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Research

Assessing Inflation: Theories, Policies and Portfolios

Executive Summary

  • As inflation spiked in the second quarter of 2021, debate about its transitory or permanent nature became more heated. Yet, as is sometimes the case with broad controversies, a lack of definition goes with a lack of comprehension.
  • Measured inflation can vary widely, depending on factors as diverse as the choice of a price index, hedonic price adjustments, and shelter and rent accounting. For example, the consumer price index tends to overstate inflation.
  • Theories of inflation have undergone two major inflection points. The 1970s oil supply shock challenged the Phillips curve, and the collapse of money velocity after the 2008 financial crisis cast doubt on the quantity theory of money.
  • Rounds of quantitative easing (QE) since 2008 have propped up asset prices but have not produced notable inflation. This raises a related misconception about QE: Money does not create credit; credit creates money. In addition, so long as policymakers are committed to balancing their budgets in the long run, helicopter money and modern monetary theory (MMT) are not inflationary per se.
  • Currently, we believe there are fatter inflation tails than the market has expected. Longer term, there is a high probability that inflation will be contained. For investors who wish to hedge against inflation risk, we demonstrate the benefit of a portfolio approach.
  • We conclude by proposing an asset allocation framework that accounts for a variety of macro scenarios over a five- to 10-year horizon. Salient positions are a private debt overweight and a public equity underweight.

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