Mini masterclass on inflation

Inspired by a recent article written by a Nobel prize (Paul Krugman) with his "Opinion" 's newsletter on the NY Times, I am here to share a couple of key points on what inflation is, and why it matters for markets (and which are some key misconceptions).

No, I promise this post is NOT going to be the usual download of basic, irrelevant information on inflation that you will find elsewhere.

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What is inflation

Inflation is a general increase in prices. If the price of the same good goes up, you need more money to buy exactly the same good.

Paraphrasing with a joke:

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No one likes prices to go up. But there are many reasons why it happens.

Either demand for the same good or service goes up or the available supply goes down, in both cases causing prices of such good/service to go up. More insights on inflation sources here.

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Inflation affects financial markets

Now, why does inflation bother investors and financial markets?

On a fundamental basis, higher prices without adjusting salaries will make people buy less. With people buying less, corporate earnings will fall. With earnings falling, stocks might go down - same things equal.

Also, higher inflation will push central banks to hike interest rates (to invite people to save instead of spending, a way to stop price increases working on the demand side), which will cause bond prices to go down.

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Rising/higher inflation (pushed by supply-side scarcity during Covid) has hammered markets in 2022, as you might remember.

We can see below US inflation (as proxy for global forces) in purple rising in 2022 and staying higher than desired (2% level, indicated by a green line) in 2023 and 2024. In the lower chart we can see the yield of a 10yr US government bond rising on the back of rising and higher inflation (remember that this means that the bond prices have kept falling).

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Looking at the stock market, we can see the negative impact of the inflation scare on the US equity market (via the S&P 500 - on a different timescale below):

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Inflation and markets right now

With the understanding of some basic dynamics out of the way, we can now discuss about what is going on RIGHT NOW and how to interpret the future.

US inflation continues to be higher than desired (above 3% vs a target of 2%), spiking up in May unexpectedly to 3.5% (with unhappy market reactions) and fading down to 3.4% as of end-April (the latest figure available) - as shown by the green line below.

Krugman states that PCE (red line below - here's more on PCE vs CPI), the preferred measure of inflation by the US central bank, is showing a more benign trend (even in light of the most recent temporary rise). Financial markets also seem to believe that the recent upticks in early 2024 should be considered statistical noise (we shall see).

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The message here is that US inflation is on the way down from its peak, which is undeniable.

What are the implications for our investments?

Fading inflation should made fixed income bonds interesting again (now paying higher yields and being cheap at low prices). In parallel, we have learnt that stock markets can work well with both lower or higher inflation (see the S&P 500 now at its historical max levels) assuming that much higher inflation will NOT suddenly pop-up as a major unexpected surprise.

The inflation topic should be settled here. Easy peasy.

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Still, the other day I received a comment via Linkedin that made me think about what people believe inflation is.

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To give you more context:

• a post was reporting possible expected returns from several asset classes in the next 12 months, many of which were assumed to be lower than the recent past at high levels of risk taking
• my answer to a conservative investor unwilling to buy the NASDAQ at high prices was to look very short term US bonds, now paying a very good high 5.4% income (over 3 months, annualized) beating current US inflation at 3.4%.

Then I got the answer above that made me think people often mix up price levels and their rate of change - with some just willing to NOT believe official data (everything is fake news) - which is why I had the idea to create this post.

Krugman explains some inflation misconceptions very well. Let me paraphrase his explanations:

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#1 People confound the level of prices with inflation, which is instead the rate of change in prices

• Focusing on groceries as an example, we can see in the chart below the red line showing the overall LEVEL of grocery prices since the eve of the pandemic, with February 2020 set equal to 100, while the blue line shows the annual percentage CHANGE in grocery prices over the same period.
• Anyone who goes food shopping can tell that stuff costs a lot more than it did a few years ago, and they’re right with grocery prices are up about 25 percent, and not falling. But the rate at which they’re rising (= inflation) has fallen drastically, from double-digits in 2022 to barely over 1 percent recently.

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#2 Inflation measures do not reflect the true cost of living

• A second source of confusion is the widespread urban legend that official measures of inflation leave out essential goods like food and gasoline, and therefore don’t reflect the true cost of living.
• If the official inflation measure looks at every major good and service sold in an economy, economists setting monetary policy (=changing interest rates) often look at “core” inflation, a measure which does indeed exclude food and energy prices. Core inflation is useful as it removes some volatile prices that can suddenly go up and down (think about oil prices, controlled by the same sources worldwide) that add nothing to the way prices move inside a local economy.
• Krugman reports that different measures of inflation - such as the Multivariate Core Trend inflation, using a statistical algorithm to produce a more flexible measure of core and not subject to motivated reasoning because it’s untouched by human hands - can show that on an annual basis core measures and plain vanilla inflation are about the same, a proof that official estimates aren’t minimizing actual inflation.

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I hope this clarifies what inflation is and what is not, why markets are affected by changes in prices and what is the inflation outlook in the near term.

Thanks!

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Feel free to share any comment with us: hello@pantar.ai

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