A General Theory of Inflation

?Prediction of inflation by central banks is a key driver of global economy today. Central banks have found a bazooka in form of quantitative easing which has an inordinate influence on economies and asset prices. On the other hand increasing interest rates when inflation is about to collapse can also have detrimental impact.

One would assume that together with intellectual heft of central banks as well as the importance of inflation prediction, central banks would have got very good at it. On the contrary, it is surprising how often central banks are wrong about their predictions of inflation. For example, between 2015 and 2020 central banks of developed countries kept predicting that inflation will go up, whereas it remained dormant. Similarly after the pandemic, nearly every central bank expected inflation to be transient whereas it just kept going up. It is either that inflation is inherently unpredictable or that central banks are probably not doing their jobs right. I believe both of these premises are correct. So what is happening here?

Here is a short primer on inflation in a rather simplistic language. It might still be hard to read through it but if you go through it once, I think you will understand most of the discussions going on around inflation.

First it is important to understand why inflation happens. As anyone who has taken Economics 101 can tell, that it is essentially a demand – supply problem. If the demand rises or supply declines, the prices will rise. And that is inflation. The natural question to ask is what makes demand or supply to fluctuate. Here is an attempt to explain these factors:

Demand Side Factors

The biggest demand side factor is when the working class & middle class have increased amount of money in their hands. I do not believe rich class becoming richer affects inflation as much since as a class they put more of their money in assets and not in goods & services. This may be a controversial statement since it might imply that the easiest way to curb inflation is to make middle class & working class poorer. It might be an easy way but it is also the wrong way. This is because economic growth ultimately happens because of the increasing demand from working class & middle class (remember the rich class doesn’t consume as much of goods & services). So trying to make middle class & working class poorer might be a way to ensure stagnant economy. Balancing between welfare of masses and inflation is a very interesting problem which very few academicians seem to be focusing on.

Any intervention on this side has to be more nuanced and we need to understand the drivers behind the demand side factors of inflation. Here is what I understand about the demand side drivers:

1.????Increased Money Supply

Money supply is essentially amount of currency in circulation. The more money in circulation, the more it will end up in hands of people and contribute positively to inflation. It is determined by two factors. First by printing done by central bank and second credit given by the financial sector. The second factor is vastly stronger than the first, though the central bank can control both of these through interest rates. Since credit growth by financial sector is such a powerful driven of inflation, it also means bank capitalization is a key factor behind inflation. An undercapitalized banking sector cannot grow credit irrespective of printing done by the central bank. That is why most financial sector crisis are followed by a long deflationary period.

Fiscal deficit run by the government can also increase the money supply since central bank may have to print additional money to support government borrowing to fund the deficit.

2.????Wage Inflation

Wage inflation is when wages of workers increase rapidly. Since worker’s wages are cost of production, wage inflation is also a supply side factor.

Wage inflation is a complex phenomenon. Wage inflation mostly happens when unemployment reaches a low point called “Natural rate of unemployment”. At this point, labour is so scarce that business have to increase the salary at a faster rate. This increases the demand from the working class and also increases the cost of goods & services produced by them thus leading to inflation. This “natural rate of unemployment” is not a fixed rate. It depends on many factors, and my suspicion is the level of organization of the labour force is a strong determinant of natural rate of unemployment. Very strong labour unions for example deter business from hiring thus increasing bargaining power of existing labour force and then even a 7% unemployment rate can become the “natural rate of unemployment”. On the other hand a very weak organization of workforce might mean even 3% unemployment may not be the “natural rate of unemployment”.

The other driver of wage inflation is how strongly the compensation of workforce is linked to inflation. This again depends on level of organization of workforce. If worker unions are too strong, they will negotiate inflation linked wages. Thus as inflation increases, wages increase and it drives further inflation. It becomes a vicious circle.

3.????Helicopter Money

Sometimes government gives money directly to people to spur growth in times of recession. It can be without any conditions or in form of employment scheme. Since they give money directly in hands of working class and middle class who are the biggest demand side driver of inflation, helicopter money has a very direct impact on inflation. One theory about source of current bout of inflation is helicopter money doled out during the pandemic.

?Supply Side Factors

1.????Oil Prices

Among all supply side factors, there is something special about oil price. There is an unusually strong correlation between oil prices and inflation. While inflation during 1970s was linked to twin oil shocks, the disinflationary period of 2015-19 can be linked to sudden increase in oil production because of shale oil production. One theory is that oil contributes to transportation costs which increases the cost of most goods & services. This explains the unusual correlation of oil price to inflation. Oil price is also one of the hardest factors to predict. Even currently the forecast of oil prices range from $38 to $145.

