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Looking at Inflation as a Credit Phenomenon?

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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?

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 Merkel

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