Hey friends -

Check out last week's podcast for a primer on how inflation is calculated and some of the alternative measures! Available everywhere podcasts are found.

In this week's letter:

• Hyped inflation: hyped inflation, hyperinflation, and what you can do about it
• Progress on the privacy front, rebutting The Washington Post, and more cocktail talk
• Honeyed Cigars, an improved hot toddy for those cold winter days

Total read time: 10 minutes, 12 seconds.

Hyped Inflation

Many in the media casually use hyperinflation to fear monger higher-than-expected rates of inflation. Jack Dorsey, CEO of Square and recently-resigned CEO of Twitter, is cut from that cloth.

jack⚡️ @jack

Hyperinflation is going to change everything. It’s happening.

October 22nd 2021

18,569 Retweets76,888 Likes

Hyperinflation is a term of art defined as 40% price increases per month. November's reported 6.8% annual inflation rate isn't anywhere in the ballpark.

What we're dealing with isn't hyperinflation. It's hyped inflation. But inflation expectations can become self-fulfilling prophecies.

Predictions are hard

It's tough to make predictions, especially about the future

- Yogi Berra (probably not)

With all of the pundits on television and social media predicting inflation, you'd hope there would be some signal among the noise. Not so much.

A paper published by Federal Reserve in 2015 analyzed predicted inflation rates versus realized CPI inflation rates over a 10-year period from 2005 to 2015. They looked at five inflation predictors:

• Inflation swaps: financial products that allow you to transfer inflation risk to a counterparty, effectively a bet on inflation
• Survey of Professional Forecasters (SPF): predictions made by professional forecasters
• Blue Chip Financial Forecasts: predictions made by a different group of professional forecasters
• Constant: inflation will be 2% per year, as targeted by the Federal Reserve
• No-change: inflation will be the same as it was in the prior year

The results are not compelling.

The Y-axis measures the average error magnitude for each inflation predictor. While forecasting is moderately better than guessing a constant 2% for the upcoming year, it is materially worse than guessing constant or no-change two years ahead. The average error for even the best estimates was over 1.5%, a shockingly large error when you recognize that inflation over that time was 2.02%.

The paper concludes:

Our results add to the discussion about how much attention policymakers and professional forecasters should pay to market-based inflation forecasts. These measures mostly reflect current and past inflation movements and do not contain a lot of useful forward-looking information.

That wasn't my takeaway, but remember that this paper was written by professional economists. Let's take another look at those forecasters.

You'd be better off paying a monkey to flip coins - almost the same accuracy, a lot cheaper than paying forecasters, and you'd own a monkey that could flip coins.

Inflation expectations

We can't write off inflation forecasts entirely. While forecasters are - on the average - inept, the inflation you and I predict daily matters a great deal. We call these inflation expectations - the rate at which consumers, businesses, and investors expect inflation to increase in the future. (I for one am glad that my expectations aren't lumped in with those professionals' forecasts.)

These inflation expectations are self-realizing. All else equals, if everyone expects inflation to go up by 2% next year, it will go up by 2% next year.

The mechanisms are straightforward. Individuals ask for salary increases that allow them to "keep up" with inflation. Businesses raise prices to "keep up" with inflation. Millions of individual decisions, all made on expectations of how much prices will increase in the future and therefore what they should do about it today. The effect is to increase prices today.

If you expect prices to increase today, then you need to ask for an even bigger salary increase to afford the additional expected price increases tomorrow. Higher salaries become a higher input cost for businesses, which forces them to raise prices.

We know how this plays out.

The dynamics here are one of a complex adaptive system. They have three key characteristics:

• Lots of individuals that each get to make their own decisions that may change over time,
• The individuals interact with one another, and
• Those interactions affect the individuals' decisions.

This is precisely why exceptionally smart, well-research forecasters are so useless at making predictions. The very dynamics of the system almost guarantee they will be wrong.

Despite this complexity, we can influence the behavior of complex adaptive systems as a whole. For instance, we can target a 2% inflation rate in part by changing individuals' expectations of what everyone else will do.

Setting expectations is one of the key tools used by the Federal Reserve to alter real inflation rates so they approach the target inflation rate. We actually track inflation expectations alongside the realized inflation we discussed last week.

