There is a widespread lack of understanding among economists and investors about what actually drives changes in the inflation rate in the short and long term. The composition between the price of individual prices and the general price level, as well as the focus on aggregate demand, has led to a high degree of misinformation about what really drives inflation. In this article, we hope to clarify the subject and explain a number of important concepts:
- Why the supply of money in relation to GDP determines long-term inflation trends.
- Why the demand for money explains short-term inflation is changing.
- Why the declining rate of money reflects increasing demand for money and the potential for high future inflation.
- Why short-term inflation trends tend to reflect financial market risk appetite.
- Why recessions tend to be disinflationary in developed economies.
- Why the focus on aggregate demand has led economists to mistakenly believe that high inflation is positive for growth.
- Why recessions tend to be inflationary in emerging market economies.
- Why Japan continues to see low inflation despite aggressive economic and financial easing.
The money supply relative to GDP determines long-term inflation trends
The definition used by Milton Friedman to explain rising inflation – t oo a lot of money chasing too few goods – is a good place to start when it comes to understanding the long-term drivers of rising prices. The more money that exists in an economy in relation to real commodity production, the higher prices will tend to be on average.
Looking at it this way, it is easy to see how recessions have the potential to be highly inflationary, especially if they are faced with aggressive money pressures, as is the case today. In fact, periods of high inflation and hyperinflation are almost exclusive to countries experiencing economic contractions. Similarly, persistent deflation almost always occurs in positive growth, for the simple reason that it is difficult for prices to fall if the availability of goods falls.
We should also note that "money" in this context refers not only to cash, but also to government bonds in public. The fact that the majority of governments can require central banks to print money to buy their bonds means that government bonds act as a form of money. As John Hussman notes, "Currency and government securities compete in the portfolios of individuals as stores of value and means of payment. The values of currency and government securities are not set independently of each other, but in tight competition." In other words, regardless of whether a government pays for its financial deficit with cash or with a bond, the inflationary effect is more or less the same.
Change in demand for money explains short-term inflationary changes
While the ratio of money supply to the size of the real economy provides the basis for long-term changes in inflation, many other forces are at play. Even in periods of rapid growth in the money supply relative to the real economy, inflationary pressures may fall, and vice versa. The reason is that individuals may become more or less willing to use their existing cash holdings. The fact that inflation has not increased this year despite the sharp increase in the supply of money relative to the real economy can only be explained by the fact that people have been willing to keep this extra amount of money as a store of value.  Falling rate reflects rising demand for money and the potential for high future inflation
Bizarrely, the increase in the money supply relative to GDP this year has literally been turned upside down and interpreted by many economists as a disinflationary force. It is argued that declining money rates – the inverse relationship between money supply and GDP – explain the lack of inflation and mean that increasing money supply will continue not to increase inflation.
In reality, the decline in speed reflects an increase in individuals' willingness to keep money as a store of value. While the amount of dollars in the United States and foreign residents has increased significantly relative to the availability of U.S. commodity production, there has been an increase in the willingness of dollar holders to use them as a store of value. This has prevented prices from rising in proportion to the increase in the money supply. The willingness of foreign central banks to raise dollars to prevent currency appreciation is an example of how the increase in the money supply (and the treasury) in the United States has been neutralized, and prevented inflation from rising significantly.
However, money still exists and acts as a store for potential inflation for the future, if and when it is used. Therefore, declining rates, rather than being a reason to expect inflation to remain low, are reason to expect inflation to increase in the future as safeguards potentially decline. In other words, the only way that increasing the money supply in relation to GDP will not lift inflation is if the recipients of the money continue to expect to keep the value despite ever-increasing amounts. Ironically, it is this confidence that inflation is dead that has led to the kind of insane financial deficits and money pressures that anything but guarantees revival.
The link between asset valuations and inflation
In recent years, stock valuations have increased and tend to be associated with rising inflation. Increasing optimism about the state of the economy tends to lead to a simultaneous increase in stock valuations and inflation expectations as shareholders become more willing to use their existing cash holdings when holding assets.
We can see from the following diagram a closer connection between stock valuations and expected inflation expectations, which is a reasonably accurate predictor of actual subsequent inflation. The correlation between the two markets has been particularly strong during and after the market crash, as fears of deflation and recession lead to an increase in the demand for raising money.
