This past weekend, the San Francisco 49ers beat the Dallas Cowboys in the divisional round of the playoffs, sending the Cowboys to an earlier-than-hoped-for offseason for the second consecutive year. For Cowboys fans, this is a frustrating but all-too-familiar scene, having watched talented Cowboy teams continually fail to advance beyond the divisional round of the playoffs since 1995. In poetic fashion, every January the calendar turns, the trees go dormant, and America’s Team goes down before reaching the NFC Championship. In 2023, however, it seems increasingly likely that they won’t be alone. This year, inflation is going down like a Cowboys team in the divisional round.
Defining Our Terms
Definitions are important. If words don’t have concrete meanings, effective and productive communication becomes impossible. Inflation is a term that, unfortunately, has as many definitions as the Cowboys have had recent playoff disappointments. For some, inflation is the cost of their favorite product increasing. For scientists, it’s a sort of “god-of-the-gaps” explanation for why the universe exists. But most people associate inflation with “a sustained general rise in the prices of goods and services over time.” And while that is the common understanding of inflation, it actually obscures the insidious nature of inflation itself. In fact, that’s what it is intended to do. Defining inflation simply as “rising prices” leads people to believe it is something that just happens. But is it?
The Correct Definition
The best (and oldest) definition of inflation is this: an artificial increase in the money supply. This definition cuts through the simplistic notion of “rising prices” and gets to the heart of the problem with inflation. Expanding the money supply always and everywhere leads to prices that are higher than they would be otherwise. This is an unassailable fact that some of our betters would like us to miss. This is not only the best definition but the only honest one as well.
“Inflation is always and everywhere a monetary phenomenon” Milton Friedman
However, for a variety of reasons this definition is sometimes forgotten in everyday experience. If everything else is equal, then increasing the money supply will always lead to higher prices. But higher prices are not always the result of an expanding money supply. Wars, natural disasters, and political theatre can and do sometimes lead to higher prices, at least for a time. And lower observed prices can sometimes occur even when the money supply is expanding. For instance, a great advance in technology may make the production of something a lot more efficient, leading to lower prices at the store even while more money in the system keeps prices higher than they would have been. Doh! Is your brain hurting yet?
Inflation is Thievery
The key word in the previous definition is the “artificial” expansion of the money supply. This word shines a light on the pilfering involved in government and private banking behaviors that create new money. When they create money through deficit spending or bank credit expansion, they call it “economic development” or “financial assistance”. If you or I were to create money, it is counterfeiting. When they create money, that new money goes to their biggest donors or clients. But make no mistake, they are “spending” that new money just like anybody else, and it affects prices throughout the economy.
Economists justify this by arguing that new money eventually makes its way around the economy, and therefore everyone benefits. But as the 17th-century economist Richard Cantillon pointed out, new money always provides the biggest benefit to those who receive it first. As money is spent and moves throughout the economy, those who receive it later in the process must deal with prices that are higher. Meanwhile, those who received the new credit or government-issued money first receive the benefit of the formerly lower prices. The evil of inflation is that it always involves a shift in wealth from one group of people to another, and not (as some might suppose) in the virtuous Robin Hood sort of way. It involves a shift of wealth from those with connections to those without.
This also highlights the biggest problem with the common understanding of inflation that I outlined earlier. Defining inflation as a “sustained rise in prices” obscures the fact that inflation is a policy of the government and private banking sector. We are not victims of inflation. No, we are victims of those who create inflation. And it’s an unfortunate fact of modern society that our language is used as a tool to obscure that fact.
Down, Down, Down in 2023
2022 was a year of rising prices. Notice, I didn’t say inflation. Prices certainly rose, with the Consumer Price Index reaching over 9% at one point before ending the year well above 6%. Prices of everything from eggs to milk to energy went up last year.
The temptation is to blame government spending. While I’m always game for blaming the government for a variety of our problems (let’s be honest, who isn’t?), in this case, they are not the primary culprit. Yes, the Federal Reserve’s target is 2% inflation every year, sucking away your purchasing power at a “stable” (ha!) rate. Plus, the government’s continued deficit spending adds new money to the system each year, and that new money results in prices that are always higher than they would be otherwise.
But it is important to note that those policies have been in place for decades. And while prices have generally gone up over the past half-century, they haven’t gone up at the rate they did last year. Plus, there were several financial market indications that suggest (despite the government’s best efforts) the overall money supply may have stagnated or even declined. Forgive me for not elaborating – you’ll just have to trust me on this. And yet, as we all know, prices partied like the 1970s. So how did this happen?
A Rather Simple Explanation
The Global Pandemic of 2020 and the subsequent response to it by a variety of governments and corporations wreaked havoc on global supply chains. This had the effect of limiting the supply of goods on the market. At the same time, western governments decided to create a lot more money in an attempt to avoid a massive recession for which they were in part responsible. The result was enormous amounts of new money chasing very few goods. When that occurs, the only possible direction for prices to go is up the elevator.
However, the pandemic and government response to it was not alone in creating these market distortions. In February of last year, Russia invaded Ukraine, disrupting the supply of grains and fertilizers that typically flow out of that part of the world and into the rest of it. Further, the West responded to Russia by slapping economic sanctions on Russian oil and gas, thus further disrupting the movement of energy throughout the world. Once again, the supply of goods and services was hampered, thus pushing prices (especially energy) much, much higher.
In short, the price increases of 2021 and 2022 were largely attributable to a pandemic, a war, and government interventions. Yes, government money printing contributed, but it was only one factor (and perhaps a relatively small one).
What Happens Next
Economic predictions are dangerous to make, as so many factors can and no doubt will change over the course of the year. But some things are quite evident as we head into 2023. Today, almost all the factors listed above have begun to reverse course. I’m not referring to government interference, mind you. That’s as constant as the sunrise. But all of the other factors are beginning to move in the opposite direction than they were in 2021 and 2022.
The money supply, if anything, is relatively stable if not in outright decline. This will lead to a fall in demand in general. At the same time, adjustments to supply chains are now accommodating massive increases in production. Companies across the globe ordered massive amounts of inventory in response to higher prices, believing that they could sell those goods at even higher prices.
But what happens when large amounts of goods hit the market at the same time that money becomes more scarce? Prices take the elevator back down. Since July the CPI has been running at an annual rate of close to zero. Big box retailers and producers like Walmart, Target, and Nike, have complained of “too many goods”. The Baltic Dry Index, a barometer of global demand for goods and services, has plummeted nearly 80% since last May.
The always overly optimistic World Bank recently slashed its forecast for global growth for 2023 to 1.7%. This is the lowest level in decades, outside of the past two recessions in 2020 and 2009. And many major economic indicators are flashing warning signs of impending price declines and recession.
Investors need to be aware of the risks to their portfolios as they head into 2023. Last year, safe and secure assets like treasury bonds saw their worst return performance in history, dropping by nearly 50%. This was driven primarily by price increases and the Federal Reserve’s response to them. The fed raised the Fed Funds rate from 0% to 4.5% in a matter of months. If prices are now stabilizing or declining, however, this year could see the Fed cut rates while bond prices rise. The return in safe assets could be spectacular, as they were in 2018-2020, or 2014. And while major US stock indexes dropped 20-30% last year, they remain fundamentally expensive. A global recession in 2023 may not bode well for them to bounce back, prompting even more demand for safe and secure assets.