Join my newsletter by subscribing below. Discover a different perspective on macroeconomics and global financial markets. I'm here to help you make sense it of all through an Islamic perspective.
You’re bombarded with news headlines about inflation. You feel the pinch yourself. All your expenses keep going up.
It’s happening everywhere.
But what’s the cause?
You know that central banks printed tons of money so that must be the reason. But there’s more to it.
Understanding what I’m about to tell you will help you make sense of how to think about future inflation.
The recent economic data is telling us inflation numbers should be going down.
But don’t be fooled.
You’ll see inflation numbers going down in the short-term but you need to think ahead. To think long-term. If it’s not your finances that you’re worried about then think about your children.
Inflation is the invisible tax. And if you’re a Muslim that doesn’t want to invest in any interest-rate savings account, you’re losing out. You’ll have to take more risk and invest in the stock market.
There are some shariah-compliant fixed income products but they’re limited.
It’s not all doom and gloom, however. There are ways to preserve the value of your money. I’ll go through them at the end.
But first, you need to understand what’s causing inflation and how you shouldn’t be gullible to the inflation numbers coming down in the short-term.
I used to think inflation could be boiled down to a couple of things: interest rates and money supply.
That’s what monetary policy is. Target inflation by adjusting interest rates and the supply of money.
When inflation is high the central banks slam on the brakes and bring interest rates up. Borrowing becomes expensive, reducing consumption spending and investment. Both these variables going down should lower inflation. Fairly standard.
But today’s inflation is a different animal.
Our understanding of inflation has been more volatile than inflation itself (I patted myself on the back after writing this line).
Remember Covid? When the whole world shut down?
The only time that Time Square and Piccadilly Circus were empty. A dream for a fast walker like me.
You even had the dolphins appear in the canals in Venice. Economic activity came to a halt and nature was restored.
Then the world opened up again.
People were eager to eat out, go shopping, and travel. Anything but stay home.
But the service industry, suppliers, manufacturers weren’t ready. When businesses cut back on production and fire a bunch of people, it takes time to get things running again.
As consumers returned from a Covid-induced hibernation, ready to spend all the money they had saved, businesses had to increase prices as all their costs went up.
Why did costs go up? Because supplies were limited and supply channels were slower. You can’t turn on the global economic supply engine as quickly as consumers demand what they want.
That was the main reason for the initial inflation shock. It was a supply-side issue.
The US experienced something similar in the 1970s.
President Richard Nixon was inaugurated in 1969. He inherited an economy with high inflation. There was a huge increase in the money supply to fund the Vietnam War and increase public spending.
To counter that, Nixon imposed wage and price controls in 1971. That just made it worse. It’s now a case study of what not to do to fight inflation.
There was wisdom in the prophet Muhammad’s (peace be upon him) choice to not impose any price controls as per this hadith narrated by Anas ibn Malik:
The people said: Messenger of Allah , prices have shot up, so fix prices for us. Thereupon the Messenger of Allah (ﷺ) said: Allah is the one Who fixes prices, Who withholds, gives lavishly and provides, and I hope that when I meet Allah, none of you will have any claim on me for an injustice regarding blood or property. - Sunan Abi Dawud 3451
But I doubt Nixon had come across this hadith.
Arthur Burns was the governor of the Federal Reserve at the time. He had trouble dealing with inflation. There were two occasions during his tenure where he failed to do enough. Look at the graph below which shows the Fed funds rate - the interest rate that the Fed sets to either stimulate or tighten the economy - from the late 60s until the early 80s.
The spike in the Fed Funds rate (the blue line) shows us when the Fed was fighting inflation. The grey columns show recessions.
You can see how raising rates causes a recession. That’s one way of bringing inflation down. Slam on the breaks with high interest rates so that borrowing slows and economic activity drops.
That’s what happens when an economy relies on debt to grow.
But what you should note is the early spikes in the Fed funds rate (1969 and 1974).
Rates were raised in the late 60s to bring inflation down. Then rates were brought down again because of a recession. But inflation came back up in the early 70s. So the Fed increases rates again to fight it. Same thing happens. A recession takes place and the Feds fund rate is brought down again.
They might have won the battle but not the war.
So inflation comes roaring again. The new governor, Paul Volcker, pushes rates to 20% to kill inflation for good. Not an easy decision to make when you know the economic havoc it will cause. But he’s touted as the brave inflation killer for that very reason.
So the Fed is constantly thinking about this period. Inflation kept crawling back until Volcker annihilated it. Jerome Powell, the current governor of the Fed, doesn’t want to have the same legacy as Arthur Burns. He’s gonna take his time to bring interest rates down again until inflation is defeated.
My point is that the Fed is suffering from recency bias.
It can’t afford to lose its credibility like it initially did in the 70s.
To fight inflation, increasing interest rates is not enough. You need to make sure that people’s expectations of inflation changes. You need people to believe that inflation will come down.
If you expect inflation to be high, you’ll adjust your life accordingly.
