Now that inflation is starting to rear its ugly head again in
developed economies, I thought I would share some thoughts. So
how and why does inflation happen? Who are its winners and
losers? What does it mean for the way we live and for our
investments, and how should we react to it? These are not easy
questions. Inflation tends to occur unevenly throughout the
economy. That is, it affects different things differently.
And there can be significant time lags between cause and
effect. This makes it difficult to figure out what will happen
and when, even though inflation eventually raises the price of
everything, including how much money people make, the income
side of the ledger tends to lag the expenditure side during
inflationary periods. For example, in the US in the 1970s,
we had a period of sustained double digit inflation,
accompanied by sluggish economic growth. We call it stagflation.
There was even something called the misery index, which combined
the inflation and unemployment rates. But not everyone was
miserable. I, for instance, was having a grand time. I worked my
way through university as a part time waiter and bartender, and,
and my tips quickly reflected the looser monetary conditions.
My big expenses like tuition were fixed, and didn't go up at
all. I was still maybe six or seven years away from landing my
first real job, and so had plenty of time for wages to
catch up with the general price level. So there are some winners
as well as losers from inflation. Winners are people
with assets that benefit such as real estate and some stocks, and
they include people with large debts, like mortgages or student
loans, because they will eventually pay off those debts
with appreciated dollars and pounds. But typically, there are
more losers than winners. The reason is that the effects of
inflation are arbitrary. I didn't deserve to benefit
because I happen to have a large student loan, I was just lucky.
In a healthy economy. That's not how things are supposed to work.
Benefits should accrue to people and companies that do the best
job of creating value for the economy as a whole. This way
economic growth is maximised and living standards increase. Also,
if inflationary expectations become entrenched, behaviour
begins to reflect that fact. For example, by taking on more debt,
or acquiring more assets than is prudent. After a while, we end
up with a period of substandard growth, just like the US in the
1970s. We've mentioned inflation's impact on some asset
classes, it's usually good for real assets, such as real estate
and commodities, and bad for bonds. Stocks are more of a
mixed bag. Theoretically, because stocks represent
ownership and productive assets, like factories and intellectual
property, inflation should be good. But that has not always
been the case. For example, the dreaded 1970s in many markets
were a terrible time for stocks. It's also true that not all
companies are created equal those with pricing power and
less exposure to input pricing pressures, usually companies
with higher gross margins, should do well. But companies
that can't raise their product prices fast enough to compensate
for rising cost pressures, can be decimated. In addition,
higher inflation correlates with higher interest rates and higher
discount rates. So it is not good for high growth companies
such as technology, all else being equal. In the short run,
whether we are in for a period of high inflation, or even
stagflation, it's up in the air. But to paraphrase the old
Chinese saying, we certainly do live in interesting times.