Inflation is not a very “researchable” topic.  Most projections about inflation are condemned to be wrong. The Fed employs over 400 Ph.D. economists, yet its inflation projections have been consistently wrong for years. 

Scientists versus Water

I believe it is extremely difficult for humans to comprehend and predict the dynamics of a large complex system, even though we have perfect knowledge of all the individual elements in such a system. 

Let me draw an analogy, call it “Scientists versus Water”:  Scientists, in a laboratory environment, think they know everything about water.  Water is H2O; water can freeze, boil, and evaporate.  However, sitting in a lab, staring at water, these scientists could never imagine tides, waves, or tsunami, let alone trying to make predictions of when these phenomena could occur.  Yet, these are what water can do too!  The scientists who only study water in a lab will never know!

In the 1990s, people already understood what Internet is but almost no one saw the coming of e-commerce and social networks.  We know what inflation is but almost no one can predict inflation.  Even today, we cannot accurately predict the weather.

For those entrepreneurs and investors who “see things coming,” we say they have unusual visions.

And that is why predicting inflation can be difficult, why successful investing can be difficult.

Where are we?

Let’s focus on the U.S. here.  First, consider this set of facts:

• The monetary base (currency in circulation plus reserve balances) has expanded from ~$600 billion (1999) to ~$2 trillion (2009) to ~$5.2 trillion (present). 
• M2-to-GDP ratio has expanded from ~45% (1999) to ~60% (2008) to ~90% (present).
• The velocity of M2 has declined from ~2.2 (1999) to ~1.7 (2009) to ~1.1 (present). 

One would expect such a drastic oversupply of fiat currency would result in hyperinflation.  However, these have happened:

• For almost four decades, real average hourly wage has little changed, hovering around $20 to $25 an hour (constant 2018 dollars).
• Post 2008, the headline CPI has never exceeded 4%.

Instead of “goods and services inflation,” we are now dealing with “asset inflation.”  Stock markets keep going up at an increasingly rapid pace.  Wealth inequality keeps expanding. 

Money must find a home, just like a flood of water must seek reservoirs to “park itself.”  Thanks to modern finance, the flood of fiat currency does not necessarily have to flow into the real “goods and services” economy but can park itself in the financial world.  Over the past two decades, the M2-to-GDP ratio doubled but the velocity of M2 declined by half!  The incremental new money printed over the past 20 years has largely been spent on buying financial assets, remaining stagnant and unproductive.

Oh well, that is just what it is.  Another example of why we cannot predict inflation.

Inflation and Stocks

Warrant Buffett argued in his 1977 article How Inflation Swindles the Equity Investor that inflation eats away investors’ investment returns.  The keyword in that article, in my view, is “physical.”  Buffett repeated that word eight times, using it to describe the transmission mechanism of how inflation hurts businesses.  In the 1970s, businesses were conducting physical volume of business and needed to expand physically.  To do just the same amount of physical business, because of inflation, companies had to spend more money.  Therefore, Buffett argued, inflation hurts!

But there were almost no Internet businesses in the 1970s.

Thanks to the Internet, many of today’s winning businesses are asset light and their business are somewhat “indexed” to inflation.  Use food delivery companies as an example.  In a normalized state, on the revenue end, the delivery platforms’ revenues are a fixed percentage of food order values (so, indexed to inflation).  On the cost end, the delivery drivers earn most of their incomes from customer tipping, which is also a fixed percentage of food order values (so, indexed to inflation).  One can argue some of today’s businesses are basically immune to inflation.

Moreover, today’s winning businesses usually benefit from “Wright’s Law” — the more they grow, the lower their costs would be.  As costs come down, demand also goes up.  What a virtuous circle!  In an inflationary world, these winning businesses could potentially do even better versus the rest of the pack.

So, does inflation still matter for (some) stocks? 

Inflation and Government Debt

This is the “juicy” part of the story.  Imagine this:

For some reasons, stock prices decline → money flows from financial markets to the real economy → money velocity goes up → inflation → more inflation → rates go up → governments find it difficult to service debt → potential government debt defaults → …

The key is “rates go up.”  As long as central banks keep rates low, the whole transmission mechanism will stop at “more inflation.”

Then, imagine this is what we get: a highly inflationary yet ultra-low interest rate environment. 

Wait a second!

That is exactly how we resolve the mountains of public debt!  Let inflation eats the debt away!

At the expense of average people’s livelihood! 

So, the end game could well be this:

• Inflation helps governments get rid of their debt.
• People who already own a lot of assets are little impacted.
• People who live paycheck to paycheck find life to be even more difficult.

Presumably, restaurants are here to stay post-pandemic.  Upscale restaurants will probably grow at the same speed as the amount of grocery stores’ shelf space selling cheap canned foods!

Given that I just laid out my “Scientists versus Water” theory, I genuinely hope I am getting it all wrong here!

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