You’re not gonna delay buying that fridge if you know prices will go up. You’ll be more prone to take on debt with a fixed interest if the amount you’ll pay back in inflation-adjusted terms will be lower. Employees will ask for higher wages to keep up with inflation. All this leads to higher inflation.
So the expectations of inflation is an important factor for how the Fed will tackle inflation.
It’s how the Fed deals with financial markets. It needs to instill the belief that inflation will come down. That the Fed will do everything in its power to fight it. If it doesn’t, markets will adjust accordingly.
Now you understand how inflation expectations can make inflation worse. So it’s important that the Fed doesn’t lose its credibility. It will always prefer doing too much rather than too little.
The current target for inflation in the US is an average annual rate of 2%. But we’re already hearing chatter of changing this hurdle rate to 3%.
Isn’t that funny?
If you think you’re gonna miss, just move the goalposts.
But it’s safe to say that the Fed is looking at the 1970s and doesn’t want to repeat it. They won’t be quick to lower rates again until they’re certain that inflation is long gone.
But looking at this period as an example of how to tackle inflation today is short-sighted.
Lyn Alden - one of the best macroeconomic analysts out there - released an essay recently on how the Fed is fighting the wrong fight. I recommend you read it here. She explains that inflation has to be diagnosed properly to treat the economy.
You already know that an increase in the money supply leads to inflation. But we have to look at where that money supply growth is coming from. There are two sources:
The main point is that when the government is running a high deficit, as is the case right now with the US government, a high rate of interest can increase inflation. It sounds counterintuitive but it makes sense. Let me break it down for you.
When a government has a high amount of debt, an increase in interest rates will increase the interest expense on that debt. The creditors who hold this debt - pension funds, insurance companies, asset managers and so on - will receive higher and higher interest payments. This translates into higher incomes which can lead to more spending and thus fuelling inflation.
This requires a completely different playbook. In this scenario, you can’t defeat inflation simply by raising interest rates. You’re gonna need other measures to combat inflation.
This is the new phrase in town. For the boffins out there you can read the paper here. You’re gonna be hearing a lot more of it over the next few months.
But this is the most important thing to understand in macroeconomics right now.
Fiscal dominance refers to the idea that when government debt becomes so high, the Fed’s ability to fight inflation is compromised. The yields on government debt rise so quickly that the public debt becomes unfundable.
The central bank’s ability to fight inflation is dominated by the government’s debt situation. So they’ll care more about making sure the government can borrow to fund its deficit rather than lowering inflation. Of course, they won’t admit this.
The Fed isn’t entirely independent. When push comes to shove, it will have to bend to the government’s will. We saw this with Covid-19 and during the great financial crisis of 2008-2009. The Fed knows that by keeping interest rates high, the interest expense of the US government balloons. There's also less taxpayers money going to public services.
I’ve mentioned in my previous article here how 20% of the tax revenue collected by the US government goes to pay the interest on its debt. That’s a crazy amount.
When you start to understand this you realise why the Qur’an is so explicit on the evils of riba.
Now I want you to take a look at the graph below.
We have to look at the total amount of debt the government has.
US debt as a percentage of gross domestic product - the amount the country produces in a given year - is more than 120%. That’s the blue line above.
Notice how in the 1970s, US debt to GDP was relatively low compared to the 1940s and today? That’s important to note.
Increasing interest rates, as the Fed did in the 1970s, helped bring inflation down. It was a tough fight, and it hurt a lot of people, but it worked.
This graph should bring to light another period you need to be looking at. The 1940s. You might recall the massive war at that time: World War II.
Wars are expensive. Governments, in this case the US government, had to borrow a lot of money to fund the war.
Guess what happened once the war stopped?
Public borrowing stopped. Money creation stopped. Inflation came back down again. You can see it on the chart for yourself.
You need to know what the source of inflation is to fight it properly.
If inflation is due to high public deficits, then increasing interest rates, which reduces bank lending, isn’t the best way to solve the issue. Increases in interest rates, when public deficits are high, means there is a surplus of money going to the private sector (remember those pensions funds, insurance funds and asset managers I mentioned above).
That’s inflationary because more money is pushed into the economy. It can get ugly real quick. High public deficits cause inflation. Interest rates are raised which increases interest payments, which further increase public deficits that lead to more inflation.
It’s a vicious cycle.
Now let’s go back to fiscal dominance.
There’s never an infinite demand for anything. Especially government debt.
As the government borrows more and more money, the bond market won’t absorb all the newly issued bonds. At some point, the bond market won’t believe that the borrower can pay back what’s owed to its lenders in real terms. Inflation will be so high that the amount paid back to bond investors, with the interest, won’t cover the loss in the value of their purchasing power.
Look at what happened in 1861 during the US civil war.
The war went on a lot longer than planned with no end in sight. Salmon Chase, the treasury secretary at the time, didn't want to increase taxes because of how unpopular that would be. So debts increased. The banks were already holding loads of debt, in the form of bonds, and in December 1861 he revealed he needed to borrow a lot more.
