The great debate of 2022 was about the nature of our inflation. 2021 was the year in which it was settled that prices would go up: however, in 2022, we struggled with why they were surging.
This matters immensely because the correct diagnosis determines the correct cure. In this case, the correct cure is the right policy response from governments and central banks. Pump in the wrong medicine and you risk killing the patient instead of helping them.
One the one side of the debate we had the transitory inflation camp. This group believed that inflation was a temporary supply chain disruption issue arising from the pandemic’s lockdown policies and Russia’s invasion of Ukraine. Such events cause prices to rise, but they are one-off shocks. Not only do prices stop going up once those shocks are absorbed by the economy, but prices could fall again as things ease.
In such a scenario, the correct response from central banks is pretty much to do nothing. That’s because higher interest rates – the usual response to inflation – would only harm an economy already struggling with higher input costs such as energy.
There was good evidence for this explanation. Producer price indices moved first, signalling that it was supply chain issues and not surging consumer demand that moved prices. Companies were merely passing on costs to the consumer price index.
But, as time went on, the inflation persisted. And central bankers stopped calling it transitory. Then the other side’s theory began to take over.
This alternative explanation is that inflation is a monetary phenomenon – a disease of money as Nigel Farage likes to say. That involves too much money chasing too few goods.
The evidence for this was the monetary explosion from central banks in response to the pandemic, as well as the vast fiscal spending from governments. Put the two together and you get inflation, say the textbooks.
If that theory is a correct explanation of what happened, then central bankers should’ve been hiking rates years ago, not to mention halting quantitative easing (QE – the creation of money in order to buy government bonds) back then. And their failure to do so is a big part of the explanation for why we have inflation.
The misdiagnosis and the blame falls on the nincompoops in charge, in other words.
Personally, I’ve been struggling with who’s right in this ideological battle. And I’ve tried sitting on both sides of the fence to see where I feel more comfortable.
I didn’t think the argument had been settled yet, because supply chain chaos and pandemic lockdown problems remain a viable explanation for higher prices, even today. Jim Rickards’ new book Sold Out explains how and why.
What makes all this unusually interesting are the implications for what happens next. If prices are going to fall back to more normal levels as supply chain crises ease, then that implies a sudden deflationary shock, just as the initial chaos triggered an inflationary shock.
It also means central bankers are behaving like the infant Maggie Simpson driving the family car in the TV show. They think they’re in control, but the steering wheel isn’t even connected to what’s going on.
But, last week I encountered some data which proves that the monetary story is at least part of the explanation for the inflation we’ve seen.
Total consumer credit in the United States is now above its pre-Covid trend. It had plunged in 2020, but since the about March of 2021 it began to accelerate rapidly in order to recover lost ground, and then some. That’s also when inflation began to pick up…
It’s a similar story for US industrial loans, which also boomed in late 2021 and early 2022. 2018, 2019 and 2021 saw commercial bank loans and leases in the United States at about $400 billion. In 2022, the number is about $1.2 trillion…
A chart of US mortgage debt has a pronounced kink upwards in early 2021 too. US government debt has the same kink in late 2021.
Why does this data matter?
Well, inflation is in part at least driven by the amount of money in the economy. If you double the money supply but keep everything else constant, then prices should double.
Lending, in our modern economy, increases the money supply itself. So if you track lending, you track changes in the money supply.
I’m sure this is confusing, but here are some home truths… When you spend money on your credit card, that money doesn’t come from somewhere. It is created in the simultaneous act of spending, borrowing and lending. The same goes for mortgages. The same is also true of when central banks buy government debt (but now of when people buy government bonds because that shifts existing savings around).
The point is that, if lending goes up, then the money supply is rising. The money supply you and I actually feel in our daily lives too, not just some weird balance sheet entry at a central bank. This surge in the money supply fed inflation in 2021 and 2022.
The idea that debt surged in 2021 via a debt boom, leading to inflation, now has the data needed to back it. The monetary explanation is at least part of the explanation.
What does it mean going forward? It means that central banks’ remedy of interest rate hikes will likely hit the mark.
The question now is whether the interest rate hikes are an overdose. You see, central bankers have a rather poor track record of slowing inflation down without causing chaos. They tend to overtighten as they try to catch up with inflation they allowed to get out of control.
You could argue that we’ve already had the said chaos in 2022. And that thought is enticing me into markets right now too.
But it would be a surprise if we don’t get a recession or proper financial crisis before markets turn up. And markets tend to react badly to both.
If you believe that central banks will overreact to inflation, then you should be buying bonds. They benefit from the deflationary shock we have coming as central bankers over tighten once again…
If you believe that they have inflation in their sights, better late than never, then you should own a diversified portfolio of stocks and bonds in anticipation that one or the other will perform well again in a return to normality in 2023. In this scenario, the inflationary outburst of 2021 was nothing more than a central bank mistake and 2022 was the price we paid for it. But the issue is now back under control and your portfolio should normalise.
Of course, it isn’t just artificial waves of freshly created money that are coursing through the economy and financial markets, distorting everything. Governments have created plenty of other similar distortions. But rather than whining about it to anyone who will listen, like I do, my friend Eoin Treacy has found a way to potentially profit from one such… irregularity. It seems obvious in hindsight that this simple measure can drive stock market returns. But, until you click here, you’d never guess.
Nick Hubble
Editor, Fortune & Freedom
