The U.S. Federal Reserve doubled the size of its balance sheet during the 1960s, largely to help pay for the Vietnam War and to fund the expanded social programs introduced under the Kennedy and Johnson Administrations. While the expansion of the balance sheet commenced almost immediately after Kennedy took office in early 1961, price inflation didn’t show up until late in the decade and into the 1970s.
Most major inflations show similar two-stage progressions: an initial stage when the money supply increases faster than prices and a later stage when prices increase faster than the money supply. The German inflation of the 1920s, the French inflation of the 1790s, and the U.S. inflation during the Civil War all showed that two-stage pattern.
We see a similar pattern today. The U.S. Federal Reserve started expanding its balance sheet to combat the Global Financial Crisis in 2008 then continued the expansion to fight various subsequent crises. The Fed’s balance sheet today is ten times bigger than before the Financial Crisis. Prices are just now beginning to turn up.
Why does inflation tend to ripple through an economy in these two stages?
In Inflation’s Root Cause, we showed how the main culprit of numerator-driven price increases is nearly always on the supply side of the equation: governments and central banks expand the money supply to fund some sort of big expenditure. The increased supply of money eventually creates higher prices.
Here we describe the actual pattern of price increases over time. Inflation nearly always progresses in two stages – one where the money expands with little or no effect on prices and the second where prices escalate faster than the money supply.
Those two stages, we believe, are created by fluctuations on the demand side of the equation.
Individuals and institutions hold cash balances in order to function as participants in an economy. An increase in cash balances creates an incremental demand for money. A decrease in cash balances creates an incremental supply.
The effect is quite similar to the relationship between product inventory and cash flow. Reducing inventory creates cash. Increasing inventory consumes it. Just as changes in product inventory consume and generate incremental cash for a business, changes in the cash balances of participants in an economy create incremental demand or incremental supply of money.
As a government starts handing money out in the early part of an inflation, people and institutions are at first slow to spend it. Cash balances rise, which creates an incremental demand for the currency that at least partially offsets the incremental supply created by the government. By increasing cash balances, people and institutions help sop up the excess money generated by the central bank. That incremental demand helps keep prices down even as the central bank creates more and more money.
Eventually, though, people and institutions reduce their cash balances. When they do, the actual money supply doesn’t really increase, but the effect on the supply and demand balance is the same. In order to reduce cash holdings, people and institutions need to exchange it for something. They buy an investment, an asset, or perhaps some consumer product. That drives the price of that item up. The seller of the item ends up with the cash. If that person or institution also wants to reduce cash holdings, he or she or it must exchange it for something else.
If an entire society wants to reduce cash all at once, we have a hot potato problem. Nobody wants to hold it. Yet, some person or some institution must hold it. All money that exists in a society has to be held by some person or some institution. Like the song that never ends, the incremental supply of money coming from people that all want to reduce their cash balances in unison can, in theory, go on for a very long time.
What is it then that makes everyone want to reduce their cash holdings in unison?
People and institutions alike weigh the value of holding money against the value of exchanging it for something else. We don’t value the money itself; we value what the money can buy. We value its purchasing power. In the rare case that we actually expect a currency’s purchasing power to increase over time, we tend to hold more currency. The longer we hold it, the more purchasing power we accumulate.
In the more likely case of expecting a reduction in the purchasing power on the horizon, we tend to reduce our cash holdings. If we knew with certainty that the purchasing power of the currency would be cut in half over the next twelve months, everyone would hold as little cash as possible.
Therein lies the reason why central bankers have a fetish with controlling inflation expectations. Central banks can create money with little or no price implications as long as they convince the public to hold the excess money. That is, as long as they convince the public that inflation is under control, people and institutions will tend to keep cash balances high. As soon as the public catches on, inflationary expectations increase, people act to reduce cash holdings, and prices begin to respond. They rise.
That turning point creates the two stages of most inflations. The first stage of the inflation, the period of deception, is when people and institutions are happy to hold the newly-created money. Cash balances increase. Prices move up at a slower rate than the money supply.
The second stage of the inflation, the period of enlightenment, is when people and institutions catch on to what the central bank is doing. They see a devaluing currency. They act to reduce cash holdings and in so doing create an incremental supply of the currency. Prices then increase faster than the money supply.
Central bankers can easily lose control of prices during that second stage. Prices begin increasing faster than the money supply as people and institutions scramble to reduce cash holdings in order to preserve purchasing power. We think we are at that turning point in the U.S. at the moment. We expect prices to rise faster than the money supply in the months and years ahead.
We believe the U.S. Federal Reserve will struggle to control inflation, partly because of the hidden incremental supply of money as people attempt to reduce cash balances and partly due to the sheer scale of money the Fed has created since the Global Financial Crisis. In this type of environment, we favor certain types of companies. We like companies with built-in and automatic price increases with no lag, delay, or negotiation. We like companies with exposure to rising prices but not rising costs. We like revenues in a jurisdiction that is ahead of the curve in battling inflation and we like companies with competitive advantages that increase with inflation. We want to position the portfolio to benefit from generally rising prices.
