The Dividend Cafe - The Algebra of Inflation

Episode Date: November 12, 2021

There is a lot of anxiety in the economy right now even though the unemployment rate is incredibly low, and nearly every metric on the planet is looking good (besides elevated price indexes). We went month after month last year with people telling us (and many of them seemed to really, really enjoy saying so, mostly because they are awful human beings) that no one would ever shop again, fly again, or “demand” again. The consumption side of the economy was dead behind a brutal pandemic, they said. And we would all be wise to stop paying our office leases, buy some comfortable couch clothes, order food delivery, get an exercise bike delivered, and sit around the house binge-watching TV and just waiting for it all to end. But now the tune has changed, a lot. Not that drama and intensity – that is the exact same. It’s just the culprit is now the opposite. Now things are too hot, too much activity, too much demand, and prices are too high. That we are supposed to take advice now from the people who zealously told us the opposite 12-18 months ago is odd to me. But I digress. Pricing pressures exist in the economy and when folks are not talking about Congressional legislation or Fed policy, they are rightly focused on that. Today I want to explain why they are focused on the right thing (price inflation), but for the wrong reason, and more importantly, with the wrong solution. And yes, with an eye towards the right conclusion in your portfolio. Off we go … Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to another Dividend Cafe. I am actually recording out here in East Hampton, and so that's why the backdrop does not look like the studio in New York. Hampton. And so that's why the backdrop does not look like the studio in New York. And yet I am recording a Diving Cafe that I am really excited to present because I believe that what I've written at DivingCafe.com this morning, what I'm about to talk to you about in this podcast, in this video, is maybe one of the hopefully better opportunities to connect some economics to present events

and to connect some economics to portfolio thinking. It's been a big theme of what we've been doing the last few weeks. And not all of it has been just centered around my book being out and how there's no free Lunch is all about these different economic principles. Because I think I've been writing about economic principles in Divin Cafe for years and years and years, well before any book coming out. But right now, we just happen to be in a period of time where I think all the stars are aligned for people to benefit tremendously with a little bit deeper understanding of some economic concepts that then give people the

ability to formulate an application as we're sitting around debating things in current policy. And one of the things I could try to dive into in the introduction to Dividend Cafe this week is that same thing would have been true a year ago. There are principles at play. There was foundational beliefs that would have been helpful in the immediate aftermath and the subsequent months of implementation of the COVID moment. And there was this vigorous, and I mean zealous, and at the time it could have been right or it could have been wrong. It turned out to be incredibly wrong, but there was the zeal didn't speak to the wrongness. It was TBD, but there was a zealous belief that we were entering a period of sustained demand contraction. We don't know if people are ever going to shop again.

People are going to change their lives. The pandemic has finally got everyone to say that we don't really like being with people. We don't like traveling places. We don't like doing things. We don't like working. traveling places. We don't like doing things. We don't like working. We don't like consuming, apparently, other than just from home, online, digital, pajama orientation. And for, I think, a lot of these people, somewhere in there, it made room for a spouse and kids. But for the most part,

there was an economic description of an incredibly alienated experience. Best case, just in this moment of what was going to be some kind of a lockdown experience. And in a lot of cases, though, it was extrapolated out. And that had profound implications on what people believed about energy prices, for example, where commodity prices were priced, what plans went into housing construction, what plans went in to the production side of the economy, because you don't make plans for higher production when you believe demand is sustainably impaired. And oh my God, was demand ever going to be sustainably impaired? And we heard it over and over again. I think we heard it from a lot of people. I don't think it's fair for me to make this wisecrack in Dividend Cafe and not share it with you on the podcast or video. We heard this from some people who seem to really enjoy saying it. incredibly awful people. And the embedded pessimism and forecasting as a means of coping that went into that shock and awe portrayal was incredibly unhelpful, much more projection

oriented for them. And I think indicative of, you know, maybe the type of people you don't want to hang out with socially, but most certainly the type of people you don't want to listen to economically. So now you fast forward and like every single thing I just said is different, except for one thing. The zeal, the intensity, the volume with which people are incredibly concerned is all the same. But now it's the polar opposite. Now it's, oh my gosh, there is this massive increase in demand and we're totally unprepared for it. People are really out and they're shopping and they're traveling and they're buying and they're doing stuff. And we just don't have enough supply for it. We're not ready. We're not going to have enough for Christmas. We're not.

