Just before Christmas, I found this post where the great Matt Levine explains the feeling of getting a huge bonus and still being sad. Between M&A, IPOs and bond issuances, 2021 has been a very busy year for banks. A lot of bad things have been said about the banking sector, most of them correct, but there is also a positive aspect: it is one of few sectors where the majority of profits get redistributed to employees and not kept solely by the top management and the shareholders.
Record profits in 2021 meant record bonuses. The difference is that this year there are new kids on the block, the crypto bros, who had an even crazier year. Getting a huge bonus does not taste the same if there is someone else getting an even bigger check. Everything in life is relative. Once I read about a research that explains why bronze medal winners are happier than silver ones and it made sense to me (I also grew up with No Fear t-shirts that claimed “second place is the first loser”).
The past year I tinkered a lot about inflation, willingly or not, and what I would call the ‘relative theory’ is the one that makes more sense to me. I find inflation a very complex topic, something that few people at best have a good grasp of…and central bankers are definitely not part of that club. I will try my best here to write the fewest possible bullshit.
My inflation in 2021
The biggest impact of inflation in 2021 on me has been to wait for it to hit me in 2022. I have no car in London, so the increase in gas prices or second-hand cars was nonexistent for me. Even secondary effects have been muted: Uber drivers mainly have 100% electric cars now and I do not take planes as much as I did a couple of years ago due to C&C, Covid and child. I own the apartment where we live, so no rent increase. Our home energy provider went bankrupt but I am still under my former contract. During the year we did a family spending review about our food costs, not linked to any inflationary considerations: there was a lot of fat to cut, so even if food prices went up (and probably did, since we are enjoying the Brexit consequences as well) we did not feel it due to…process efficiencies.
2022 will be a lot of fun. Here is a non-comprehensive list of stuff that will cost more for me:
- my mortgage (for the record, I am not complaining, I think the Bank of England made the correct choice)
- my utility bills. The energy one is comprehensible but in UK there is this, very stupid, custom to link a lot of service costs to annual inflation, like my mobile subscription. It is a very perverse system by which, if you are too busy living your life, those costs will spiral because they are linked to inflation BUT they are also part of the inflation basket themselves. So you are forced to play the most loved English game: contract renegotiation. I can keep my mobile or broadband sub cost under control but to do so I have to jump provider every two years…(do not even let me start on how stupid it is to apply the same logic to train tickets in a country that is trying to go carbon neutral by 2040)
- taxes. National insurance contributions will increase by 1.25% on April 2022; last year my council tax increased by more than 6%, I can only imagine what will happen in 2022…
- nursery. This might be the biggest blow, usually they review their cost in August so nothing is set in stone yet…but I suspect a bad surprise will come given the general environment.
I am not an inflation-conspirationist but you can understand that if I had to judge only on my personal experience and not on the data, 2021 would have been a year like the others, inflation-wise. Right now the biggest and more evident cost that can hit me is the nursery: that’s how a single data point can drive a whole narrative for a lot of people.
Inflation and me
I was born in Italy in 1978. In the seventies and the eighties, Italy experienced a wild inflation spiral. The basic circle was: high inflation -> high salary increase demanded by employees -> higher costs for employers -> Lira (the Italian one, not the Turkish) devaluation -> higher inflation.
Different ingredients made that spiral possible:
- Italy had (and has) to import 99% of its energy needs. Since oil was a key input for industrial production, heating and mobility, when the price spiked the only option for Italians was to bite the bullet and accept higher costs.
- Unions were really strong and they were able to negotiate salaries liked to inflation.
- Italy’s economy was (is) build on the manufactoring and exporting sector; with such a pressure on input costs, the only way to remain competitive was to devalue the country currency, so that imports became more expensive vs local products and exports became cheaper in foreign countries.
- Politicians could have solved the input cost issues promoting new ways to generate electicity (nuclear, like France) and increase productivity; instead they took the easy way of devaluation. Devaluation was mainly fine for the average Italian because…when you already live in the most beautiful country in the world, you do not need to travel. The fact that the Deutsche Mark was so strong against the Lira was actually good because it was a boon for the turist industry and no one cared to travel to Germany nor use German products (until the quality gap between Italian and German goods became too wide but it only happened decades later).
Might have been the aftermath of the war but at the time Italians were great savers and their favorite investments were Government Bonds and real estate. Real estate was a great hedge against inflation, especially in a country that had to be rebuilt and was experiencing population growth. With inflation at 17%, retail investors thought they had a great deal from Government Bonds paying 14%, even if in reality they were losing 3%-real a year.
