The Fed Means Business...Contraction
Updated: Apr 15, 2022
Inflation Comes in Two Varieties. Understanding Them Sheds Light on Where Prices Are Headed
Today the CPI registered an 8.5% increase for March. Of that, 32% was contributed by energy alone, with food contributing 8.8%. We wrote earlier that we expected March inflation to come in hot, and it certainly was elevated compared to the prior month and March of last year. Yet, the markets rallied once the figures were released. Why? As bad as an 8.5% year-over-year increase in consumer goods is, the expectation is that that is as bad as it will get. Is that rationale justified?
goodstead always maintains positions in investments that perform well during periods of elevated inflation. This is because we don't believe that we can know the future well enough to know when inflation will rise and fall. For example, while we and many others thought that the risks of higher inflation post-pandemic were elevated, we had no way of knowing
that it would find another gear and trend even higher due to Russia's invasion of Ukraine and its impacts on global energy and food prices. We maintain a balanced portfolio at all times for precisely these reasons. Still, is concern about inflation approaching hysteria? We suspect that there are reasons to believe so, much beyond the fact that core inflation, while high, remains anchored within reasonable bounds.
Two-and-a-half years after the emergence of the COVID-19 virus and the attendant global pandemic, the world now struggles with the emergence of a new threat: elevated price inflation. We wrote in March 2021 about inflation that
Federal Reserve Chairman Jay Powell has said that the Federal Reserve won't move to increase interest rates until they see full employment and inflation that comes in consistently above target. This gives monetary policymakers quite a bit of runway to get the plane off the ground and flying again before they have to start worrying about overheating the engines. While we believe that higher inflation is on the way, we do not believe that it will approach unsustainable levels, and that the productivity growth that disaster relief and increased consumer spending will engender should more than compensate for inflation acceleration. That said, goodstead doesn't make its living by predicting the future. Our portfolios are built to perform about the same in high- and low-inflation environments. We hope that our Members sleep better knowing that.
Cost-push Inflation
One year on, we now see the lowest unemployment rate since just before the pandemic, at 3.6%. This falls below what is referred to as the natural rate of unemployment, which is the rate of employment left over when everyone who wants a job has one. (The remainder, Frictional Unemployment, consists of people between jobs.) In the chart below you can see the spike in unemployment from the pandemic-induced layoffs and its subsequent decline to its current, low level.
The Labor Force Participation Rate, which is a measure of those able to work that either do or are looking to, remains one point below its pre-pandemic level. (It looks lower in the graph below because the y axis is truncated at 58.) This is consistent with some older workers retiring early, and some workers who were previously in the workforce leaving (to care for children, to seek additional education or training, or any number of other reasons.)
The picture is slightly better when you consider only workers in their prime, or ages 25 -54. Among this segment, participation is only half a point lower than it was at the start of the pandemic. Most of those who left the workforce are now back in it, and since there are fewer sellers of labor in the market while buyers of labor have increased, the market-clearing price of labor has increased. This means higher wages for workers in the meantime.
As if further evidence of this dynamic were necessary, we can see that initial claims for unemployment are at a low since the end of the pandemic and continue to move lower. This is what an economy at full employment looks like, and is one of the two goals that the Federal Reserve is tasked by legislation with pursuing.
In response to the increased demand on the part of American businesses for labor, Average Hourly Earnings are also increasing. The wage rate is the price of labor, so as the clearing price of labor increases, the wage rate also increases. Wage gains for all private employees have continued after the pandemic-induced recession, despite having fallen sharply after the recession as government transfers expired. While the trend rate of growth was elevated after the recession, the pace of its increase seems to have moderated some.
Higher wages mean that businesses have a choice to make: pass on these cost increases to its consumers, or accept them and tolerate lower profit margins. The prevailing Theory of the Corporation holds that the corporation maximizes only for profit; if it can pass on cost increases, it will. When companies pass along cost increases to their consumers, this shows up as consumer price inflation. Below we reproduce the Personal Consumption Expenditures (PCE) Index, a measure of the change in prices that consumers pay for goods and services in the United States. It's the Federal Reserve's preferred measure of inflation (as opposed to the Consumer Price Index (CPI), produced by the Bureau of Labor Statistics), for reasons that don't make sense to get into here. The Trimmed Mean PCE uses mathematical techniques to calculate the increase in core prices, as outliers in the price change of some goods and services can distort the picture we're trying to ascertain.
