Markets are now betting that inflation will soon subside, allowing the Fed to pivot. But, if inflation turns out to be persistent and not transitory, the Fed could have a lot more work to do, to the detriment of asset prices.
There are two schools of thought on the issue of transient versus persistent inflation.
A school thinks that high inflation will stop the current inflation spurt, thus proving that inflation is transitory this time.
On the other side of the argument, the BIS warns that inflation may remain persistent in high inflation regimes as they fear we will enter.
Both views may be correct. The current surge in inflation may be transitory, but we may be entering a long period where inflation remains moderately above that of the past 20 years.
This article compares the two views to help assess how inflation might behave in the months and years ahead. Given the Fed’s huge impact on the markets and its extremely hawkish stance on inflation, a well-reasoned inflation forecast is imperative for investors.
Many economists believe that higher prices lead to demand destruction, which normalizes the supply and demand price curves and stops sharp price increases over the next few months.
Walmart and other retailers are helping support this idea. According to Walmart’s press release dated 07/25/2022:
“Rising levels of food and fuel inflation are affecting how customers spend, and while we’ve made good progress eliminating hardline categories, apparel at Walmart US requires more markdown dollars.“
The chart below shows that earlier spikes in high inflation were transitory. In these cases, high inflation rates lasted for up to two and a half years, but fell as quickly as they rose.
The Bank for International Settlements (BIS) recently published Inflation: A Look Under the Hood. In the article, they argue that high inflation regimes, which we may be entering, can be persistent and not transitory. It should be noted that in a regime of high inflation, inflation may be volatile and not be durably very high. Essentially, the average inflation rate on the plan is higher than on a low inflation plan.
If the BIS is correct, inflation could fall sharply over the next three to six months, but average inflation rates over the next decade or more could persist well above the preferred 2% target. from the Fed.
The inflation crisis today
Economist Milton Friedman once said: “Inflation is always and everywhere a monetary phenomenon.” Basically, the more money there is, the more inflation there is and vice versa.
While we largely agree with his theory, the current surge in inflation is due to monetary machinations, as he postulates, but also the result of supply problems.
Understanding how money is created is essential to understanding inflation. Contrary to popular opinion, the Fed does not print money. All money is loaned into existence. The Fed simply adds or subtracts banks’ reserves. Excess reserves allow banks to lend money and therefore print money.
In 2020 and 2021, the federal government borrowed over $6 trillion. In doing so, they dramatically increased the money supply. However, new money is inflationary only if it is spent. Printing a million dollars and burying it in a hole shouldn’t affect prices.
Unlike traditional government spending habits, during the pandemic they borrowed and issued checks to individuals and businesses. The economy was basically cash-driven versus a slower decline that often accompanies government borrowing and spending.
The chart below shows that the monetary base has grown by more than $3 trillion in less than two years. This compares to a similar $3 trillion seven-year growth after the financial crisis.
At the same time that money was circulating in the economy, the supply of goods and services stopped. Global supply lines around the world have been hampered. The fundamental laws of supply and demand kicked in and prices soared.
The transitory vision
As the chart above shows, the monetary base is beginning to decline. In fact, it’s down 8.6% over the past year. Fiscal deficits have normalized, but at high levels. More importantly, the direct flow of money from the government to the economy has come to an end. Finally, consider that supply lines at home and abroad are recovering, allowing the supply of goods and services to normalize.
Assuming the current political stalemate prevents large doses of fiscal stimulus and supply issues continue to ease, prices should decline.
In support of this view, wages are not keeping up with inflation, putting consumers in a financial bind. Many people have no choice but to cut spending or rely on credit and savings to support them. Personal savings have fallen to their lowest level in 12 years and the use of credit cards is growing rapidly. The means of consumption are dwindling.
The Fed is reducing system liquidity to fight inflation. In doing so, new monetary creation (bank loans) decreases. Therefore, given that the price supply and demand curves are rapidly normalizing, we believe that the current inflation spurt is the cure for this inflation spurt. Like the earlier high inflation, it seems likely that the recent surge in transitory inflation is also coming to an end.
BIS self-feeding dynamics
The BRI takes a different view. They believe that when prices rise above 5%, “the self-feeding dynamic engages.
The BIS explains two inflation regimes, which it calls low and high. Low is what we’ve been used to for the past 30 years. In a low regime, the main driver of temporary inflation is when the prices of certain goods and services rise or fall out of step with most other prices. These changes tend to last for short periods and do not affect consumption choices.
The BIS argues that inflation drives consumer and business spending decisions in a high inflation regime. This results in changes in behavior, which lead to a greater correlation between the individual prices of goods and services. Inflation breeds inflation and therefore becomes persistent.
For their part, the graph below shows that prices become more correlated with each other when inflation rates exceed 5%.
When inflation is recognized and no longer seen as transitory, personal and business economic decisions change. According to the BRI:
Once the general level of prices becomes a focus of attention, workers and businesses will first try to compensate for the erosion of purchasing power or profit margins they have already suffered.
This circular dynamic is known as the price-wage spiral. Employees and unions are demanding higher wages to fight inflation. To meet their demands and maintain their profit margins, companies raise their prices. Higher prices call for renewed demands for higher wages, and so on.
The charts below show little correlation between wages and inflation in low inflation environments. However, the correlation accelerates markedly in the high inflation regime of 1964-1985.
Can we compare the 70s to 2022?
Although the BIS report is food for thought, we must consider that the only recent experience of persistent inflation (>5%) dates back more than 40 years.
Back then, there was little debt and much less economic dependence on debt and interest rates.
Today’s economy is heavily dependent on low interest rates. A two to three percent increase in interest rates will have a much greater negative effect on the economy than forty years ago. Because of this dynamic, Fed policy is a much more important determinant of inflation and economic activity than it ever has been. If that’s true, the Fed should be able to manage inflation better this time around.
Unlike in the 70s and 80s, wages are not keeping up with inflation. The deunionization and outsourcing of jobs over the past forty years are partly responsible for this. Until very recently, workers had little influence. If that changes in today’s tight labor market, the likelihood of a price-wage spiral will increase.
Stay humble about your inflation stance. No one knows whether inflation will be transitory or persistent. Although we believe to be transitory, we understand that there are many forces that determine prices, and the relationship between many of them is not fully understood or appreciated.
If a price-wage spiral develops, the likelihood of persistent inflation is real. This scenario should scare the Fed. This will force them to reduce employment and break out of the wage-price spiral.
By the late 1970s, stock prices were in the single digits and debt levels were negligible. Today, valuations are nearly four times those levels, and debt as a percentage of GDP is at levels considered unthinkable not too long ago. As we wrote earlier, the Fed’s monetary policy has much more influence on economic activity because of the huge reliance on debt and interest rates. As a result, their political actions and their direct and indirect effects on liquidity strongly influence asset prices.
The Fed is in charge and its reaction to inflation will dictate market returns.
Pay attention; it’s not the 1970s!
The author or his company may have positions in the titles mentioned at the time of publication. Any opinions expressed herein are solely those of the author and in no way represent the views or opinions of any other person or entity.