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Filtering the signal from the noise is always the name of the game for long-term investors. There are times when that task is easier than others, there are times when it takes a little more effort. And then there are the times when Donald Trump is in the White House.

It would be unfair to completely blame the newly inaugurated two-time El Jefe for the cacophony of noise. Hopes and dreams about how great life will be once we just put Skynet* in charge have been driving equity markets into a self-fulfilling frenzy for much longer than The Donald has been re-acquainting himself with the Oval Office. Indeed, making sense of economic data which seems, at times, to be just made up on the fly by some bored apparatchik has been a big challenge for several years now.

The last month has been on another level though. For that reason, I am not even going to try. Within the flurry of executive orders, accusations of autocracy and general dismantling of the a priori world order, there are quite possibly some aspirations which have virtue. There are certainly likely to be significant and lasting effects. Forecasting what will come to pass and whether it will indeed lead us to the promised land is a surefire recipe for eggy-face syndrome.

Or should I say – expensive eggy-face syndrome. The price of eggs has been skyrocketing Stateside, as avian influenza has decimated the poultry population and thus egg supplies. As we all learned in ‘Economics 101’ and then again in a much more real fashion in 2021 and 2022, when supply is restricted, the price usually goes up.

Expensive eggs were not the only story when the United States Bureau of Labor Statistics released its monthly CPI inflation report in mid-February. On the face of it the data was ‘hot’ – showing prices rising 0.5% month on month, versus market expectations of a smaller rise of 0.3%. That took the year-over-year rate to 3%. A full 0.1 percentage point higher than the market consensus. Inflation going up when it should be going down is not what the Fed wants to see to justify further rate cuts. And if the Fed doesn’t cut rates, then bond investors aren’t going to be as happy. Thus, the subsequent rise in yields seemed entirely rational and justified. The fact that within two days of the CPI report the bond market had found an alternate source of price data, which didn’t look quite so scary and had thus unwound the entirety of the post-CPI reaction, is but more evidence of the febrility of modern financial markets.

Anyone who has worked with me (or near me) over the last 20 years or so will be acutely aware of my fractious relationship with inflation (and central banks, central bankers and academic economics). And yes – I do need to get out more.

Inflation is a poorly understood phenomenon. It has macroeconomic and microeconomic elements, which make it very complex to analyse and impossible to model. As such there exists no robust framework to fully understand it, let alone forecast it. That’s a rather inconvenient truth given that it is so incredibly central to our entire monetary system, acting as the gold standard target for modern central banks the world over.

How this situation arose is understandable. When central banks were politicised and targetless, it was too easy to create money or lower interest rates whenever politically expedient. And, to cut a long story short, the result was often rampant inflation. The lesson learned was that inflation is just about the worst of all worlds. It hurts everyone (as opposed to taxes which can be structured to target or protect specific groups), it hurts asset prices (equities are often said to be a real asset which protect investors against the pernicious effects of inflation, but that really depends on how high interest rates have to go to deal with said inflation), it is difficult and painful to stop (see the previous parenthetical with regards to interest rates) and it generally results in a change of government. Even Teflon politicians struggle to survive the fallout of runaway inflation (just look around the UK, US and Europe right now to see that dynamic in action).

Forcing central banks to consider the inflationary impacts of their policies therefore seems incredibly logical and highly desirable. As is often the case, however, inflation targeting may be another example of a good idea taken too far.

Asking central banks not to create loads of inflation in a sort of hand-wavy and non-specific fashion was never going to be seen as a credible framework. Asking them to hit a specific numerical target for inflation might well be much worse.

When CPI indices were a few tenths under these utterly arbitrary numerical targets (it may surprise some of you to know that there is zero theoretical or empirical basis for a 2% target versus 1%, 3% or even 0%) central bankers felt not only justified but actually compelled to print trillions of dollars (pounds, euros, yen) to try and nudge up those CPI indices by a few tenths. Ask them why and you’re likely to be bombarded with gobbledygook.

