible to determine how much stimulus is required to escape the liquidity trap of deflation or begin to perceive the exact length of time a deflationary event would have lasted. But the occasional bout of deflation is healthy and is a required readjustment to unabated asset price inflation. Depressions without extra government debt and monetary stimulus are historically tough, but the fallout is more like ripping off the band-aid rather than making the slow painful decision to stretch out your skin and pull your hair over decades.

Just like government is unable to predict the growth of the economy, no single economist can accurately predict the fallout of increasing the supply of money in an economy. What is likely to happen is avoiding a crash in asset prices or even inflating asset prices as suggested by Dr. Israel, and to a certain extent avoid a driving off the cliff in terms of inflation. We will see a devaluation of money as multiple billions of new dollars are being pumped into the economy. If left unchecked, increasing the monetary supply will make housing prices even more out of reach for many Canadians and those who struggle today could fall behind even more. The underlying risks in the financial markets could increase with falsely propped up valuations, especially given that the US FED announced rounds of buying bond ETFs last week. What we can generally predict is that governments will be forced to pull back the balance sheets of central banks and increase taxes to reduce the debts, otherwise the outcome is likely to create a lack of confidence in the Canadian dollar.

Eventually, incumbent bureaucrats and elected officials will pay no price for being wrong and likely offer each other meaningless congratulatory platitudes. While no amount of financial planning will be able to mitigate that, the future of financial planning looks to be more vital than ever. The cost of not getting the right advice has always far outweighed the cost of getting advice, but putting together a holistic plan that includes maximizing tax efficiencies, balancing investment and insurance planning, estate and wealth transfer planning and mitigating unknown risks is now priceless. Dealing with certified and qualified professionals is an absolute in these interesting times, and certainly as the future looks even more interesting.

[1] https://www.bankofcanada.ca/2019/08/bank-canada-balance-sheet/#table1

[2] https://www.shadowstats.com/article/no-438-public-comment-on-inflation-measurement

[3] https://reason.com/2014/11/30/whatever-happened-to-inflation/?fbclid=IwAR1oCgtPmAkQlWlfiQ6l5iFd9dI5oV8OICq4InmQ6G4-htTO_SORdZ16MbA

[4] https://mises.org/wire/why-has-there-been-so-little-consumer-price-inflation