Etherbridge Updates - Inflation

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Inflation

We get a lot of questions about inflation. Most of these revolve around as to why have we seen muted inflation since 2008. How can you be so sure we will see inflation in the future when previous rounds of quantitative easing haven't brought about inflation?

We can find the answer to all of these questions in the metric we use to calculate, measure and understand inflation, the Consumer Price Index (CPI). Finance is the science of fund management, and over time we have developed metrics to generalise our thoughts and make inferences. Michael always reminds me that when a lie is shared by enough people, it becomes indistinguishable from the truth. The world of finance bends the knee to the metaphysical abstraction that is CPI.

This week's newsletter intends to challenge CPI from a first-principles basis and illustrate to you just how enormous of an enforced fiction it is.

For a while now, I am sure most of us have felt that CPI is an inadequate measure; after all, we are not only observers of markets but active participants in the economy. We have all seen and personally felt the continuously rising cost of goods and services.

What is the relationship between money, inflation and goods and services?

The total amount of money in circulation chases after the total amount of goods and services. In a year when money supply remains flat and goods and services increases, each individual unit of money now buys you more. Prices therefore are deflating.

When money supply increases more than the increase in available goods and services, prices inflate. After all there is now more money chasing the same amount of goods and services.

Over the last 10 years these relationships and their validity have taken serious strain. Those who believe increases in money supply should result in increases in inflation have been dumbstruck by CPI data. Keynesian economists and modern monetary theorists have laughed in face of Austrian economists and wish to continue down the road of monetary debasement. They cite CPI to prove we shouldn’t be concerned about the central banks undisciplined money printing and building deficits, if anything they want more stimulus.

The problem with this is that neither is right nor wrong. Inflation isn’t a simple metric and it certainly isn’t distributed equally.

What is CPI?

According to Investopedia "The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in a predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living. The CPI is one of the most frequently used statistics for identifying periods of inflation or deflation."

"The CPI measures the average change in prices over time that consumers pay for a basket of goods and services, commonly known as inflation. Essentially it attempts to quantify the aggregate price level in an economy and thus measure the purchasing power of a country's unit of currency."

Changes in CPI year on year is how we define inflation. It attempts to give market participants a hurdle rate that they need to beat with their savings to maintain or grow their purchasing power over time.

The money they have stored up in savings needs to be put to work through investment in bonds, stocks and property. Inflation acts as our incentive to spend and invest now, if we didn't our cash would lose the percentage change in CPI every year in what we can buy.

The assumption goes a little something like this, if the interest on my bonds, the rent on my properties and the dividends on my stocks are greater than CPI, my purchasing power is therefore increasing and vice versa. The crux here is purchasing power.

Money is a claim on goods, services and assets. I save with the intention of being able to get what I want out of life. I save so that one day I can, afford a house of my own, a car, good education for my children, quality healthcare for my family and the list goes on.

Michael Saylor of MicroStrategy describes it best. He defines inflation as the change in the price of the things I want to be able to buy in the future. To illustrate this, let's think of two fictional characters, Alice and Bob.

Bob is happy with his lot in life; if he could have it his way, he would continue to live at home in his mother's basement playing PlayStation for hours on end. He saves a bit of the allowance that his parents give him. What is Bob's inflation rate? In Bob's case, CPI is an adequate measure of inflation; after all, Bob is more worried about the cost of beer than the rising cost of a future home. All he needs to do is invest his savings into something that beats changes in CPI because everything he wants in life makes up the constituents of CPI's basket of goods.

What about Alice though? Alice wants more out of life; she actually wants to own something. She wants to own her own home, she wants to send her kids to the same private school she went to, she doesn't want to have to worry about medical bills, she wants to make investments in cashflow generating stocks, and she wants a Mercedes. What is Alice's inflation rate? Do the constituents of CPI adequately track the changes in prices of the things she wants in life? The answer is a loud, resounding, HELL NO.

Alice needs to determine her personal hurdle rate. CPI fails in being a legitimate indicator of purchasing power because it doesn't include assets or best in class services such as education and healthcare.

What is Alice's hurdle rate? Let's dive into the rising costs of what Alice wants in life. All of the estimates to follow represent the nominal change in prices since money printing really got going in 2009.

A home:

Housing data is complicated because it varies so much depending on location. Megacities like New York, San Francisco, and London attract buyers looking for properties where they can store their value. Property in these areas is scarce and attractive to own. This scarcity has led to prices in these areas outpacing the less in demand smaller cities. Still, on a broad basis, property prices have inflated at least double that of perceived inflation.