And so the supply side of the economy is unprepared for the demand side, most of which is reasonably true. And yet it has to be pointed out how incredibly different that is than what we were saying just a year ago. And so I right now want to do something that's probably going to be a little trickier to do on the video than it was in the written form. But I very much want to walk through what it is that we believe about, shall we say, the economics of inflation and the algebra of fixing these pricing pressures. I've already talked about, don't worry, I'm not going to go down the path right now about how long-term

inflation is not driven by government spending and that government spending is actually creates stagnation in the economy at certain excess levels. You know how I feel about that, I hope. And if you're a first time listener, you have ample archives to walk through that thesis, which I would defend to my dying day. But I think that right now, the inflation we're talking about, meaning the escalation of prices and the economy needs to be re-understood as to what the real problem is and what the real solution is and where that matters to us. So I want to go back to Milton Friedman's famous line, inflation is always a monetary phenomena and it is always too much money chasing too few goods. And I think that there's an incredible amount of wisdom in that pithy little saying. And I think that there's an incredible amount of wisdom in that

pithy little saying. And I believe that other than me adding and services to the word goods, too much money chasing too few goods and services. And then other than a sort of caveat that I learned from Dr. Lacey Hunt, an economist I admire greatly, and I've gotten to know and have studied immensely for many, many years. I do think it's extremely fair to point out that Milton said that in the context of presupposed level velocity, that he was able at that time for quite some time, that there was a pretty sustained stability around the velocity of money, the rate at which it turned over. And that right now we live in a period of such rapidly declining velocity that it alters the intent of Milton's

statement. But I want to share with you the quantity theory of money. And it's not because I am viewing you like my economic students at Pacific Christian High School. And I'm trying to throw in, you know, one of the classroom lessons. I have not yet taught them about the quantity theory of money, but I most certainly will be. Irving Fisher, one of the most famous economists of 20th century, was right about awful lot of things. He was wrong on some things, but reasonably non-controversial in the quantity theory of money that money supply times velocity of money equals the price level times the amount of goods and services in the economy. And we algebraically say it as MV equals PT. It's a very, very famous theorem in economics. And those of you that are good at this kind of thing, you can restructure these things, restate the order of the identity. And it can come out to the price level equals money supply times velocity divided by supply.

That's the same algebraic reconstruction of MV equals PT. So don't worry if I lost you because I'm going to come right back around and I'll re-grab you, I promise. The point I want to make here is that there was a lot of concern 13 years ago that quantitative easing at QE1, 2, and 3 would prove to be inflationary because people saw it as a big increase in money supply. And the argument as to why it proved not to be inflationary, and in fact, we saw decreases in the inflation rate basically every year, what we call disinflation was because of the V, the M times the V, even though M was going higher, the V was going lower and it was counteracting. Okay. The supply of money times the velocity of money, if velocity is declining, it doesn't

matter if money supply is increasing, you theoretically get a lower rate of inflation. And that's what we were dealing with. But right now, I don't think the error is that people are merely ignoring velocity. People are always ignoring velocity. It's always an error. But that's the stuff I usually talk about. That's the stuff regarding loan demand collapsing, a lack of confidence in ongoing projects based on the growth of the future being sucked into the present through excess government spending,

the known problems in future economic growth because of the existence of excessive debt relative to our ability to generate growth. All of those things depress velocity, which does create stagnation and along with it, disinflation. But right now, the inflation side is not coming from too much money. It is coming from chasing too few goods. And this is the supply side of the economy. This is the other side of the equation. MV equals PT, the price level times the total amount of supply in the economy. The total aggregate goods and services and all the things of supply in the economy, okay, the total aggregate goods and services and all the things that happen into the economy. And we could talk about it in the context of merely supply chain issues, ports being shut down, not enough drivers, all of those things are true and they have brought the T down and therefore are holding