Because he didn’t increase taxes, the value of those bonds plummeted. The bondholders had little faith that the US government could pay them back because of its poor finances.
Salmon couldn’t raise more debt with a much higher interest rate (as determined by the market). So he passed a new law in 1862: Legal Tender Act. The government could print new money to buy its debt. This new legal tender, which were paper bills that couldn’t be redeemed for gold and silver, had to be accepted by US citizens as a medium of exchange.
How about that as a way to raise money?
If no one is going to lend you money, just print it!
And then you had the National Bank Act in 1863 which allowed national banks to issue their own notes. Using these notes they were forced to buy US treasuries to finance the public deficit.
Before 1862, all the money in circulation was backed by gold and silver. But now the money would be backed by nothing. Thanks to the new law, creditors would have to accept this newly printed money.
So what about today?
What happens if the market can’t absorb anymore debt because there’s so much debt outstanding? How does it go about its business of borrowing money to fund its deficit?
Think about how inflation plays into this. If inflation is high, the government gets a free tax in the form of non-interest bearing debt.
By holding cash you’re effectively paying a tax on it, which is inflation. That’s free money for the government.
Most people ignore this if inflation is low. But you can’t ignore it when inflation is high. No one would want to hold cash then. They’d put their money into assets that generate cash flows or real assets with intrinsic value.
To finance deficits, the easiest thing for a government to do is print money. But there are other options too.
They can increase taxes which would be hugely unpopular. They can cut down on public spending which is already happening but that would be even more unpopular.
The easiest option is to print money using the Fed. You might not feel the cost but you will. The inflation from this increase in the money supply is the extra tax you’ll pay.
But the government is also wary of high inflation. They’re not ignorant to what’s happening in countries like Argentina where inflation is more than 100%.
So how can the government and the Fed print more money whilst trying to keep inflation low?
One way is for the government to require banks to hold their reserves in cash at the central bank. The central bank would pay zero interest on those reserves.
If inflation is a tax on all the money that pays zero interest (in this case currency or cash) then increasing the tax base (the amount of money that generates zero interest) reduces inflation.
By increasing the inflation tax base (the amount of money that can be eroded in value because of inflation and is not generating an interest rate) you bring inflation down. Remember that when public deficits are high, the interest paid on this debt can be inflationary as there is a surplus of money going to the debt holders. So reducing this should reduce inflation.
The point of the inflation tax is for the government to have an outstanding amount of debt that it doesn’t have to pay any interest on. The interest savings is a resource for the government that can fund the deficits.
When the Fed buys bonds from the government with printed money, the interest it receives is sent back to the government. That’s not the case if the Fed has to pay interest on reserves. The Fed still has to balance its books. But if no interest is paid on reserves then the income it receives from the interest on the government bonds it holds are transferred back to the government.
All this is doing is allowing the government to print more money, which is inflationary, but forcing financial institutions to lose money on their reserves via inflation. In the end, it’s the depositors that will pay the price. You and me.
This is financial repression. It’ll have major ramifications to the banking system.
Typically investors demand a return, as interest, that will cover at least the inflation rate. But if banks are forced to keep reserves that pay zero interest, then savers will see their money erode in value. This is when investors will look for alternatives.
It’s one thing to bring inflation down using these shenanigans. But for inflation to really come down then public deficits will have to come down too. And that’s unlikely to happen in the near future.
With such high deficits, inflation is something we’re going to have to live with.
There are other inflationary forces taking place across the world. One of them being demographics.
The world is getting older and fertility rates are dropping. What happens when the amount of dependents (i.e. retirees and young people not working) increases faster than the number of workers? Savings go down. More money is spent as dependents produce less but consume more. This pushes inflation higher.
You need to understand this new regime to better prepare for future inflation.
In the end those holding cash will lose out as a deluge of new money erodes its value.
It’s important you understand where the world is heading. I’m of the firm belief that even though inflation will be brought down in the short-term because of the aggressive hike in interest rate, inflation will come back up again. Why? Because of high public deficits and demographics.
So how can you protect yourself?
Buying real assets is one way. Real estate, commodities, precious metals like gold and silver, and bitcoin. You want to be holding assets that either have intrinsic value or are scarce.
ETFs are a good way to gain exposure to certain commodities.
You need to understand how your money is being tampered with because of government policy.
Not only that. But also understand how the Fed’s ability to fight inflation will be compromised by how much debt the government has.
What’s the solution? Well productivity has to increase considerably so that the economy can grow its way out of its debt. Can AI accomplish this? I don’t know.
The most likely outcome is to inflate all this debt away by printing money.
Either way don’t be left with an even higher tax bill by not holding real assets.
I manage a $100m private investment fund and I explore Islamic finance and economics through a personal lens. I help simplify financial markets from a Muslim perspective.
Subscribe below for more insights.
Letting curiosity guide me to help you make sense of our economic system and how Islamic principles provide equitable solutions.