Italians were like frogs in increasingly hot water: their condition was worse and worse but at an ‘acceptable speed’. Everything started to change in 1986, when the Exchange Rate Mechanism to control the volatility between European currencies got changed to keep them in a narrow range. The devaluation strategy was definitely retired once Italy joined the EUR in 1999.
Why it might not happen again
When I started to read about investing ages ago, the inflation risk was centered in everyone’s mind, at least around me. To my uninitiated mind, gold bugs were simply ‘investors’. There are different types of inflation risks:
Hyper-inflation
Or what I would call, the click-bait inflation risk, stories about the Weimar Republic or Zimbabwe. Yes, there have been some instances in the past when some countries experienced multi-year inflation rates so high that you blinked and the next morning you had to go to buy bread with a wheelbarrow:
When I was around 10, one summer I went on holiday with my parents to Croatia. Local inflation was so high that we were paying with notes that some Croatian saw for the first time when my father handed the paper to them. I still remember the question mark on their faces. Hyper-inflation tales do not require black and white photos or far away continents. Croatia also just exited a bloody civil war after a Communist dictatorship, that’s the key element that rarely gets mentioned. If you think that something similar can happen in Europe (or the US)…first you have to see the European Union collapse and then, maybe, there might be some instances of hyperinflation here and there. Hyperinflation cannot be created by central banks alone, other events, big ones like a war or a social upheaval, have to come along. Here is a great post by Cullen Roche that explains this concept way better than I could ever do.
Persistent high inflation
How high is high inflation? Depends who you ask. G7 Central Banks typically target and consider optimal an inflation rate of 2%; a high range could be anything between 7% and 20%. Some Emerging Market economies lived many years with inflation hovering around 5% without any big issue. In the end, if you want to grow your economy out of poverty, high-single-digit inflation is an acceptable by-product. High and sustained economic growth cannot be achieved with 2% inflation.
Inflation expectation is the key aspect here. Economic growth brings a lot of social benefits, so the ‘ruling class’ has every interest in pursuing it. But inflation is a difficult beast to manage. Governments can dial-up inflation from 2% to 5% quite easily in the short term, what it is really hard is to bring back long-term inflation expectations from 10% to 4%. Persistent inflation, like deflation, is driven by the general population’s expectations: there is no government message that can change your mind if you think that you can buy a washing machine today at a lower price than tomorrow. Japan spent more than a decade trying to convince citizens to save less and spend more and did not succeed yet. Once expectations are ingrained in people’s minds, to break them you need a big shock.
Turkey is a great example of the risk of running high inflation for a long time. Turkish economy experienced a boom in the 2000s, growing more than 7%/year for more than 10 years after a crisis in 2001. The central bank decided to make price stability in the country a priority and succeeded as the annual inflation rate declined from 54.2% in 2001 to around 8.8% in 2007. Since then inflation remained above 5%. The problems started when Erdogan morphed from a democratically elected president into a dictator. Free economies do not work well under dictatorships and even less when the Central Bank loses its autonomy and becomes an extension of the dictator agenda. When the economic growth started to deteriorate, Erdogan took the 1980s Italian economic playbook: Turkish economy relied on the manufacturing industry and had to import energy, and in part food, from outside. The inflation vicious cycle was on. But then Erdogan decided that to fight inflation you need lower interest rates instead of increasing them. And this led to today’s situation.
Again, you can see that the disaster was a combination of factors, not just the local Central Bank making policy mistakes.
Transitory inflation
Premise: my memory is really bad. Mid 2020 (I guess) someone went on a RWM podcast (cannot recall which one) and used a very good metaphor to describe the inflation impact of fiscal policies post Covid-19: it will be like a python eating a pig. Imagine the shape of the snake while the pig gets digested throughout its length, this ‘bump’ in an otherwise linear shape that moves down.
Transitory inflation will follow the same pattern: a bump, the almost 7% we saw this year in the US, that will be followed by a regression to the standard 2% mean. Transitory inflation means that prices will go like this:
2020: $1
2021: $1.07 (7% bump)
2022: $1.1021 (3% increase)
2023: 1.1241 (2% increase)
Transitory inflation does not mean that at any point in time prices will go back to $1, it means that prices will not grow at 7% for years and years.
Why I am in the “transitory camp”
Again, this is just the thinking of a person that is not remotely a subject expert but spent a lot of time reading about it. Back in 2008, I was the first to believe that Quantitative Easing would have created massive inflation and invested in gold. As you know, things went a little different but at least I learned the benefits of diversification: if I went all-in on gold AND I got paid, I would have felt (wrongly) that I knew it all and probably lose even more in a later trade.
