What is Inflation and Disinflation:

To understand whether there will be inflation or disinflation, we have to first understand what inflation and disinflation are, respectively. Inflation is a general rise in the price level of an economy over a certain period of time, i.e., the purchasing power of money is decreasing (Fernando, 2020). Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level, i.e., the purchasing power of money is decreasing but at a slower rate (Kenton, 2019).

Technically speaking the US economy was already in disinflation in 2020, as the rate of inflation was 1.2% in comparison to 1.8% in 2019 which matches the criteria mentioned above to determine whether in an economy is in disinflation (Duffin, 2021). However, it will be argued that the current central bank measure of inflation is flawed and that there will be major catalysts for demand in 2021, which will lead the rate of inflation higher than the levels seen last year and the year before.

CPI - a flawed measure of inflation:

The numbers that I have used above (1.2% and 1.8%), it must be understood how these numbers are calculated and how that effects our measure of inflation. Most central banks target inflation based on the Consumer Price Index (CPI), leading it to be the de facto measure of changes in the price level. In the United States the Bureau of Labour Statistics produces the CPI data (Westfall, 2020). However, the CPI in its current form is quite controversial as it has gone through numerous methodological changes. These methodological changes were enacted as part of the recommendations issued by the Boskin commission in 1996, which concluded that the CPI overstates inflation by 1.1 percent a year (al., 1996). The biases highlighted included substitution bias, quality change bias and outlet substitution bias. These changes have meant that over time CPI has transformed from a Cost of Goods Index (COGI) to a Cost of Living Index (COLI). This has happened as a result of new methodology which takes into account changes in the quality of goods and substitution. Furthermore, the exclusion of certain metrics such as housing costs and complex ways to calculate certain variables has only added to the discrepancy. This overall tends to result in a lower CPI. This was arguably done, as it benefits the government as it reduces their cost of living adjustments for government payments to Social Security recipients and other beneficiaries of government aid whose compensation is tied to inflation. In the last fiscal year, approximately 30 percent of total federal spending was indexed to movements in consumer prices (Wilson, 1998). This can really be seen as an attempt to bring down the federal deficit in the United States in the years following 1996, without having Congress to commit political suicide by cutting social security benefits. I would contend that this can be considered as manipulation of data by the Bureau of Labour Statistics (BLS), and by artificially lowering the official rate of inflation they help feed into the illusion of both stability and that we are experiencing an economic recovery. Therefore, throughout this essay I will turn towards other metrics of measuring and proving that the US economy is experiencing and will be experiencing inflationary pressure which will lead to higher rates of inflation.

The Quantity Theory of Money:

The equation explains the relationship between the following four components: money supply, velocity of money, price level and real GDP. It proposes that the money supply multiplied by the velocity of money is equivalent to the price level multiplied by the real GDP. Over the last few years, we have seen that the money supply has been increasing as the Fed has been expanding their balance sheet, while the price level has been increasing marginally (according to CPI), while real GDP has been increasing too. For the equation to be true we must see a fall in the velocity of money. This is exactly what we have seen. Since the 2000s the velocity of money has been trending downwards as a result of long term factors and then almost expectedly in Q2 of 2020 the velocity of money fell by over 40% as a result of the pandemic (System, 2021). For there to be an uptick in inflation it is necessary that the velocity of money increase. This leads to both a long term and short term factor which have had a substantial impact on the velocity of money which I will address later on.

Quantitative Easing:

Since late 2008, the Fed’s total assets had been rising as part of the Quantitative Easing (QE) program that they had initiated to calm the markets and take assets like the MBS (Mortgage Backed Security) off the hands of institutional investors and provide greater liquidity. Contrary to popular belief the Federal Reserve (Fed) did not actually print physical money as part of their QE program. The Fed can directly credit member banks account’s, as all US banks have bank accounts with the central banks, which reaffirms the image of the Fed as the bank for banks. By buying assets such as government bonds, or even MBSs by newly created money, the Fed is increasing the money supply. This increase in the money supply helps to reduce interest rates. All these open market operations are performed by the FOMC (Federal Open Market Committee) (Amadeo, 2020). Many economists had predicted that QE programs launched by the United States, UK, and the EU (although not called QE in the EU, it amounted to the same) would lead to increased inflationary pressure in the economy which would lead us to seeing higher rates of inflation (Whittaker, 2012). Thanks to hindsight, the general consensus today would be that we haven’t seen the kind of inflation that was expected when the monetary response the financial crisis of 2008 was starting. CPI as a measure is already understated, but the real place to look for inflation is nowhere other than the stock market itself. Since 2009 all the way to February of last year was the largest running bull market in the history of the United States’ economy (Franck, 2020). It lasted for over 10 years. During this time period the S&P 500 went from lows of 850 points in March of 2009 to highs of over 3,400 points (Data, 2021). For context if you had bought a share in an ETF that tracks the S&P 500 during the lows in 2009 and sold in February you would have booked approximately 300% in returns. One may assert and argue that well surely earnings must have increased to justify these higher valuations given to companies in the stock market. However, this would be incorrect to assert. The P/E ratio is a notorious value investing metric used by financial analysts. It is simply the market capitalisation of a company divided by that earnings of that company. The P/E ratio for the S&P 500 hit a 10-year low of 13.01 September of 2011, and since has skyrocketed to over 38.23 in December of last year (Macrotrends, 2021). This means that stocks have gotten just under 3 times more expensive over the last 10 or so years. To further emphasise the large amounts of capital flowing into the stock market it is pivotal to look at the US total market capitalisation as a percentage of GDP. Once again in the lows of 2009 the total market capitalisation was just over 50% of the US GDP at the time, since then we have reached an all-time high where the total market capitalisation is an astounding 190.5% of US GDP (YCharts, 2021 ). This underscores how there has been inflation in the stock market, showed by the higher earnings multiples that investors are willing to pay. The reason why we haven’t seen a substantial increase in the price of consumer goods is because most of the new money created as a result of QE has stayed in the financial system and has not made it out into the demand deposit accounts of consumers. This leads to the next logical thought which would be that for there to be a substantial increase in inflation there would need to be an outflow of money from the financial sector into the hands of consumers. This would be represented through the movement of money from M2 to M1 i.e., M1 would account for a greater proportion of M2. We can link this back to the Quantity Theory of Money. This flow of capital into the stock market highlights the savings glut, as Bernanke had coined it. People, be it directly as retail investors or through hedge funds have been pouring money into the market or they are saving it and therefore, they haven’t been transacting with that money, i.e., they are not spending these dollars to buy goods and services at all. To highlight this point even further the velocity of MZM must also be taken into account. The velocity of MZM tells us how often financial assets are switching hands within the economy. The graph for velocity of MZM has a similar trajectory as the graph for velocity of money, and it highlights the fact that once someone buys a financial asset, they are much less likely to transact with it now than they were in the early 2000s. Furthermore, in the short term the velocity of money and velocity of MZM have fallen by approximately 40% and 25% respectively. It as a result of these falls in the velocity of money in both the long term and the short term that there hasn’t been much inflationary pressure on the economy. In the long-run all the inflationary pressure has been absorbed by the stock market and other assets.

