“We’re not even thinking about thinking about raising rates.”
- Jerome Powell, Federal Reserve Chairman, June 2020
“We’re committed to leaving that punchbowl or monetary policy accommodation in place until the job is fully and truly done.”
- Mary Daly, San Francisco Fed, March 2021
A financial TV host interviews a "strategist" on Zoom who is wearing a shirt and tie with pajama bottoms. She asks..."Which one are we more at risk of...inflation, deflation or stagflation?" The guest replies…”yes”.
- Unknown date between 2020 & 2022
In the article I posted in October of last year, “Desperately Seeking Inflation…”, I wrote about the Federal Reserve and their inability to see inflation. As an institution that is well-known to set policy by always looking through the rearview mirror, they fully missed the price inflation building up in the system and as Mary Daly states in the above quote, they did in fact keep the monetary punchbowl going full steam for far too long. On top of the monetary heroin being injected into the system over the past two years by the Federal Reserve, the Federal Government was busy handing out checks to most of the U.S. population. This, in addition to a very questionable decision to shut down the entire global economy led to many shortages and severe supply chain issues. Here we are more than two years later dealing with what would seem to be an “inflation” issue. All eyes are focused on the 9.1% CPI (consumer price index) headline for June. Numbers so high that they take us back to the days of listening to “Jessie’s Girl” and “I Love a Rainy Night” on the radio in 1981. Instead of listening to Eddie Rabbit, the current Federal Reserve Chairman, Jerome Powell, is listening to the Pet Shop Boys “What Have I Done to Deserve This” on repeat with the volume turned up to eleven.
These high and persistent CPI numbers have become a political issue for the current Administration and the Fed is now going down the path of raising interest rates to fight this inflation. The Federal Reserve controls the Federal Funds Rate which is the rate that banks pay for overnight borrowing. They can influence rates out to about 5 years but have no direct control over long term rates as those are generally set by market expectations and the overall economic environment. Nonetheless, this independent institution that employs over 400 Ph.D. economists actually believes it can pull on levers, ropes and pulleys to control price stability and employment. As Jay Powell tries to channel his inner Paul Volcker, one might ask, do we really have a true inflation problem and can the Fed even fix it? Is the current inflation monetary in nature (true inflation is always monetary, driven by a rapid increase in money supply) or is it driven by supply shocks and the unusual circumstances created during the pandemic induced recession?
There were several sharp and intense bouts of inflation prior to the mid-1950’s. Each of them ended very quickly resulting in recession/deflation. In 1947, the CPI hit nearly 20%. By 1949, inflation was back to under 2%. Oddly enough, the Federal Reserve had nothing to do with the CPI coming back down. When the CPI was up near 20% during that time, the panicked Federal Reserve was trying to lobby Congress to let them have some discretionary control over bank reserve requirements to remedy the situation but they never actually did anything as CPI started dropping on its own. So how did inflation come down so rapidly? It was due to the severe recession of ‘48-’49. Recessions tend to have the side effect of…bringing down inflation.
Beginning in the mid-1950’s, we started seeing a slow and steady increase in prices as opposed to the prior short bursts in prices that always came down quickly. The 1960’s arrived and we started seeing true monetary inflation but the Federal Reserve was asleep at the wheel and probably busy watching “The Adventures of Rocky and Bullwinkle and Friends”. The 1970’s period saw what was referred to as stagflation, where we had high inflation with disappointing growth. If this wasn’t bad enough, people started listening to Disco music! This period of course became known as the “Great Inflation'' lasting from 1965 to 1982. By the time 1985 rolled around, CPI was back under 4% just in time for Dire Straits to release the song “Money For Nothing”. So what does any of this have to do with the here and now? What might be causing this current price “inflation”?
Many people would say “It doesn’t matter what’s causing it, I am paying more for all this stuff I buy!”. Many things are in fact higher in price but knowing what is actually causing a significant part of it will help us figure out how it all ends. When the recession happened in 2020, many ports and shipping companies laid off their employees as they would in any other recession. As we moved through 2020, the Government started sending checks to everyone that was sitting at home along with providing nearly a trillion dollars in forgivable loans to any business that requested it (along with many scammers that extracted billions from the program and went on lavish spending sprees). With all of that Government money in hand, many started buying a lot of “stuff” online (Amazon, Peloton, etc). Most of this “stuff” came from China and Asia, so suddenly in late 2020, a staggering amount of cargo ships made their way into the ports that were drastically understaffed since many had been laid off or not at work since they were coughed on by someone. This was the first unexpected shock, as you would normally not expect to see all of this incoming cargo during an economic downturn/recession. 2021 comes along and we see a continued recovery from the deep economic drawdown during 2020. Containers that arrived in the U.S. had made their way into and around the country but then another problem occurred. The empty containers started piling up at the ports since the ships had to head back to China/Asia. They normally go back with the empty containers but due to severe labor shortages they could not sit back and wait for the empty containers to be loaded back on the ship. Now you have a container shortage and China has to start manufacturing new containers. Container rates moving into early ‘21 doubled from a couple months earlier and then more than doubled again by July ‘21 as the US Government started sending even more checks and stimulus to the entire U.S. population. On top of the container costs, shipping rates then skyrocketed which also fed into the price of goods increasing. This came along just as companies started to build up large amounts of inventory due to all of this “demand”. So what is now happening with all of this inventory and “demand”?
We have started to hear warnings from numerous retail companies (Target, Wal-Mart, etc) that their inventory has built up to excessive levels and prices will likely be cut. Q1 GDP came in at -1.6% and Q2 GDP is forecasted to also be negative. Real-time data shows slowing all over the place. Various yield curves are already forecasting Fed rate cuts in 2023! Commodity and energy prices which had been on a tear since late 2020 have collapsed over the past couple months. Here are some examples of what has happened in those markets and their price moves from the recent peaks (as of 7/22/22):
Energy Sector (XLE) -24%
Lumber -57%
Baltic Freight Index -65%
Copper -34%
Crude Oil WTI -18%
Gasoline RBOB -25%
Wheat -44%
Corn -32%
Soybeans -25%
Cotton -42%
Used car prices have started to drop and housing is showing signs of completely stalling out in many areas. Higher long-term rates are already showing signs of a rapid tightening effect on liquidity and demand. We have also started to see job cut announcements, especially in the Tech sector. Many people on financial television like to pontificate and argue about if and when we may or may not be in a recession, giving their infamous "50-50 chance" comments, but by the time a government committee decides on a recession we are usually at the end of it, if not already out of it. You have to look at things in real-time but so much of the economic data is very lagging which is one of the reasons why the Fed seemingly has blinders on all the time.
This brings us back to the “inflation” story. Are we dealing with true monetary inflation due a strong economy and excessive money in the system or was this in fact a short-lived anomaly due to supply chain disruptions combined with a massive amount of stimulus money? It certainly appears to be the latter. Will the Federal Reserve continue to tighten monetary policy into an already slowing economy that is likely already in recession to give the impression of fighting this “inflation”? They might, as long as they continue looking at data in the rear-view mirror. The Federal Reserve’s track record of incompetence is enough to make Captain Peter “Wrong Way” Peachfuzz blush.
So which one are we more at risk of...inflation, deflation or stagflation?
Yes…
- Eric