The inflation playbook 4 decades later

The current market belief that inflation is rife comes during a time when very few in the markets can recall the oil price shocks of 1972 and 1978 nor the Volcker years of monetary targeting from 1979 to 1982.  Indeed, the ‘inflation playbook’ that central bankers are gleefully dusting off (their relevancy now is greater than at any time during the last 4 decades) is 2 generations old and, quite possibly, predicated on unproven beliefs.

The current policy response to the perceived ‘inflation shock’ really needs some modern thinking.  Let me reason…

Is there an inflation?

This question is fundamental to the policy response but no-one has proven that there is an inflation problem.  Sure, the CPI is up 8.6% year-on-year in the US but this is not inflation per se.  Energy and food prices have risen but other prices are stable.  The wide variation in CPI components (energy is +106%, airfares +60% while doctors fees are +1.1%) points to a relative price effect that could easily be reversed (the Ukraine war finishes causing oil prices to fall and post-covid demand for travel wanes leading to airfare discounting).  But, more importantly, this disparity does not fit the definition of an inflation – where all prices rise proportionally – that is an 8.6% across the board increase in prices.  Further still, inflation is not just an increase in prices – it is an increase in the rate of change of  prices.  This means that energy prices dont just rise and stop.  Inflation means that prices (all prices) rise and continue to rise through time with a propogation mechanism that allows it.  The traditional mechanism has been money – where the money supply is allowed to grow at a rate that at least matches the rate of inflation over time so that the nominal price level does not feel short of fuel to continue the price increases.  The jury is out on whether inflation is with us or the CPI rise just reflects a temporary increase in the price of a few key commodities and services.

Is inflation such a bad thing?

Despite 4 decades of stable prices, the inflation literature concluded that inflation is quite an efficient form of taxation.  Seignorage is the decline in purchasing power suffered by holders of nominal assets such as fixed rate securities and (heaven knows who does this these days?) holders of currency.  In the present case, holders of US dollar bonds and currency are paying the taxes.  Whereas in the 1970’s the amount of currency in the average worker’s wallet was high, the current situation is much lower with most electronic forms of payment being linked to interest bearing deposits.  As interest rates rise, the nominal tax on currency holdings is cushioned.  The incidence of the taxation effect or seignorage is diminished on the average worker and increased on the holders of nominal assets (typically bonds). Nevertheless, the inflation tax can make the government’s real debt burden shrink quite quickly without political repercussions.

The 4 decade old playbook

The death of inflation in the 1980’s was somewhat surprising to economists who never really got around to understanding why inflation stopped let alone why it started in the first place.  Hyper-inflations are clearly monetary in their cause and propogation but mild or moderate levels in the high single digits are curious.  Without knowing the cause it seems silly to respond with a generic policy response like jacking up short term interest rates. This was Greenspan’s Fed reaction function and arguably kept short-term interest rates too high for too long at around 4%. It does seem we are heading back in this direction particularly when the President of the European Central Bank Christine Lagarde says things like “…we will do everything we can to keep inflation within our 2% target range.” No debate here about relative prices and inflation…

Some believe that sectoral shifts are confused with inflation where prices signal resource re-allocations (eg high oil prices stimulate switching to solar) and this gets reflected in the CPI.  The correct policy response to this event is to facilitate the shift rather than stifle it.  My head and heart are in this camp.  That is, it remains to be seen whether the current CPI increase is inflation.  If not, then the price mechanism needs to do its thing.

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Australians all let us rejoice, for we love money and mischief

With over a month to go until the Australian election I am prepared to call it:  The incumbent Liberal party led by Scott Morrison will be returned with an increased majority.  Why so?  Well, the money v mischief theory has both legs in favour of the Liberal party. 

A brief recapitulation of the M v M theory with reference to the current political climate in Australia.  The first plank in the theory is that the ‘thoughtful swinging voter’ does not make up his/her mind until they are in the voting booth.  They then ask themselves, ‘ what has the current guy in power done for me?’  Money is the main issue here and the current government has done a lot to feather the pockets of the electorate.  The over 10% reduction in the petrol price recently to cushion the cost of higher energy prices is a classic.  How many electors go out to the polling booth and stop off to buy petrol on the way?   Only 1% who do this will be enough to win the election.

