The Opportunity Of Misplaced Inflation

Consider this: Businesses seek to maximize profit (or cash flow). Profits are a function of both revenues and expenses. While important, prices are just one component of the profit algorithm.

Profit ($) = price ($ per unit) x volume (units) – costs ($)

From this equation, it should be abundantly clear that a company’s fortune rests upon more than unit prices. In fact, profits might rise despite prices falling. This routinely happens when companies expand capacity or increase productivity (i.e. lower unit costs). Lower prices facilitate higher volumes which can increase efficiency. This combination often leads to greater profits, which is the ultimate goal.

True, falling prices might indicate a lack of demand. But often times they times don’t. The same applies for the economy writ large.

Profound Investment Implications

In summary, I find the treatment of inflation to be flawed in two ways. First, defining monetary stability in terms of goods and services is inconsistent with its original conception. Inflation simply has no relevance in a fiat currency regime due to the lack of an objective standard. Secondly, the fixation on unit prices for assessing macroeconomic health seems disconnected from microeconomic realities.

Today’s lack of inflation is not a problem; it’s prosperity. So long as markets and people are left free to create and work, deflation will likely persist. We should expect (and welcome) inflation target undershoots in spite of policymakers concocting all sorts of crazy theories and policies in order to stoke it. (Thank goodness!)

The investment implications are potentially profound. What if these misunderstandings underpin the secular decline in interest rates? If so, it seems likely that markets will continue to incorrectly process the incoming inflation data given how institutionalized inflation is in investment frameworks. This should present profitable opportunities for the rest of us. Perhaps the undershooting of inflation targets—and other related trends—will persist as the growth we’re enjoying continues. In that case, I, for one, look forward to disappointing inflation readings for years to come … for both my wallet’s and investment portfolio’s sake.

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