Looking at Inflation as a Credit Phenomenon?


Modify Purchasing Power Parity by adding in stocks and bonds

An optimal currency board price basket would contain both assets and goods.

Looking at Inflation as a Credit Phenomenon?

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In one sense, assets are future goods.  Assets throw off an uncertain stream of future benefits, which can be used to purchase goods at that time.  Based on the demographics of an economy, if marginal dollars tend to be saved versus spent, stimulus would affect the economy differently:

  • Spent: we get goods/services price inflation.
  • Saved/Invested: we get asset price inflation.

Asset price inflation is different.  It is difficult to transfer resources from the present to the future.  Even a zero coupon bond relies on the solvency of the issuer, and the realized goods/services inflation. Hoarding gold/commodities relies on the idea that they will be more scarce in the future, which is unlikely as prices rise to encourage more supply.

Cash rarely earns more than the CPI.  Bonds have long cycles where they are alternatively “certificates of confiscation” or “beneficiaries of deflation.”

Asset prices rising is not always a good thing.  The rise in prices may reflect additional productivity or they may reflect a higher price for transferring goods to the future.

When I was a bond manager for an insurance company that had long-dated promises to pay, I bought a variety of fixed-rate bonds that that appreciated dramatically in value in a falling interest rate environment.  What did that do to my expected cash flow stream?  Nothing.  If anything, it meant we would earn less because we would reinvest excess cash flows at rates lower than the market yield of the bonds.

This is a reason why QE from the Fed is questionable. Their asset purchases push up the price of assets, but the cash flows don’t change. Maybe a few more entities decide to issue debt in the process, but that doesn’t mean the debt gets used for expansion.  It may well replace equity, given its cheapness.

Maybe the answer here is to look at inflation as a credit phenomenon, whether the credit is used to purchase assets or goods/services.  At present, assets are inflating more than goods/services, and that has been true for some time.  I suspect that relationship will reverse, but when that will come I can’t predict.

By David Merkel, CFA of alephblog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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