In order to have persistent inflation, you need salaries to go up. The other day I read that IKEA is going to raise prices at its shops. They said the reasons are input costs and supply chain issues; the real (and only) reason is that they think their customers can afford to buy their furniture at a higher cost. That’s it. Either their competitors already raised their prices or IKEA is convinced they will not lose too many customers after the move. If your input costs go up but you are convinced that no one will buy your widget at a higher cost, you will find other solutions to stay profitable: change inputs, lower quality, squeeze your employees, you name it. This news is also evidence that inflation is currently running above trend, not that inflation is going to be persistently this high. Evidence of persistent, high inflation would be IKEA raising its prices 9% in 2023, 2024, and so on. We are not there yet.
Imagine if governments reacted to the 2020 recession with the 2008 playbook, austerity measures and deficit controls. There will be no supply chain issues because no one would have the money to buy anything, IKEA furniture included. It is the fiscal policy, the ‘stimmies’, the ‘transitory Universal Basic Income’ that created inflation. Ben Carlson in 2020 said that if we exited this crisis with inflation it would mean that policies, fiscal and monetary, were successful and I completely agree with him. Is it better to buy IKEA furniture at a higher price or not to have the money to buy it at all? Current inflation is a W.
Second-hand car prices exploded because people had the means to buy those cars AND had places to go, not only to work but also to spend even more money. The only way inflation will persist is if ‘stimmies’ will persist, and I do not think that will happen. Even if those checks keep coming, they have to grow WITH inflation in order to have the spiral effect and this is an even more unlikely scenario.
Do you remember my example about Italy? One element of the cycle was the strong unions’ element. Today unions are at best a reminiscence of the past, especially outside the government sector. It is difficult to maintain a permanent negotiating power to keep collective increases in salaries. There are selective skill shortages? Yes, and those jobs will maintain strong salary growth for years. But the current generalized worker shortage will not persist. Those jobs will either be filled by automation or, most likely, by people going back to their old, hated job because the State is not paying anymore a Universal Income (until the next recession).
During the holidays I spent some time with my brother and one of my cousins. They are both designers who did the same university. My brother has a private practice in Milan, my cousin works for a hot payment company in Amsterdam. They are both looking for young designers to help them. My brother found one of his former students (he teaches at the university as well) that was working in a bakery after finishing his studies because he did not find any job; he is going to pay him less than €1k/month. My cousin is competing with full-remote American startups that are hiring his co-workers offering €200k/year. There are some reasons why there is such a gap in that market but those reasons do not justify ALL that gap. An increasing amount of companies are allowing fully remote or location agnostic and this will push salaries further down, not up (in my cousin’s example, there are winners in Europe but losers in the US).
Central Banks hiking rates to 1% or 2% does not mean they are fighting persistent inflation, it is just a normalization from a previous, very loose, monetary policy. 2% should be the norm, not 0%. 2% will also give Central Banks room to cut rates in future recessions, it is a risk management tool.
What QE might have created is asset price inflation and increased inequality. This is the relative-inflation theory, there might be persistent inflation on certain items. Growing inequality means that a group of people has more and more money…but they are all chasing the same things. There is a finite amount of large, beach-front land in Hawaii; there are only 30 NBA teams; Banksy and Beeple produce a finite amount of art (I mean, I hope for the current holders they will…); and these are the items that drive rich people complains about inflation.
I complain about nursery fees but if I move out of London the price will drop; I complain about nursery fees but in the part of the world where we live, having a kid is a luxury if you are middle class (and by middle class I mean the top 20% that is not the top 5%). No one pointed a gun to my head to have a child or two. I even invested in a nursery and it went bankrupt! Despite the high prices and the high demand, it is a very hard business to run (starting a nursery biz just months before Covid exploded did not help either).
I am lucky enough that every year I receive a salary increase that is at least in line with inflation (I am not sure this year will be the case though). A lot of people do not even get that but I am still pissed because in my mind a salary increase should not be ‘just to stay the same’. During the Great Financial Crisis, I managed to keep my job and my friends did too: it was a great period for us because everything was at a discount. The past two years my net worth grew nicely and…I am less happy than in 2008 because I am simply part of the peloton, not the guy sprinting ahead.
The inflation-price was definitely worth avoiding the collective misery the world experienced in 2008. Unfortunately, we are not wired to collectively rejoice that.
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