Markets are now betting that inflation will subside soon, allowing the Fed to pivot. But if inflation proves to be persistent rather than temporary, the Fed may have more work to do, at the cost of asset prices.
There are two schools of thought on the issue of transient versus persistent inflation.
One school believes that high inflation will stop the current rise in inflation, proving that inflation is temporary this time.
On the other side of the argument, the BIS warns that inflation can remain constant in high inflation regimes because it fears our entry.
Both opinions may be true. The current rise in inflation may be temporary, but we may enter a prolonged period where inflation remains moderately higher than the rate of the past 20 years.
This article compares the two viewpoints to help estimate how inflation will behave in the coming months and years. Given the tremendous influence of the Federal Reserve on the markets and its very hawkish stance on inflation, a reasonable inflation forecast is essential for investors.
Many economists believe that rising prices destroy demand, which normalizes the supply/demand price curves and stops sharp price increases over the coming months.
Walmart and other retailers are helping support this idea. Per Walmart press release dated 25/7/2022:
“Increasing levels of food and fuel inflation are affecting how customers spend, and while we’ve made good progress removing tough categories, clothing at Walmart US requires More price cuts for the dollar.“
The chart below shows that previous spikes in high inflation were temporary. In those cases, high inflation rates persisted for up to two and a half years but fell just as quickly as they rose.
The Bank for International Settlements (BIS) recently published its Inflation Report: A Look Under the Hood. In the article, they argue that systems of high inflation, as we may enter them, can be fixed rather than temporary. It is worth distinguishing that in a system of high inflation, inflation can be volatile rather than constantly high. Basically, the average rate of inflation in the system is higher than the rate of low inflation.
If the BIS is correct, inflation could drop sharply in the next three to six months, but average inflation rates over the next decade or more could still be well above the Fed’s preferred 2% target.
Today’s bout of inflation
Economist Milton Friedman once said: “Inflation is always and everywhere a monetary phenomenon.” Basically, the more money, the higher the inflation and vice versa.
While we largely support his theory, the current bout of inflation is due, he supposes, to monetary intrigue, but it is also the result of supply problems.
Understanding how money is created is vital to understanding inflation. Contrary to popular opinion, the Federal Reserve does not print money. All money is lent to exist. The Federal Reserve simply adds or subtracts the reserves in the banks. Excess reserves allow banks to lend money and thus print money.
In 2020 and 2021, the federal government borrowed more than $6 trillion. By doing so, they have greatly increased the money supply. However, new money is inflationary only if the money is spent. Printing a billion dollars and burying it in a hole does not affect prices.
In contrast to the government’s traditional spending habits, during the pandemic, they borrowed and wrote checks for individuals and businesses. The economy was primarily dependent on money in exchange for the slower distillation that often accompanies government borrowing and spending.
The chart below shows that the monetary base has increased by more than $3 trillion in less than two years. That compares to a similar $3 trillion growth over the seven years after the financial crisis.
At the same time that money was flowing through the economy, the supply of goods and services stopped. Global supply lines around the world have been hampered. The basic laws of supply and demand prevailed, and prices rose even higher.
As the above graph shows, the monetary base has begun to decline. In fact, it’s down 8.6% over the past year. Normalize the fiscal deficit, albeit at high levels. More importantly, the direct flow of money from the government to the economy is over. Finally, keep in mind that supply lines here and abroad are recovering, allowing the supply of goods and services to return to normal.
Assuming that the current political impasse prevents large doses of fiscal stimulus and supply line problems continue to subside, prices should fall.
In further support of this view, wages are not keeping pace with the inflation that puts consumers in financial trouble. Many people struggle with no choice but to reduce their spending or rely on credit and savings to support it. Personal savings are at a 12-year low, and credit card use is expanding rapidly. The means of consumption are dwindling.
The Federal Reserve is reducing the liquidity of the system to fight inflation. By doing this, the formation of new money (bank loans) decreases. Ergo, since the price supply/demand curves are symmetrical rapidly, we believe that the current bout of inflation is the antidote to this wave of inflation. Like the previous high inflation, the recent outbreak of transient inflation also appears to be coming to an end.
The dynamics of autotrophic BIS
The Bank for International Settlements has a different opinion. They think that with prices above 5%, “The dynamics of self-feeding begins.
The Bank for International Settlements explains two systems of inflation that they call low and high. Low is what we’ve been used to for the past 30 years. In a depressed system, the primary driver of temporary inflation is when the prices of certain goods and services rise or fall below most others. These changes tend to last for short periods and do not affect consumption choices.
The Bank for International Settlements argues that inflation drives consumer and corporate spending decisions under a high inflation regime. This results in behavioral changes, resulting in an increased interdependence of individual prices for goods and services. Inflation generates inflation and thus becomes persistent.
As for their view, the chart below shows that prices are becoming more correlated with inflation rising above 5%.
When inflation becomes recognized and is no longer seen as temporary, personal and business economic decisions change. Per BIS:
Once the general price level becomes a focus, workers and firms will initially try to offset the erosion of purchasing power or profit margins they have already incurred.
This circular dynamic is known as the price-wage spiral. Employees and unions are demanding higher wages to combat inflation. To meet their demands and maintain profit margins, companies raise prices. Higher prices require renewed demands for higher wages, and so forth.
The charts below show little correlation between wages and inflation in low inflation environments. However, the correlation rebounded significantly in the 1964-1985 high inflation regime.
Can we compare the 1970s to 2022?
While the BIS report provides material for thought, we must take into account the only recent experience with persistent inflation (>5%) over 40 years ago.
At the time, there was little debt and much less economic dependence on debt and interest rates.
Today’s economy is highly dependent on low interest rates. An interest rate increase of 2 to 3% would have a much greater negative impact on the economy than it did forty years ago. Because of this dynamic, Federal Reserve policy is a much greater determinant of inflation and economic activity than it has ever been before. If true, then the Fed should be able to manage inflation better this time around.
Unlike in the 1970s and 1980s, wages are not keeping pace with inflation. The de-union and outsourcing jobs of the past 40 years are partly to blame. Until very recently, workers had little influence. If this changes in today’s tight labor market, the potential for a price and wage vortex will increase.
Stay humble in your inflation stance. Nobody has a crystal ball about whether inflation will be temporary or persistent. While we think it is fleeting, we understand that there are many forces that move prices, and the relationship between many of them is not fully understood or appreciated.
If a price-wage spiral develops, the potential for continued inflation is real. This scenario should frighten the Federal Reserve. It will force them to cut back and kick their legs out of the wage-price spiral.
In the late 1970s, profit/loss multiples on stocks were in the single digits, and debt levels were minimal. Today, valuations are nearly four times those levels, and debt as a percentage of GDP is at levels unimaginable not long ago. As we wrote earlier, the Fed’s monetary policy is more influential on economic activity due to the massive reliance on debt and interest rates. Accordingly, their policy actions and their direct and indirect effects on liquidity significantly affect asset prices.
The Fed is in the driving seat, and its reaction to inflation will determine market returns.
Whatch out; This is not the seventies!