Why the Velocity of Money Will Rise:

In the short term we can very much expect the velocity of money to recover back to the levels seen in 2019 and early 2020. This can be expected as the US economy has very much been expecting a V shaped recovery which is well in progress. There are going to be many factors driving this V shaped recovery. The vaccine roll out has begun and there has been the indication that mass vaccination in the United States will be done by early Q3 of this year. This will mean that the economy will start reopening and that people will start spending more money, which is bound to raise the velocity of money close to 2019 levels. Furthermore, given the current political environment where Biden has won the presidency and controls both the House and Senate means he has tremendous power in terms of fiscal policy. There is the expectation that another $1,400 stimulus check will be approved and passed once he is sworn on the 20th and when Congress reconvenes later this month. The Biden stimulus check, unlike the Trump stimulus checks will go to people who earn less than $99,000 or less than $198,000 if a family (Lambert, 2021). The people who fit into that lower income bracket would have a much higher marginal propensity to consume than those in higher income brackets, and therefore it would be reasonable to assume that a majority of this $1,400 check will be spent. This will be aided by the reopening of the economy and a strong and recovering labour market, which will create almost no incentive to save.

Given the indication of the Fed we can also expect interest rates to be kept close to 0% through at least 2023 (Rugaber, 2020). This means that the Fed will continue with its expansionary monetary policy and therefore increasing the money supply till at least 2023.

Piecing this back into the Quantity theory of money equation give us a simple answer. It points towards a higher price level and more inflation in 2021 which will be at higher levels than both 2020 and 2019. I would argue that the percentage change in velocity of money multiplied by the percentage change in the money supply will be growing faster than the change in real GDP, and therefore the change in the price level will be significant and we will see inflation going into 2021.

Long Term Trends:  

I also believe that there are some long term trends that are going to be inflationary. One of them will be the shrinking inequality gap which will occur under the Biden with his plans to raise taxes on the ultra-rich and provide stipends to those who are in lower incomes brackets and thus more likely to spend it. There are also the demographic changes which are occurring in our society, such as the issue of the ageing population which could also possibly have inflationary pressure on the economy (Pradhan, 2020). However, I do not feel that it would be appropriate to expand further on these, given the scope of the essay title.

Supply Side:

While I have not gone into much depth regarding the supply side, I think that nonetheless it is very important and required to build a holistic picture of the economy. The data reaffirms my view of there being increasing inflationary pressure in the economy. The factor that is at play is the extent of supply disruptions. The combination of impaired supply chains and a spike can be a deadly combination together for inflationary pressure.

It is interesting to note that the majority of exchange traded commodities greatly increased in price in 2020 and far outpaced the price increases that the CPI indicated for 2020. Copper prices increased over 26%, Palladium prices increased over 25%, Corn prices increased over 24.5%, Zinc prices increased over 19.7% and Gas prices increased over 16% (Investors, 2021). These price increases are only indicative of some of the cost-push inflation we are seeing as a result of disrupted supply chains and the inability of workers to get to their workplaces which has significantly augmented prices. Furthermore, from a logistics standpoint the cost of utilising containers has been rising exponentially over the last few weeks. Shipping prices have almost quadrupled, with prices just under $2,000 for a 40-foot container in November of last year and now that same 40-foot container is costing shippers over $9,000. Therefore, it would not be unreasonable to expect some of these increases in price being passed on to consumers, especially for goods which have inelastic price elasticities. Examples would include corn and wheat which are necessary staples in the human diet.

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