As you can see in the chart above, the PCE inflation rate (blue line) has been steadily trending higher since the beginning of the second quarter of 2021. It now stands at a month-over-month rate of change of 6.4%, a level which is concerning to the Federal Reserve, as the second of its two mandates is to enforce price stability--which is bureaucrat for maintaining a steady rate of inflation. While the inflation rate has been trending higher, the rate of change has been declining (red line), as successive increases in the inflation rate have been smaller than those that immediately preceded. In fact, the rate of change is on par with recent rates of increase, such as the one just ten years prior in 2011.
Wages aren't the only costs that businesses face. The cost of raw materials--commodity prices--have also been escalating rapidly. The war in Ukraine has caused already elevated energy prices to go higher--and since Ukraine and Russia are two of the largest producers of wheat in the world, both energy and wheat prices have breached the stratosphere and are going to the moon.
The market for raw materials is a global one in which all buyers and sellers face what is essentially a global price. While we see that input prices have been high in the United States, they are actually high across the world.
According to the IMF, the price of all commodities has increased to a level we haven't seen since the lead-up to the Global Financial Crisis. Similarly, elevated price levels trailed the Global Financial Crisis as aggregate demand recovered and spare capacity had not yet been brought back online (a theme we'll be returning to shortly). In these earlier two episodes prices eventually reverted to more normal, if historically elevated, levels after having attained highs similar to those we're currently witnessing.
In the below chart, we can see that inflation is at elevated levels across both the US and EU economies, while it appears muted and trending downward in China. Chinese statistics are generally unreliable, as significant incentives exist for their skewing by the political operatives that wield the levers of power in China. Nonetheless, inflation in China seemed to be following the same upward path as in the US and EU as of the end of the third quarter 2021; since then, inflation has declined and is reported as currently flat.
As mentioned before, the market for raw materials is a global one, so China faces the same inflationary pressures as does its more developed competitors; however, its "COVID Zero" policy, under which it seeks to isolate and extinguish outbreaks of contagion through the aggressive use of lockdowns, is also fit for constraining growth.
When input prices, such as raw materials, intermediate goods, and labor increase, they can cause upward pressure on the prices of finished goods. This is typically known as cost-push inflation and is the type most closely associated with the inflationary episode the United States experienced at the end of the 1970s and the beginning of the 1980s. Then, increased energy prices caused general prices to rise precipitously, resulting in labor demanding wage increases to afford those higher prices. This results in what we refer to as a "wage-price spiral", a type of positive feedback loop where increases in the former cause increases in the latter, and vice versa.
When economists wring their hands about high inflation, it is typically for this reason: once consumer psychology becomes conditioned to expect higher prices, it is very difficult to reverse. Renowned inflation-slayer Paul Volcker, whom Jimmy Carter nominated to lead the Federal Reserve and Ronald Reagan renominated when his initial term expired, was able to do so only by raising interest rates to crippling levels, from 11% to as high as 21.5% in 1981. The rapid increase in interest rates caused the Recession of 1981-2 which, until the 2007-8 Global Financial Crisis, was the worst economic downturn since the Great Depression. Unemployment would peak at 10%, but a year later inflation fell to 5%.
There are more things that are different between 2022 and 1979 than are the same. The Russian invasion of Ukraine has resulted in a 1970's-style energy shock, and we have yet to see the extent of the impact that the increase in the price of wheat will have on the world, and especially emerging economies. Europe is much more vulnerable to high natural gas prices than is the United States. The United States is largely energy self-sufficient. Automobiles are much, much more fuel-efficient than in the 1980s.
Americans aren't driving as much as they were before the pandemic, and given work-from-home norms, probably will never drive to the office as often as they did before. Only now are we seeing gas prices that are on a par on an inflation-adjusted basis with those seen in the '70s, and they bite less. Cost-push inflation has been an issue coming out of the recession, but its impact is bar far less significant than its sometime companion: Demand-pull Inflation.
Demand-pull Inflation
"Too much money chasing too few goods." This is the way we're accustomed to thinking about inflation. It has to do with thinking of inflation as a monetary phenomenon: one having to do with the supply of money, printing-press monetary policy, and the Weimar Republic. Everyone knows that if you print too much money, then money becomes devalued and buys less. Everyone knows that if everyone has too much money, then they will all bid up the prices for goods that they want.
