“We don’t really know what it is, we don’t really know what causes it, we don’t really know how to measure it, but we really know we’re worried about it!”

The stock market is never happy unless it has something miserable to complain and worry about. Having moved on incredibly quickly from a worldwide pandemic, the chattering investor classes have retrained their sights on that old 1970s bugaboo, “inflation.”

As you can tell from the cumbersome subtitle, inflation is the most confusing and misunderstood investment concept that we think about. Every policy maker, every economist, and every investor has a view on inflation, most of it informed by the skyrocketing interest rates of the 1970s. Calculations of inflation go into every model, every forecast, and every policy decision. The idea of real vs. nominal data is based on inflation, and of course an entire asset class (Treasury Inflation Protected Securities) was created to protect investors against inflation.

The truth is, almost none of the conventional thinking on inflation is truly supported by the actual experience of the past fifty years. For example, classic Keynesian thinking could not at all explain the stagflation of the 1970s, when you had skyrocketing inflation combined with a moribund economy. Fast forward to today, when we have record low interest rates despite multi-trillion-dollar annual government budget deficits. That wasn’t supposed to happen either.

When you dig beneath the surface, very little about inflation adds up to what almost all the investment community thinks. So, we thought we would lay out the issues to see if we could get a better understanding of how to think about this chameleon of an economic concept.

What Is Inflation?

The definition of inflation as price oriented didn’t really take hold until the 1970’s, when the dramatic increase in prices and interest rates brought “inflation” into the forefront of the public psyche. Also, the monetarist notion that “inflation” was caused by money supply increases gained a stronger foothold as the previously mentioned “stagflation” was simply not possible under the Keynesian thinking that had dominated in the post war period.

The big problem to consider is this: Which prices are we measuring, how do we actually measure them, and how do weight them?

Put simply, everyone has their own personal inflation rate, and they vary dramatically depending on socioeconomic status and your personal consumption basket. “Inflation” is definitely not a simple one-size-fits-all concept.

What Causes Inflation?

Most people would say that when the economy gets too strong and/or the government prints too much money, inflation goes up.

Except that that’s not true either. As noted, it wasn’t true throughout the 1970s. Now think about the 1983-2007 period. This was a remarkable period of consistent economic growth. While punctuated with two small and ultimately inconsequential recessions, the U.S. economy churned forward like an unstoppable force, with globalism and technology creating unimaginable new businesses and opportunities. Interest rates fell persistently for 25 years.

The 2008 to current period is, well, a whole new unexplainable economic period when thinking about inflation and interest rates. As we know, rates have been zero most of the time in the U.S., and negative in much of the rest of the world. Federal deficits are at numbers never even dreamed of. Until 2021, “inflation” continued to be remarkably low. Even after 2021, interest rates are still at historically de minimis levels.

So, we are skeptical of the blithe notion, subscribed to by the Federal Reserve Board and most of Wall Street, that they understand the causes of inflation and can nudge them in a certain direction with a little interest rate change here and a little stimulus there. The current idea that we “need” to generate 2% inflation and that we can just put the brakes on the economy at that point strikes us as being arrogant folly.

Can We Measure Inflation?

For the investment geeks among us, the rubber really hits the road in doing a deep dive into just how the government weights and measures price changes for people in the real world. Our conclusion is that you can’t do it in any way that makes sense and helps with policy decisions, and by ascribing false accuracy to your methodology, you end up doing more harm than good.

By far the most problematic and largest component of the CPI is how should we measure home prices change? Hah, trick question! Turns out home ownership is not included at all in the CPI. The BLS considers owning a home to be a capital investment like stock and bonds, and as such, no home price changes are in the index. What they do measure is rents, using a concept called owner’s equivalent rent. If you think about it, measuring home price changes is extremely difficult, but rents tend to reset annually for essentially the same product, giving many data points and a pretty reasonable approximation of what rents are doing.

Truthfully, using rents as a proxy for home prices worked quite well until the mid-2000s. But what happens when we have home prices booming or busting while rents don’t change or even move in the opposite direction? Now we have a serious measurement problem that creates a statistic in sharp contrast to reality.

That had never happened before the mid-2000s housing boom, but suddenly because of non-existent underwriting standards and low interest rates, home speculation zoomed out of control and price gains in many markets were annualizing at a double-digit pace. But none of that showed up in the CPI, which is reported as 3.4% in 2005, 3.2% in 2006, and 2.9% in 2007.[i]

The challenge becomes even deeper when we realize each person and each region has their own individual inflation rate, which probably can’t be calculated anyway. We all have a set of shared expenditures (food, clothing, shelter), but each of us will be in a different life stage at any given moment and will be more or less impacted by things such as educational expenses, medical expenses and/or costs for childcare.

Basing monetary and fiscal policy, not to mention the cost-of-living adjustment (“COLA”) for Social Security recipients, on such data is not likely to end well.

So Why Are We Terrified of Inflation?

Even though it’s now 40-50 years ago, the inflation and stagflation of the 1970s left scars on the psyche of market participants and policy makers that still exist. While inflation is very hard to measure, there’s no doubt that a general sustained rise in prices will increase overall interest rates. Since all financial and real estate assets are valued with some sort of interest rate discounting mechanism, higher rates will cause lower prices. Also, because we are starting from historically low levels, an absolute interest rate rise of say, 2%, will mathematically reduce asset prices much more than in the distant past.


As noted, the topic of inflation proved to be so thorny that we are covered with band-aids in attempting to summarize it. It really is the classic rabbit hole, where you start in one direction and end up lost in a totally different one.

So, if we think that Keynes, Friedman, Buffett, and the Bureau of Labor Studies are seriously misguided about important aspects of “inflation,” then what is the right answer?

Sadly, we don’t presume to know. The big argument today is whether the large burst of “inflation” in 2021 is “transitory.” We would lean to “transitory” but with a very low confidence level. Even therein, what is the proper definition of transitory – six months, one year, three years? No one knows.

We do, however, feel confident in saying that the Federal Reserve Board, which bases its policy decisions on a very tenuous balance between employment and “inflation,” has made and will again make major policy errors by relying heavily on “inflation” numbers as calculated. The concept of “inflation targeting,” whereby the Fed can maneuver inflation to a certain level and then stop it right there, strikes us as full of hubris and quite dangerous. Be on the lookout for potential mistakes that may result from inflation targeting overconfidence.

If nothing else, we hope that the next time you hear a chattering head talk about “inflation,” your new immediate response is: “It’s just not that simple!”


[i] Source: U.S. Bureau of Labor Statistics
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Jay Weinstein, CFA®

Jay is a managing director based in our Potomac, Maryland office.