The mischief piece is also in favour.   Despite being one of the least inspiring, boring and uncontroversial leaders of the opposition, Mr Albanese still finds himself as favourite to win the election in the opinion polls.   These statistical flumoxes are so irrelevant and incorrect that they are not worth the paper (or electrons) they are printed on (or stored by).   Nevertheless, they find themselves in the news thereby forming the view that the true underdog is the government.   Mischievous voters favour the underdog. 

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Hey Vlad, whats in it for me?

The power for prosperity trade has long been perfected in Asia.  Be it the Chinese Communist party or the Singaporean Peoples Action Party, it is well established that if you want to rule a country you need to pay the masses for their support.  Asian people are not philosophically committed to democracy, by and large, so they will listen to a deal.  If those seeking political power want to, say, build a casino or two, or rid the nation of defiant opposition, then there is a price that the people will extract to compensate them for their acquiescence. Typically this can be in the form of rapid economic growth.  Economic power is political power in our modern era and smart governments know this.
The Chinese Communist Party has played this trick for decades and won.  It is difficult to foresee a situation where Chairman Xi loses power while economic growth ticks along at 6-7% per year or, put another way, the average Chinese family’s income doubles every 10 years.   But you cannot treat the electorate as stupid –  one prominent Singaporean’s  threat to cut housing assistance to electorate’s that didn’t support the PAP 15 years ago was a little too blunt to be acceptable behaviour in a nation that counts itself as the intellectuals of Asia.
So what can Vladimir Putin learn from Asia’s winning formula? Where do we start? Is the Ukrainian invasion a winner?…Whereas modern warfare had been expected to take place in either the bang-bang world or cyber-space it seems the true theatre of war is the banking system.  Big missiles may look good at parades and kill indiscriminately but nothing can compare with no money.  Only rich countries go to war.  Poor countries can make their own arrangements.
The West is doing its best to make Russia poor.  Having worked with Central Banks for much of my JPMorgan career I can say that the Central Banking community have been dragged kicking and screaming into this fight. Typically, Central Banks keep their reserves with each other since they trust each other not to default.  (The pressure on each Central Bank, however, to deny Russia its assets has been strong and they have frozen these assets.  However this sets a nasty precedent for them and they will be scrambling to protect their own reserves from similar actions.)  In Central Bank – land, liquidity is King and it is not uncommon for them to keep ‘secret accounts’ that act as emergency funds in the event of official reserves being frozen.  These accounts are typically held at money-centre banks, sometimes administered by hand selected members of the Central Bank itself seconded to the bank.  While Russia had USD670billion in foreign reserves prior to the Ukraine invasion, they may have had USD6billion in secret accounts that may or may not have been recalled.  If not withdrawn in advance, these accounts will be frozen inside the private institutions.  USD6billion is hardly enough to run a war however it could buy some time.
The meme-culture that has been so effective driving the likes of Gamestop to prices that cannot be justified is probably Vlad’s biggest foe.  Angry young men and women with a smart-phone and a brokerage account are difficult to placate so any company that baulks at supporting the Russian blockade will suffer their wrath.  Major companies such as Apple, Zara, Shell, Coca Cola and others have simply just abandoned their assets in Russia which is a small price to pay compared with the alternative from the meme-brigade.
So what, Vlad, is in this invasion for the average Russian or the far-from average Oligarch?  Cut off from their wealth and their instagram accounts, the Russian people must be asking what’s the point of the Ukrainian invasion.  Old school propaganda is the natural fallback for Vlad Putin but this is the 21st Century and no-one laps that rubbish up without asking questions.  The private jets and ships that the oligarchs play with have effectively been seized and impounded with scant regard for their property.  One can only imagine how quickly these treasures will turn to rust-buckets or become target practice for international navies.  Red Square in Mayfair will soon be overtaken by squatters.
Nothing above indicates that Vladimir Putin has understood the forces that have kept him in power, made excuses for his errors and allowed him to prosper.  These are economic forces that, as in Asia, have created wealth along with his power.  Putin was a folk hero of sorts, challenging the West while making his people rich.  Now he is just a thug and a murderer who has missed the point of modern politics.  What’s in it for me, Vlad? Nothing, you say, Vladimir…oh dear.  Then that is the end of you, Vlad, it’s only a matter of time… 