Most of the time in the US, setting expectations is an effective tool to manage actual inflation rates. Our track record of managing inflation over the last 70 years is pretty good. Most people's inflation expectations are well anchored - even if they experience higher-than-normal inflation for a short period, they expect that inflation will revert to their previous experiences in due course. In short, their expectations remain unchanged despite incoming data.

When inflation expectations become poorly anchored, we find ourselves in a very different situation.

Up, up, and away!

We have never experienced hyperinflation in the US. The persistently high inflation from the early 1970s through the early 80s is the closest we've come in living memory; inflation peaked at just over 14% annualized in 1980. The dynamics nonetheless begin to give us a glimpse into how poorly anchored expectations can spiral into ever-higher prices.

There were real cost shocks in the late 60s and throughout the 70s. Among the largest were two massive spikes in the price of oil - a quadrupling in '73 due to an Arab oil embargo and a tripling in '79 related to the Iranian Revolution. Other issues were also at play, including growing government imbalances concurrent with persistently low-interest rates by the Federal Reserve.

As prices continued to increase over multiple years, inflation expectations became poorly anchored. Consumers and individuals expected prices to go up because prices had increased previously. Each time prices increased, it reinforced expectations that prices would keep going up. Higher price expectations become a positive feedback loop.

It wasn't until dramatic action by Paul Volcker as chairman of the Federal Reserve that inflation came back down to earth. Among the major changes was that Volcker convinced the public that he would do whatever it took to rein in inflation, including plunging the country into a recession if that was a necessary byproduct of the Federal Reserve's policies. After a severe and protracted recession from 1981-1982 where unemployment jumped to 11%, the public took Volcker seriously. Inflation returned to 5% by the end of 1982 and fell further to 3% by 1983.

Without a capable leader at the helm of a strong, independent central bank, that positive feedback loop can continue unchecked.

Hyperinflation realized

All of the data and figures that follow, unless otherwise noted, come from Reinhart and Rogoff's brilliant book This Time Is Different. Data and figures are available here.

Inflation itself is not a new phenomenon, but it was always limited by the physical nature of money. Governments could - and did - debase their currency by re-stamping coins or reducing the weight of precious metals in each coin. But such shenanigans have their limits. In a world without a robust financial sector that creates more money through fractional lending, money is limited by the availability of coins. Inflation expectations, while they may fluctuate, eventually reconcile with the availability of coins.

Fiat money - that funny paper stuff we use today - doesn't have such constraints. Its availability is limited only by the velocity of the printing press and the willingness of the printer to use it.

That spike post 1900 is the world moving towards fiat currency. While a much-preferred tool to manage the economy for responsible governments, it is also much more subject to abuse. The change is astonishing.

Making this even more remarkable, the 1800-2007 inflation numbers exclude 3 countries - Germany, Greece, and Hungary. Their inflation numbers overwhelm the rest of the data. A brief look at their maximum inflation rates show why.

Missing from this ignominious list is Zimbabwe, who posted the second-highest inflation of all time in November 2008: 89.7 sextillion percent. That looks something like this: 89,700,000,000,000,000,000,000%. It's still almost 11,000 times lower than Hungary's 1946 record!

At some point, these inflation numbers are pointless. The country's currency is useless as money and is better repurposed as wallpaper or kindling. Even using the average annualized global inflation from 1800 onwards of 24%, well below the 40% per month inflation that denotes hyperinflation, your money would be worth just 25 cents on the dollar five years after earning it.

The damage this can do to inflation expectations is extraordinary. When you watch your hard-earned savings evaporate, a central authority will struggle to convince you it can’t happen again. Such inflation can de-anchor an entire generation's expectations and pose real challenges to central banks for whom setting inflation expectations is an important tool.

We're fortunate in the US to have experienced only limited bouts of high inflation in living history. The highest anyone could have experienced was about 20% in 1917. The remaining 97,000 citizens old enough to remember it exert minimal influence on the other 329 million's inflation expectations. We experienced mid-teens inflation in the three years following WWII and again in the 70s. Inflation otherwise has generally stayed below 5% and often below 3%.

Our successful inflation management track record is self-fulfilling - we're more likely to be successful in the future because citizens expect the central bank to continue to be successful. Hyperinflation has an exceptionally low probability of rearing its head.

Other countries are not so fortunate. Countries like Turkey have central banks that are controlled by corrupt governments. Other countries like those throughout Latin America have populations that have been conditioned to expect that high inflation will beget high inflation. Beyond a not-corrupt government and competent, independent bank, the fix for inflation expectations is both simple and painful - manage as best you can until a new generation comes of age without the memories of persistently high inflation.

