Why you should be prepared for a period of high inflation

Inflation is a stealthy thief. It takes away your purchasing power without you even noticing. In Singapore, using food as an example, a plate of chicken rice used to cost me $2.50 during my college days. Fast forward 12 years, a plate of chicken rice is now about $3.50 on average. That is a 40% increase over 12 years translating to a simple inflation of 3.33% annually.

With the US and other countries pumping in trillions of dollars into the world, we can expect a period of high inflation. You might ask why is the effect not seen yet. The answer lies in the "Quantity Theory of Money". The basis of the theory is a simple formula,

Where,
M = money supply in the economy,
V = velocity of circulation,
P = price level in the economy
Q = output produced by the economy

With trillions of dollars printed out from thin air, the money supply in the economy had naturally increased. According to the chart below, we can clearly see a spike in money supply since 2020.

But why have we not see any inflation or at least we do not really feel it yet? The answer is simple, that is because the velocity of circulation has also been declining during the same period of time.

Velocity of money is simply the rate at which money changes hand. When I buy something from you and hand over my money to you for the goods, the money changes hand. Naturally, this means more business activities will lead to higher velocity of money supply. As you can see from the chart above, velocity of money has been declining for a while now. In fact it is at its historic low if we zoom out the timeframe.

While money supply is at its historic high,

Let's now look at the other side of the equation. "Q" is the output of the economy. Essentially, this is the overall productivity of the economy, how much goods and services were produced in a period of time. Productivity does not improve or increase overnight and it requires years to grow. So we can expect "Q" to be relatively stable in a short period of 5 years.

Hence, the effect of inflation has not been really seen because we have historic low velocity of money and productivity being hit as a result of the pandemic. For now, things balanced out without changing "P", the price of goods and services in the economy. However, what will happen when we emerge out of the pandemic and business activities start to pick up? Here is when I think a period of high inflation is going to start.

During this period, velocity of money starts to pick up due to increase in business transactions. However, productivity is not picking up as quickly. With the money supply at a historic high, the increase in business activities will cause sharp increases in prices as well.

This can also be explained from a demand/supply point of view. Due to the pandemic, travel and consumption are reduced and overall demand for goods are reduced as well. Post crisis, demand for goods is expected to increase but because many businesses had permanently shutdown, we have lesser supply of goods. Hence, with more demand but a temporary shortage of goods, price naturally increases.

In this period of inflation, I believe there are certain types of goods that will see higher inflation than others. Those industries that productivity aren't much affected by the pandemic will see lower inflation (e.g. internet businesses like Netflix), while businesses like food/beverages and general retail are likely to see higher inflation.

Some might wonder why there is a disconnect between the economy and the stock market. While the economy seems to be suffering, the stock markets are seeing a potential V-shape recovery. I personally attribute this to inflation. To many people, the concept of inflation is only on consumer goods. However, the impact of inflation can be seen in all markets. Equities, properties, bonds and etc.

I expect a period of high inflation as a result of high money supply and a potential sharp increase in velocity of money circulation post crisis. Once the money is in the system, it is tough to get it out. In the US, the Fed had tried to do so in 2018 but failed terribly and ended up having to inject more. In the Europe, they have not even tried since the 2008 crisis.

If my analysis is sound, high inflation is likely coming and ironically, it will come when the economy starts to recover from the pandemic. While I point out the potential problem in this post, I have not talked about the solution. I will leave it to the next post to discuss how I am positioning my portfolio for this period of high inflation. 😎