There is merit to the argument. The supply of money has dramatically increased since the Global Financial Crisis, when the Federal Reserve, under the direction of Ben Bernanke, engaged in very aggressive monetary policy to prevent the collapse of not only the United States' economy, but likely that of the entire world. As you can see in the chart below, M3, the standard measure of what we think of when we talk about money, increased in the wake of the Global Financial Crisis, but just took off and reached an entirely other gear in 2020.
As we've written before, money is a unit of measurement. When you increase the money supply, it's like adding gradations to a ruler: the distance between point A and B doesn't change; you just have more points on the number line to go through. But there is a temporary psychological impact to adding these gradations. People feel richer when their bank account balance is higher--until they realize that those dollars buy less than they did before. It's an instrument that, while effective, loses efficacy the more often you use it. The inflationary periods of the 70's were especially marked by this dynamic as the Federal Reserve attempted to promote full employment by letting inflation rip from time to time.
The Federal Reserve can raise interest rates to reduce the amount of money in the economy. It has started doing so and has signaled its willingness to continue to do so and to do so more aggressively should inflation not prove so quiescent. The other thing it can do is to stop buying assets and paying for them with printed money. This latter policy has been a feature of the Fed's unconventional market operations of the past few years and has resulted in a pretty large portfolio of holdings.
Acting Vice-Chair Lael Brainard indicated that the Fed was now prepared to accelerate its disposition of assets and the winddown of its balance sheet. This just means that they will not buy new stuff. Over time. The statement caught markets by surprise as market participants began contemplating what a world looks like in which the Fed isn't a major player in fixed income markets. The chart below, via the Financial Times, presents a better depiction of the growth of the Fed's balance sheet than our poor illustrative abilities could ever accomplish.
The idea is to go from $9 trillion in assets to something more like $1 trillion. Doing so will mean a lot of bond sales. (For purposes of comparison, the US economy produces $24 trillion of goods and services in a single year.) Government purchases have provided a backstop to fixed income asset prices over the past few years. It's not altogether clear to us how much an impact the cessation of purchases or outright sales will have on yields. The impact will be marginal, but if that were all there was to it, we would have our answer; rather, the psychological impact on bond markets of not having a buyer of last resort intervening is difficult to size. Suffice it to say, we see bond yields rising further--which is fine, because goodstead doesn't view corporate bonds as a core investment at current prices.
Besides the amazing amount of liquidity in the system, consumer demand has been pretty robust--although we do now see evidence of its change. Consumer Sentiment recently posted its lowest reading since August of 2011, which is right around the time of the last large spike in inflation. Inflation damages consumer sentiment and makes consumers wary, causing them to hold back spending. This is crucial because if they thought that prices would only continue to skyrocket into the foreseeable future, then they would consume as much as they possibly could out of the expectation that their money would be worth less and would buy less in the future. This reaction to increases in price is telling that long-term inflation expectations remain anchored.
We also don't think of ourselves as Inflationistas. We believe that on balance the Fed still did the right thing in preventing the world economy from collapsing in 2007-8, and again in 2020. Extraordinary times call for extraordinary measures. In the long run, we're all dead, and needless human suffering should be avoided at all costs. That said, we recognize that inflation is yet another economic risk that has to be faced, and it is for this reason that our portfolios always maintain positions that perform well in high-inflation environments: commodities, real estate, and defensive equities.
So, What Happens Next?
As we wrote last time, the only thing we know for certain is that things will change, and that the future will not look like the past. For reasons that we'll discuss now, we believe that the current inflationary episode is more like inflation in 1918-1921 and 1946-1947 than it is like inflation in 1973-1980.
The inflation of the 1970s and 80s was driven first by energy prices and then by wage increases. This was cost-push inflation, and responded to the Fed's increase in interest rates by falling. But there was also an element of demand-pull inflation, as the United States went off the gold standard and debased the dollar. Mo' money, mo' inflation, as consumers rush to spend before the value of their money diminishes. This dynamic responded to increased interest rates in a similar way.
But what if raising rates weren't effective in taming inflation? What if inflation weren't due only--or solely--to too much liquidity in the system? What if inflation weren't due to too many people trying to do their pent-up consumer demanding at the same time? What if inflation was in fact due not to a rightward shift in the aggregate demand curve, but rather in a contraction of productive capacity? In other words, what if it weren't increased demand that was driving inflation, but rather diminished supply?