While I assign a near-zero probability to hyperinflation here in the US, I'm still a coin-flipping monkey shy of making an actual inflation forecast. And while I'm not in the business of making financial recommendations, I'm comfortable highlighting one inflation hedge that's stood the test of time.

What to do about inflation?

My goal is simple - to give you the information I'd want if I were in your shoes. Most other letters at this point would explore gold, other commodities, Bitcoin, real estate, treasury inflation-protected securities, and any number of other asset classes that may be a hedge against inflation. Or they would analyze specific companies that can pass on their rising costs of inputs as increased prices to consumers.

But I digress. That's all terribly complicated. A far simpler and familiar inflation hedge is available.

We have available to us today low-cost index funds that track the overall stock market. When you invest in an index fund, such as one that mirrors the 500 or so largest public US companies, you make a bet:

• Those companies will produce excess cash over time: they will generate more cash than they take in,
• They will grow the rate at which they produce excess cash over time and at a rate above inflation, and
• The return generated from dividends and stock price appreciation will reflect the above cash-producing dynamics over long time horizons.

Said more simply - you're making a bet that American companies will succeed and that their stock prices will reflect that success given enough time. I'm happy to report that it's been a good bet for almost 150 years.

Cocktail Talk

• I predicted a few weeks back that competition would drive down and possibly eliminate overdraft fees as long as it was left alone to play out. Capital One subsequently eliminated overdraft fees. Last week, to my dismay, The Washington Post Editorial Board ignored well-published research to advocate for greater regulation. They kindly published my letter in response: "Don't limit low-income customer access to checking accounts for the sake of good intentions." (The Washington Post)
• At long last, good news from the world of privacy! Back in June, Belgium proposed a new law that would have required encrypted communications services - like Signal - to create backdoors. Signal is end-to-end encrypted - only the sender and the receiver can read the messages, Signal only sees the jumbled encrypted version of the messages. A backdoor is what it sounds like - a way for the service provider to decrypt the messages and read them. A backdoor built into Signal would ostensibly be for law enforcement purposes, but there is no way to prevent others from using it. But the good news! Massive public outcry resulted in a rewriting of the law: "To promote digital security, the use of encryption is free." (Tutanota)
• More good news from the world of privacy! Startup Slik just launched a new service for end-to-end encrypted decentralized file storage, which might be the most jargon-based sentence I've ever written. Breaking it down, end-to-end encrypted means that only you the uploader can view the contents of the files. Decentralized means that copies of the files are stored independently on many servers owned by independent storage providers. Slik has effectively recreated a Dropbox-type service that's more private and eliminates centralized control of your files. It's a great, practical example of what's possible only with blockchain and crypto. (Slik)
• While I spend my time deep in the world of fintech, my brother spends his solving ALS and Alzheimer's. He and his cofounder started Amylyx, a pharmaceutical startup, out of college. They’re filing for regulatory approval for ALS and are evaluating the results of a Phase 2 trail for Alzheimer’s, both diseases with limited effective treatments today. Earlier this week, Amylyx filed their S-1 with the SEC - the first major step to taking the company public. It’s been an extraordinary journey and is on track to make a significant difference in millions of lives. (SEC)

Your Weekly Cocktail

A midday pick-me-up after coming in from the cold

Honeyed Cigars

1.5oz Bourbon
0.5oz KAS Krupnikas
0.25oz Laphroaig 10 Year Single Malt Scotch
4 Allspice Berries
6 Whole Cloves
1 Lemon Wedge
Hot Water

Add everything to a mug. Let it steep for at least 4 minutes. Enjoy! (Alternative: if you don't have Krupnikas, swap for 1 tablespoon honey.)

As the weather gets colder, this becomes a staple in my home. I find traditional hot toddies to be much welcomed but a bit boring - there's so much more you can do! Krupnikas is a spiced honey-based liqueur popular in Lithuania and Poland. I fell in love with it after a friend introduced me to the family-owned KAS distillery based here in NY. It pairs wonderfully with the intense smokiness of Laphroaig - a flavor akin to eating a cigar. The spices for me are as classically cold weather as they come. If I may be sold bold as to recommend - once you finish your drink, top back up with more alcohol and hot water and enjoy another round!

Cheers,
Jared

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