They became so used to doing so that they no longer considered it extreme, risky, experimental or even unorthodox. Monetary madness has become normal – because the inflation target says so. Thus, when a very different situation arose in the aftermath of the pandemic, they didn’t stop to wonder, they simply pulled out the monetary cannons and lo and behold suddenly inflation was in the double digits and we are all re-learning the lessons of the 70s (thankfully with fewer pairs of flares). Isn’t it ironic that these uber-educated (and I don’t mean educated in a cab they hailed via an app) and experienced inflation targeters ended up creating the exact outcome that their new-fangled targets were designed to prevent.

The problem however runs much deeper. Fundamentally, I take issue with the equivocation surrounding consumer price indices and inflation in the first place. Inflation is usually defined as a general rise in the level of prices. In that respect it is a largely ‘macro’ phenomenon. Famous economist Milton Friedman described it as “always and everywhere a monetary phenomenon”. Sometimes it is described as too much money chasing too few goods. All these definitions are describing the same macroeconomic process – that of a reduction in the purchasing power of money. Print too much money and it starts to lose its value.

It follows that not all rising prices are inflation as defined above. Sometimes prices rise for other reasons. They may rise because there is a lack of effective competition in a particular industry which allows for predatory pricing behaviour (microeconomics), they may rise because certain goods are imported and there is an adverse exchange rate movement (market-based), they may rise because globally traded commodity prices increase (global and market-based), they may rise because there is a drought which causes destruction of a significant crop (supply-side) or myriad other factors which lay outside the sphere of monetary economics and monetary policy (globalisation and deglobalisation have had measurable and persistent effects on prices but they are utterly out of the control of central banks and central bankers). The point is that prices change frequently but changing prices are not always evidence of an inflationary process.

Consumer price indices do not discriminate, however. They simply seek to measure all prices in an economy, weight them by their average significance for an average consumer, measure how those prices change over time, make some statistical adjustments to make the geeks happy and then call the resultant output a price index equivalent to the theoretical ‘inflation’.

Economists and central bankers know this. They are not stupid (though they often say and do things which make me wonder). They recognise that some price changes are more relevant for their monetary policy framework and others less so.

So, they engage in a series of adjustments, distortions and equivocations to try and get to the signal contained within the noise. The problem, of course, is that by doing so they render the whole exercise rather farcical.

Take a bow Charles Goodhart. In 1975 the notable UK economist and former (at that time future) secretary of the Bank of England’s monetary review committee wrote that:

Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.

Thankfully for all concerned (because I am fairly sure that most of you just read that sentence, as I did, and said “er… what?”) this adage is now better known in the form:

When a measure becomes a target, it ceases to be a good measure.

This adage is now known popularly as Goodhart’s Law, and it rather perfectly captures part of the problem here. Consumer price indices in a global, open, free-trading world don’t do a very good job of proxying a domestic monetary, inflationary process, which is the very thing that central banks actually have some direct influence over. Now, because central bankers are so accustomed to excusing away various aspects of the CPI basket, we’ve all long since forgotten why we look at these things in the first place – it has become dogma. This month in the US there were significant contributions to the headline surprise in CPI which came from transportation services and the notoriously volatile used car component (notoriously volatile but in no way notorious for being reflective of domestic monetary conditions).

There were many aspects of the report that showed sequential improvement from prior months. If some prices are going up and some are going down is that really inflation? Which signal you choose to take pretty much boils down to personal preference or whether you’re long bonds or not.

Inflation – we don’t understand it, we can’t measure it and we sure as sugar can’t control it. Yet landing it on a target the size of a 50 pence piece has become the entire raison d’etre of our monetary and financial system. If that was my pitch in the Dragon’s Den I would deservedly be booted out in record time.

*For those who are not aficionados of the Terminator films, Skynet is the highly sophisticated artificial intelligence defence system that launches a nuclear attack when humans try to deactivate it.

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This article is provided for general information purposes only and should not be construed as personal financial advice to invest in any fund or product. These are the investment manager’s views at the time of writing and should not be construed as investment advice. The opinions expressed are correct at time of writing and may be subject to change. Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.

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