Strong positive correlation between SPX and 10-year expectations of breakeven inflation
Why downturns tend to be disinflationary in developed economies
Over the last two decades, recessions have been associated with declining rather than increasing inflation in developed economies, despite the direct inflationary effect of reduced commodity and service output. The reason is that the indirect effect of increasing credit stress and declining asset values seen during economic contractions tends to act as a disinflationary force, increasing the demand for cash in relation to goods and services. Real GDP, CPI and 5-year rolling correlation
It is worth noting that this has not always been the case. Before the turn of the century, both the downturn in the stock market and economic contractions were associated with rising inflation. Our feeling is that since 2000, higher levels of market liquidity have led to asset prices increasingly being seen as a loose form of money. In periods of economic weakness, the decline in equities has reduced people's willingness to use their existing cash balance, and acted as a disinflating force.
High inflation is not positive for economic growth
The positive correlation that has been seen between economic activity and inflation rates in the US and other developed countries in recent years has led ordinary economists to conclude that increasing aggregate demand causes both increasing growth and rising inflation, and therefore low inflation must reflect weak growth, which must therefore be stimulated by political initiatives.
The idea of aggregate demand driving inflation and output gathers the response from individual commodity prices to changes in consumer preferences with the response from the general price level to changes in the demand for all commodities in the economy. Increases in the general price level are not driven by an increase in the demand for goods, but by an increase in the amount of money that people are able and willing to spend on them. Similarly, the increase in production is not driven by an increase in demand for goods, but by an increase in companies' ability to satisfy as much demand as possible.
The unshakable belief among decision-makers that higher inflation is necessary to support economic growth has led them to commit to increasing the money supply until growth recovers. In fact, excessive money pressure is actually undermining growth by allowing politicians to increase consumption to harmful levels and reduce productivity by lowering real interest rates ( see "Brace For Sub-1% Long-Term Growth" ).  Why recessions tend to be inflationary in emerging market economies
Unlike in most developed markets, we see in emerging market economies routinely slowing or negative growth and weakness in asset prices that occur along with rising rather than falling prices . Historically high inflation levels are often ingrained in the minds of citizens in emerging markets, which means that they are much less likely to keep their currency as a valuable asset. In times of economic weakness, residents have a strong tendency to either convert their local currency savings into dollars or gold, or simply bring forward purchases of goods and services in anticipation of higher prices, thus leading to higher inflation.
This is not only true at the individual level, but also at the political level. Central banks in emerging economies continue to accumulate dollars and other reserve currencies as a way to prevent increasing pressure on their currencies and build a defense against future economic shocks. In this way, they effectively import inflation from developed market economies.
Strong negative correlation between Turkish stock ratings and 10-year expectations of breakeven inflation
The crucial difference between the US and Japan  The surge in government debt and money supply relative to real GDP in Japan in recent decades is often seen as proof that the United States will continue to experience low inflation rates, as has been the case in Japan. However, there is a crucial difference between the two countries; one is the world's largest creditor nation, and one is the world's largest debtor nation.
Japan boasts a net position for external assets of over 70% of GDP, which has acted as a major and constant disinflating force due to the large amounts of dividends and coupon payments that Japanese citizens have earned on their foreign assets in in relation to what they have paid on their foreign obligations. Japan's net income surplus corresponds to 3% of GDP, reflecting foreign demand for the Japanese yen, which partially offsets the effect of increasing money supply.
Source: BOJ, BEA
In contrast, the United States has a net international deficit of over 60% of GDP due to decades of balance of payments deficits. The much lower interest rate paid on its liabilities (mostly government bonds) compared to what it receives on its international assets (mainly FDI), allows the US to run a small primary income surplus of around 1% of GDP. The problem, however, is that for the primary revenue surplus to remain positive domestically, the real interest rate must remain negative, which in itself undermines the demand to keep the dollar as a store of value.
While Japan's net foreign assets act as potential demand for the Japanese yen in the event that these assets are repatriated, US debt acts as a potential supply of US dollars in the event that foreign investors begin to sell. The fact that the United States has had the luxury of being the world's reserve currency has increasingly left dollars for foreign investors, especially foreign central banks.
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