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Why do people gamble?  A straight application of prospect theory says that when offered the choice of $1 with certainty versus a gamble with expected value of, say, 85cents then it is rational to stay with the $1.  Yet the gambling industry is alive and well and has been for thousands of years. Why? Milton […]

Oops they’re doing it again…Omicron

Israel shocked the world this morning by banning all travel from other countries in response to the ‘Omicron-variant’ of the Covid 19 virus.  The behaviour of this variant is largely unknown so it is a little perplexing that a perceived leader in the handling of the pandemic should react so abruptly and without the statistical evidence that a reasonable person would demand.  Their actions are more surprising given how ‘pandemic-weary’ the world’s populations are,  having been continuously subjected to draconian restrictions by well-meaning health regulators without much concern for the broader economic and social consequences of their actions.

The impending danger is that the majority of governments in the world, who individually and collectively are struggling to let go of the draconian restrictions they imposed on their societies, only to declare defeat as recently as a few weeks ago, feel compelled to follow Israel’s lead!!! Please, please, please don’t do this…

At the beginning of the pandemic on March 3 2020, I correctly analysed the economic impact on markets in this blog and earlier still in January 2020 noted the difficulties established institutions had deciding when to switch off their contingency plans during the SARS epidemic.  I argued in March 2020 that the economic impact of Covid 19 could only justify a small market correction of about 2%, which would be temporary and followed by a systematic outperformance of the markets over subsequent months.  In fact, the stock markets fell close to 40% but rallied back strongly.  At the time I wrote that “…I can confidently assert that after this statistical playtime is
completed the prospect of predicting a 10% decline in stock prices as a
consequence of the Covid19 is statistically zero…” and that “…A feature of the sell off over the past week has been the uniform
disposal of equities without much regard for the sectors/countries most
negatively affected by Covid19 let alone those pockets that may benefit…”

Ready your powder, team, we are headed for another one of these opportunities but again!  If the governments collectively shut down the transport and service sectors in an attempt (doomed to failure by the way) to fight Omicron then something close to panic will set into the markets.  The panic this time, however, will not be over the virus itself.  Rather, it will be driven by the costly actions of governments trying to fight an unwinnable battle [1]. 

In any event, the markets look to be weakening for the next week or two.  Get ready to buy with your ears back…


1. The government’s resources would be better applied to understanding exactly what the Omicron-variant really represents so that they can make fully-informed decisions.  At the beginning of the pandemic the established folk-lore held that the death rate would be 4% and this would affect all age-groups uniformly.  Subsequently, it became known that many infections were asymptomatic such that the true death rate is closer to 0.2% or lower and that unhealthy people above 60 are those most likely to succumb.  I venture an opinion that if the true statistics were known in advance of the first lockdown orders then there would have been none.


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Gamestop: a test of the test of market efficiency

Despite being a source of great mirth, the discovery that highly paid equity analysts and fund managers can do no better than a monkey throwing darts at the stock tables is somewhat unfulfilling. The inability to beat the monkey is consistent with a random walk for stock prices and hence this has been adopted as […]

The C-bond

The way a Green Bond works is the following: 1. A company (or government) says it wants to borrow money to do something ‘Green’. This could be a wind farm, a coconut plantation or something less exotic. 2. The International Capital Markets Association lists 4  broad criteria that need to be followed. These are quite […]


C is the chemical element symbol for Carbon.  Carbon is number 6 in the Periodic Table of the Elements and is the fourth most common element in the Universe behind Hydrogen, Helium and Oxygen.  Carbon is a fundamental component of many organic compounds and has a common presence in all known forms of life.  Wikipedia […]