Let's undertake a thought experiment. A global pandemic caused by a hitherto-unknown virus sweeps the world causing factories to shut down, cities to go into hibernation, and international trade to be disrupted. Let's also suppose that a conflict in the heart of the world's grain supply occurs approximately around this time, either before or after. Let's also imagine that the monetary authority regime is new and eager to burnish its inflation-fighting credentials. What would you expect to see?
The chart above depicts wholesale prices. You can see prices spiking in the aftermath of the First World War, through the Spanish Flu pandemic, and even into the first years of the Depression of 1920-21. This was despite the highest interest rates until the 70s.
Wars are generally bad for inflation. You have limited productive capacity because labor is seconded to other purposes, and the procurement of resources for war-fighting is generally price insensitive. You can see in the below chart similarly elevated levels of inflation surrounding the American Civil War, as well as the spike in inflation after the First World War and the Spanish Flu--as well as during the Second World War.
Intellectual hero of conservative economics, Milton Friedman, and his atemporal arch-nemesis, Paul Krugman, don't agree on much--but they do agree that the ensuing recession of 1920-21 was precipitated by contractionary monetary policy. The Fed raised rates, but it didn't cause a contraction in aggregate demand--that wasn't the problem to begin with--but it caused a further contraction in aggregate supply, which led to what we would call the "Great Depression" if not for the even greater Great Depression of 1929.
Similarly, as economies recovered from the supply chain disruption and contraction in non-government spending that occurred during the Second World War, supply was constrained and unable to meet the recovery in private demand. Inflation peaked in 1946 at levels much higher than today--18.1% in 1946, and 8.8% in 1947--before falling to more normal levels due to the contraction in demand that was the 1949 recession, which was brought on by higher interest rates.
Should We Then Prepare for Recession?
Potentially--but not yet. Growth in the developed world has been positive on a real basis. The United States is the fastest-growing major economy in the world right now--faster than China, and faster than the BRICS that we used to talk about when we talked about growth. That will change as world trade recovers--except in China where the combination of continuing lockdowns, debt overhang, burst tech and property bubbles, declining population growth and an already high capital stock should keep growth subdued.
Leading indicators of US growth are still positive, though off of their remarkable post-pandemic highs (when the economy basically made up for a year of lost productivity by jamming it into the subsequent one). We don't expect growth to remain in the 4%-5% range, but we wouldn't be surprised by growth that averaged out between 2% and 3%.
The Yield Curve, which is the price of money forecast out into the future using the prices of government debt for its basis, briefly inverted over the past week. This means that the required yield on long-term debt fell below the required yield on short-term debt, a typically bearish sign. Despite the spread between the 2- and 10-year Treasury yield going briefly negative, it has since recovered and is now positive. This is more consistent with a flat yield curve than a negative yield curve, signifying that the market believes that short-term risks and long-term risks are basically even.
Still, other measures that we watch closely have been deteriorating, albeit off pretty extraordinary highs. Home prices seem to have peaked, potentially indicating that the mad rush to buy square footage is over, or affordability has become an issue for homebuyers.
Cheap money in the form of low interest rates means that you get more credit in the economy than you would at a more neutral rate. This often shows up in durable goods like washers and dryers, cars, and the most durable good of all--the one that holds all the other durable goods--houses. These purchases are large and often financed, so when interest rates go up, the cost to borrow goes up as well, and credit contracts as a consequence. New mortgage originations rise when rates fall, and they fall when rates rise.
If originations are falling, then that typically means that sales of existing homes will follow--and less homes means less durable goods to fill them. New orders were down in February after months of steady increase.
The trend rate of growth of inventories was also lower. This reflects either sufficient inventory on hand to meet projected demand, or else reduced business manager confidence. Either way, businesses are slowing down their purchasing.
Our long-time readers know by now that we don't think we're any better than anyone else at telling the future. All we are willing to say is what has happened in the past, and what scenarios the market is pricing in. We don't think that the bull market in equities will continue, that bonds are really worth the paper they're written on, that commodities are due for a price correction, or that inflation or bitcoin will go to the moon. We do think that inflation is likely to remain elevated but not catastrophically high, that interest rates should continue to rise as the Fed tries to cool down the economy and globalization slows, that GDP growth should stall and revert to more normal levels and that emerging market equities are attractively priced. Substantial risks loom on the downside, including a Federal Reserve-instigated recession, and higher interest rates due to slowing globalization ("slobalization"). It will be an interesting summer.