the P lower in the way that this algebraic, excuse me, pushing the P higher in the way that this algebraic formula works, in the way that prices are defined in an economy. Growing supply of goods and services would not only offset the inflationary effects of a growing money supply, but it would make for a necessary growing money supply if we were to avoid deflation in an economy of growing goods and services. So growing goods and services coming with a higher money supply is not only expected and not inflationary. It is a good thing. However, what we have right now is the exact opposite situation in which regardless of the money supply and its counteracting with velocity, we are stuck with a depressed level of goods and services, not significantly depressed. And this is the chart I put in Dividend Cafe. The level of supply, services remain a tad below pre-COVID levels.

Goods are higher than pre-COVID levels. But the difference is, and you have to look at the chart at Dividend Cafe, the demand level is blown up much higher. So where there was always a sort of equilibrium between supply and demand pre-COVID, both things dropped during COVID. Now, both have come higher. You would think the supply level being higher would be fine. But there is a delta between the demand level and the supply level. And that inability for supply to reach demand level, that's creating the price pressures. That's creating what is being described as inflation, higher prices, too much money chasing too few goods. They're not

able to get enough supply to soak up the additional liquidity of monetary supply in the economy. And I put a chart of both the good side and the services side in dividend cafe today so that you can see where these things stand where those deltas lie and get an idea of where we are now where does it go from here well first of all let me sum up the way I did in dividend cafe the m of mv equals pt money supply is arguing for inflation. The V, the velocity, it's a little much lower, is arguing for disinflation. But the T, the supply level, which is what the final variable is we need to solve for the price level, inflation versus disinflation. The T is the T to be determined. At this moment in time, clearly the supply level is inadequate. So where are we going from here?

This is the same as it ever was. went post-crisis, post-post-crisis, post-post-post-QE, post-Trump, post-tax reform, but all these things, they say, okay, here we are. There's been a lot of good and a lot of bad since 2008. But now it's 2019. We seem to kind of resolve a lot of the trade war stuff. The Fed had sort of done what they had done. The question now from organic growth of the economy standpoint with 13 years of, well, at that point, let's call it 11 years of sub-trend line GDP growth, but nevertheless positive economic growth, where are we going to get the

next leg in our next inning, next extension of economic growth. And my argument was we needed more productivity, meaning more business investment. And CapEx was going to, you know, had kind of gone up in 2017 and then was sort of stunted a little bit. And that was the question mark. COVID came and then obviously all the conversation changed. Conversations right back to CapEx. And now some are saying, look, supply delivery times are so high, which they are. Labor shortages are so severe, which they are. There are all of these different things that we've made a joke of the word transitory because some people believe that if it goes four months instead of one month,

it isn't transitory. And some people believe that if it goes five years instead of one month, it isn't transitory. And some people believe that if it goes five years, you can still call it transitory. So I have no interest in playing this word salad, okay, that is almost always driven for people's different political talking points. What we have is obviously right now, very significant supply disruptions that have multiple layers to them, labor shortages, port shortages, early retirements, people not going back to work, inadequate supply of laborers, particularly in the truck driving space and the delivery space. There's a lot of these elements. I have absolutely no doubt in my mind, there are market solutions to all of them. But market solutions, creating some equilibrium could

take three months, it could take a little less, it could take a little more, no one knows. And I don't want to put a timeline on it. But I do believe that the necessity of having supply in the economy come higher, this is the heart of what it means to be a supply-sider, you need more productivity, which means you need more investment, you need more business investment, if you are going to meet the delta, that higher demand. Now, maybe the demand comes down a bit just because of the post-pent-up demand that, again, we were told didn't exist in the COVID moment. The pent-up demand did exist, and maybe it will kind of simmer down a bit.