The Calculus of Lockdown

Lockdowns have become commonplace as a way to prevent or stall a flare-up in Covid-19 infections.  The justification for a lockdown must be more than just saving the life of the 1% or so of those who get infected since there are significant costs placed on the broader community.  These costs can be as minimal […]

Robinhood, the Efficient Markets Hypothesis and the Gamification of Investing

30 years ago, investing was a serious business.  (Actually, it was no more serious than it is today, just harder to access.)  Opening a brokerage account required minimum balances that were beyond the reach of the average twelve year old, placing orders was manual requiring multiple telephone calls, settlement was T+5 for equities and commission rates were high and non-negotiable except to the most well-heeled investors.  These days, technology has wiped out several layers of human intervention to the point that an individual school girl – lets call her Marion – can buy a fraction of a share in her favourite Chinese Dance-Tok company using her mobile phone during play-lunch.  Robinhood is the market leader in this astonishing technological advance allowing Marion to spend $5 on Dance-Tok shares without any trading fees whatsoever.

Robinhood has made Marion’s investment experience into something resembling a mobile phone game.  A successful trade is trumpeted with a congratulatory rift, confetti streams across the screen and happy faces report profits.  Robinhood is also accused as one of the major brokers involved in the Gamestop ‘rocket event’ where a group of like-minded investors began purchasing the company’s stock at higher and higher prices for FUN.  Gamestop was ripe for a short-squeeze on account of some high profile hedge funds being negative on the stock.  As the stock rose from $8 to $50 the shorts were forced to cover and onward went the shareprice to $460 at its height.  Unlike the traditional approach to squeezing shorts where a small group buy the majority of the outstanding float of a stock, this was a ‘crowdfunded’ voluntary coordinated effort that drove Gamestop’s price far beyond its arbitrageable limits without attracting arbitrage.

The Gamestop – rocket has largely come back to earth and the regulatory post-mortems have begun.  Robinhood’s gamification of the investing experience is directly in the sights of the SEC, congressional lawmakers and various agencies.  Is an app that opens up the investment markets to the Marion’s of society such a bad thing and should it be allowed to be ‘FUN’?

The Efficient Markets Hypothesis (EMH) has a lot to say about this issue.  In its simplest form, the EMH posits that the current price of a security is an unbiased predictor of the range of future outcomes for the stock.  Another way to think about it is that the price of the stock reflects all publicly available information so that there can be no advantage to any individual investor from studying what is already known in the market.  This is great news for Marion and her friends who decide to purchase IBM, JPMorgan or Dance-Tok during play lunch.  The EMH promises that her investing experience will be just as safe as any other investor in the markets – she is on a level playing field with all other investors.  The EMH also posits that the expected return on a stock must be positive in order to induce investors to hold it (there are exceptions to this rule) so that Marion’s investing game actually has an expectation of making money whereas most other games require in-app purchases which are costly to keep playing.  Robinhood therefore finds a lot of support for its app from the EMH.

The EMH, on the other hand, has a tougher time defending the cohort driving Gamestop’s rocket experience.  $460 is a long way from a fair-value range for the stock of $5 to $10 as some analysts had posited.  As the stock price rose many times short sellers must have been tempted to sell.  However, this risked being slammed by the cohort of rocketeers that simply bid up the stock at every opportunity.  In its strictest form, the EMH requires that a self-financing portfolio should not have a positive return.  This is the rule against a money-machine that costs nothing to operate but spits out money at various points in time with no risk of a negative outcome.  On this logic Gamestop’s rocket did not violate the EMH since there was always a chance that some rocketeer would push the stock price higher for FUN thereby causing a loss to short sellers.  At some point, of course, the rocketeers run out of money and the FUN stops.

I doubt that stopping the bells, whistles and confetti on Robinhood will make the app any less appealing or relevant to the new breed of investor.  Forcing Robinhood to charge a fee per trade, on the other hand, will kill the rocketeers but also force the Marion’s of society to seek their thrills in Roblox.  This would be such a shame


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