Stocks:

Stocks are capital assets. From a first-principles point of view, the reason anyone would buy a stock is to enjoy in the value flows generated from business activities. If I want $1 million in dividends every year, how much do I have to spend today, and how much will I have to pay in the future?

We understand there's more to stocks than just a dividend, however without a dividend in place what you are really doing is buying something in the hope that maybe one day, you will share in the companies value flows.

Dividend yield helps us understand how much we need to invest in order to earn our $1 million annual dividend. The dividend yield of the S&P 500 today is around 1,5%. Before 2008 it was commonplace to see dividend yields north of 3%. Today I need to invest $66 000 000 in order to earn my million-dollar dividend. This same value flow used to cost you $30 million. That's an average increase of about 6% annually.

Another way to look at it is the number of working hours required to purchase an S&P 500 index share.

It takes more labor than ever to theoretically "buy" the S&P 500
Source: Bloomberg. Shows an increase of more than two times the amount of time required to work in order to purchase a share in the SP500.

Best in class services like Education and Healthcare:

Source: US Bureau of Labour Statistics. Displays the various increases in price across different goods and services. Further illustrating the unequal distribution of inflation. Side note: it's interesting to see what goods are deflating vs inflating. A common theme points to goods exposed to free-market economics vs the more regulated/ government-controlled services.

It's evident that the things we want in life, the very reason we build up savings, inflate at alarming rates relative to our perceived inflation rate reflected in CPI. What you see here is the Cantillon Effect. When new money is created, it goes first to the wealthy, those who are savers. These savers are unlike consumers because they want assets, leaving newly created money stuck in propping up the value of real and financial assets.

We have shown wealth inequality before but will show it here again as it perfectly illustrates this unequal distribution of inflation. How newly printed money doesn't go toward buying CPI goods and services but instead is used to purchase store of value assets like property, bonds and stocks.

In light of the evident inadequacies of our inflation metric CPI, we recommend that you use changes in M2 money supply as your new proxy in economic calculation. If you are someone that intends to use your savings to buy and own assets then changes in M2 is really what you need to beat if you are trying to maintain purchasing power.

Are you Bob or Alice ?


Notable Articles and News Stories This Week:

BlackRock May Start Trading Bitcoin Futures in its Funds

BlackRock, the worlds largest asset manager, has recently filed documents with the SEC highlighting its intentions to add bitcoin futures to its funds. An excerpt from the filing stated, "Certain Funds may engage in futures contracts based on bitcoin." This is the first time that the BlackRock group has expressed interest to include bitcoin in any of its investment products directly. This shows how even the largest asset managers in the world have decided that it is worth including the digital asset in their portfolios.

Read about it here

Proposed Crypto Wallet Rule Among Those Frozen by Biden Pending Review

The controversial rule proposed by former Treasury Secretary Steven Mnuchin that would require personal digital wallets to be KYC'ed by any exchange interacting with them has been frozen. Crypto advocates expressed concerns over the new requirement and have hailed the recent decision to freeze the rule. Critics and businesses in the industry expressed concern at the impossibility of implementing such a practice as when you interact with a blockchain address it is most often pseudonymous and therefore tough to gather details of the end-user. It would have significantly hindered the growth of many of the US companies in the space.

Read the story here

83% of Cryptocurrencies That Peaked in 2018 are Still Down by 90%

An analysis by digital asset data provider Messari has shown how many digital assets that hit all-time highs in 2018 are still drawn down by over 90%. This is important as it shows the amount of due diligence that needs to go into these assets when making investment decisions. Understanding how the market perceives them, how they accrue value, and their use case can affect their price and long term viability. These are just some of the fundamental factors that can drive price in the digital asset market, and understanding them can help one make better investments in the space.

Read the analysis here

Biden Is Expected to Tap Michael Barr as Comptroller of the Currency

According to the WSJ, Joe Biden is expected to announce Michael Barr as the OCC's new head. Michael Barr was a former advisor to Ripple Labs and has extensive experience in the digital asset space. When appointed as advisor to Ripple Labs, he stated the reason for accepting the position as wanting to foster innovation, "Our global payments system is badly outdated. I think innovation in payments can help make the financial system safer, reduce cost, and improve access and efficiency for consumers and businesses alike." This is another appointment made by the new president of someone who has experience in the digital asset industry following on from the reports of Gary Gensler being made head of the SEC last week.

Read the about the appointment here


Whilst we all have the option to look, to seek to understand, it’s often easier not to. Bitcoin, Ethereum and distributed ledger technology are complex systems that require significant due diligence. At Etherbridge, we aim to lower the barriers of understanding this fast-growing digital economy.

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This is not financial advice. All opinions expressed here are our own. We encourage investors to do their own research before making any investments.