2.????Inflationary Expectations

Another very special supply side factor is inflationary expectation. Most bouts of inflation (demand induced or supply induced) are temporary and resolve themselves. But inflationary expectation is one of the factors that can make inflation go on for a long time. The accepted theory about inflationary expectations is that when inflation remains high for very long, people expect prices to keep rising. Then they start raising prices of their services (to compensate for future rise in prices) which increases inflation. This creates a vicious circle because this increase in inflation will lead to people increasing price of their services even further.

Inflationary expectation is the reason why central banks should try to curb inflation by driving interest rates higher even at the cost of low economic growth. Because once the inflationary expectations set in, the fight against inflation becomes extremely hard. Once inflationary expectation sets in, it might not be possible to get rid of inflation without a deep recession.

3.????Currency Stability

The strength of a nation’s currency depends squarely on difference between amounts of money coming into the country from foreign nations minus the amount of money going out from the country. This again has two components: current account (difference between exports and imports of goods & services) and capital account (difference between investments in and out of the country). The current account depends on export competitiveness whereas the capital account depends on growth potential of the economy, prevailing interest rate as well as whether the currency is one of the reserve currencies as well (whether trading nations accept the currency in question as payment). Another important factor is amount of liabilities in foreign currency. If there is too much of loan in foreign currency, the interest needs to be paid, the rollovers need to be done and that can be a potential source of weakness for the currency.

When the currency weakens, all imported goods become more expensive and since imported commodities like oil determine prices of many other goods & services, soon enough prices of all goods and services start moving up setting in inflation. When this happens the short term measure available to governments is either increase the interest rate or start selling dollars (in case there is a large forex reserve available). If the government doesn’t do it, sooner or later inflationary expectations will start setting in and it would be impossible to fight inflation without inducing a deep recession.

4.????Production shocks

Beside oil, there can be other production shocks like a devastating war, rise in price of other commodities etc. Even the Covid pandemic lead to a production shock due to supply chain bottlenecks as well as much of the labour force staying away from job. Incidentally it can be argued that Covid also reduced inflation since it was also a demand shock since so many people were not earning any salary during the time. However, that demand shock was mitigated to a very large extend by the helicopter money doled out by the government.

5.????Linkage to international trade

Since cost of imported goods can greatly influence inflation, the integration with global trade can also affect inflation. Thus a closer global trading system like WTO will make it possible to easily import cheapest goods from various sources thus driving down inflation. (Of course if it is not compensated by equal increase in exports or capital inflows then these cheap imports can lead to higher inflation also because they will depreciate the currency.)

Similarly a breakdown of global trading systems can also lead to increase in inflation.

6.????Taxes and duties

Increase in taxes and duties on good, services and imports directly affect the final price of goods & services and hence can be inflationary. Note that only indirect taxes are inflationary and direct taxes like income tax are deflationary.

Hope this longish read was informative. To me assessment of these factors gave rise to two questions:

(1) It appears making the little guy poorest is the surest way to curb inflation. That is probably why right wing governments control inflation better than left wing governments. What is the method to optimize the welfare of general population while keeping inflation in control??I do not have any answers as of now.?

(2) Why do central banks keep getting it wrong on inflation? I do not know know the answer to this also since I have no idea how they forecast inflation. But my hunch is that since data orientation is the hallmark of theoretical economics & finance, they probably are ignoring many of the factors which are hard to quantify. These include possible scenarios of oil supply, current capitalization levels of banks, scenarios of cooperation on international trade networks, extent of organization of labour force etc. I would be most interested to know if these factors are considered.

With perfect hindsight, I can say that shale oil production was one important factor behind disinflationary trends during 2015 – 19 and I don’t think central banks included it as a factor for inflation forecast. Similarly central banks took covid pandemic to be similar to the demand shock of global financial crisis despite very good bank capitalization, evidence that Spanish Flu was inflationary, the helicopter money doled out by the governments, and growing constraints over oil supply.?This again was probably a sign of ignoring the hard to quantify factors.

Disclaimer

Abhishek Chauhan is Principal Officer of Eklavya Capital Advisors, a SEBI regulated Portfolio Management Service Provider.

The information, opinion, or analysis provided in this article is not an investment advice and is intended for general informational purposes only.?The contents and information in this document may include inaccuracies or typographical errors and all liability with respect to actions taken or not taken based on the contents of the article are hereby expressly disclaimed.?

Any reader or this article should refrain from acting on the basis of this article without first seeking independent advice in that regard. The views expressed in the article by the author is in his individual capacity only.