Chapter 1: Unraveling Inflation's Timeline

In examining the structural factors behind today's inflation, a pressing question arises: why did inflation remain subdued during the 2010s? Why didn't we see significant inflation in 2014 or 2017, despite the Federal Reserve's efforts to stimulate the economy through easy monetary policy and quantitative easing (QE) since 2008?

Several factors contribute to this timeline. The onset of COVID-19 and the ongoing Russia-Ukraine conflict have disrupted global supply chains, labor markets, and commodity prices, creating imbalances that could suggest inflationary pressures. However, if these were the sole causes, we might expect inflation to diminish once these disruptions are resolved, which would alleviate the Federal Reserve's concerns.

In my view, the increasing levels of debt relative to GDP and the growing dominance of the financial sector over the real economy are the fundamental drivers of the inflationary trends we are witnessing today.

To illustrate this, consider the graph below, which shows a marked increase in the size of the financial economy compared to the real economy starting in 2008, a change largely attributed to QE. The blue line represents the total of household assets, liabilities, and government debt, serving as a proxy for the financial economy's scale. As this sum grows, it indicates more claims on the goods and services produced by the real economy (represented by the red line). If many individuals attempt to convert their financial wealth into tangible goods and services simultaneously, the limited supply results in rising prices, leading to inflation.

Financial Economy vs. Real Economy

Imagine a casino that generously distributes chips but only collects cash later. Here, cash symbolizes the real economy, while the chips represent the financial economy. If luck is on the players' side, the volume of chips can greatly exceed the available cash. Once players realize this discrepancy, a rush to cash out ensues, causing chip values to plummet.

This leads us back to the question of inflation in the 2010s. My hypothesis is that throughout much of the last decade, the stock market, real estate sector, and emerging markets like cryptocurrency acted as a substantial sponge, absorbing funds that could have otherwise driven up the prices of goods and services.

This situation created a self-reinforcing cycle characterized by:

1. Rising stock and real estate prices encouraging further investment in these asset classes.
2. Money flowing into asset markets rather than goods and services, keeping inflation in check (notably, home prices are excluded from CPI).
3. Low inflation enabling the Federal Reserve to maintain reduced interest rates, which spurs credit growth and boosts collateral values.
4. An increase in credit leads to further appreciation in stock and real estate prices, perpetuating the cycle.

It is essential to note two outcomes of this cycle: First, the financial economy expands at the expense of the real economy, as funds continue to flow into thriving assets. Second, the correlation between low inflation and rising asset prices is reciprocal—rising asset prices contribute to sustained low inflation.

However, this positive feedback loop cannot persist indefinitely. Eventually, akin to casino patrons, investors will recognize that there aren't enough tangible resources available (or future earnings to support valuations). This realization has become evident with significant declines in stock values for companies like Zoom and Netflix. The resulting sell-off triggers a rush to liquidate positions, causing asset prices to drop. As asset prices decline, the previously low inflation begins to rise, leading to increased interest rates.

A unique aspect of the current market downturn is that Treasury bonds, typically a safe haven during declines, are now part of the problem. With nominal yields near zero and real yields deeply negative, coupled with high inflation, Treasury bonds offer minimal reward. This scarcity of safe investment options increases the likelihood of investors seeking inflation-hedging assets such as gold or commodities, further fueling inflation.

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Chapter 2: The Real Drivers of Inflation

The following video explores the misconception surrounding inflation and its actual causes:

This video titled "You are being LIED to about inflation (here's the REAL cause)" delves into the common myths about inflation and uncovers the underlying truths behind its recent surge.

Additionally, another relevant video addresses the question of price stability:

Titled "Why can't prices just stay the same?", this video investigates the complexities of price fluctuations and their implications for the economy.