But this idea that you want to, like, let's go have the Fed hike rates significantly for the purpose of curtailing demand, there may be other reasons it's appropriate to do. purpose of curtailing demand. There may be other reasons it's appropriate to do, but that notion, like when it was not a monetary created dynamic, it's a supply related one, the idea of trying to solve it that way. The example I made up when I was typing Div Cafe in real time. So this is the fun thing about recording is I now have the chance to decide if I like what I wrote or not, because I wrote it and I just ran with it. But then now I have to kind of work through if I think it's good or not, but I think I'm going to stick with it. It's like dropping a huge, very, very, very, very heavy metal object on your foot as a way of dealing with a toothache. Like let's distract our mouth from the tooth pain by just hurting the heck out

of our foot. It doesn't make any sense. It's not, we know what the problem is. Let's just solve the problem instead of trying to create another one. It makes no sense. So we will either solve the supply side to meet level of demand, which will counteract with the other side of the equation and produce an equilibrium in prices or we will not. And my point in this is that the supply side of the economy will dictate where it goes, that that is going to be determined primarily by business investment. Now people can come and say, David, how can you be so sanguine? The supply side is clearly going to be really threatened. And if we were sitting here still maybe days away from signing into law, a massive marginal increase on business taxes, on corporate profits,

on investment income, on personal income, I would totally agree. But the fact of the matter is, it looks like we're very much not about to do that. I don't know if there's going to be any bill at all, but I do know from all the drafts that are presently circulating and where things allegedly stand politically, that those things have been struck from the bill. Now, are they doing what they could to boost incentives to productivity, to help the supply side, deregulation, side, deregulation, decrease of tax burdens and so forth. No, they're not. But I don't really think that that's what I'm referring to here today. Ultimately, I don't know the answer as to when the incentives will be present enough to generate the business investment. In the short

term, there's plenty of them right now because prices are higher. And yet there's just no easy solution to getting more semiconductors, to getting more truck drivers, to getting, you know, you can increase the hours of the ports and so forth, but we have a lot more work to do than that. I try not to go into a lane that I feel is not my lane. I think the things I write about, I know about. I study them religiously. And hopefully, people can absolutely disagree with some of my insights, but I don't offer insights without a researched and I think evidence-based point of view. There are things I just don't know about, and I don't know how we're getting more cargo out of the ports. My view is that we are, but I don't know how, and I don't think those things are inconsistent, because I also think that the next time my wife starts her car, it's going to run, and I don't really know how that works either.

if you knew how true that was, would be laughing. I literally have like no idea how a car works. And yet I'm pretty confident it will. So this is not a matter of blind faith in the supply side economy. There are definitely things that hinder it. But my point is that the incentives are lining up behind the need for greater productivity, the various elements on energy, materials, the various elements on energy, materials, industrials. This is what we have to get more of to meet the demand curve, to establish equilibrium that then does the two things going on at once here. It counteracts inflationary concerns and it creates economic growth. And I don't have any levers on public policy. And a lot of the people ideologically, I more side with ideologically and this stuff. They're not really the ones in power right now.

So that's just not where the area of focus is. Market forces that help produce greater productivity. That's where I want to be invested. That's where I want my clients to be invested. And it's where I believe the economy will go. And the framework by which we understand these things has got to be understood this way. It is always in forever within the quantity theory of money. And right now we are dealing with not enough goods and services relative to demand. And the monetary side of the aisle is sitting over there on the left side of the equation watching. That's my take, and I'm sticking to it.

I hope it's been helpful. I hope you've learned a bit. I went fast in the video and podcast here. You can read DividendCafe.com at your own pace, and then also get hopefully even more clarity from the writing than you get from the speaking, along with beautiful little charts that we curate and put together throughout the week. So I hope this Divin Cafe has been helpful. I appreciate you listening, watching, and now reading.

Have a wonderful weekend. Thank you for being a part of the Divin Cafe. The Bonson Group is a group of the Dividend Cafe. Thank you. those of Hightower Advisors LLC or any of its affiliates. Hightower Advisors do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client's individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor for any related questions.