Chill about inflation

A great note from Nataxis on US inflation. Chill!

Historical Backdrop

In the post-WWII period, the United States has seen just a couple of problematic periods of significant inflation. The most recent of which was a 10-year period with two bursts of accelerating inflation in the 70s/80s. First, inflation quickly accelerated in 1973, before peaking and then quickly decelerating in 1975. Then for a short period, prices stabilized before reaccelerating in 1978. In the second wave, price growth peaked in the Summer of 1980, before decelerating throughout the 1980-1983 period. This decade was driven by a battery of factors including oil shocks from OPEC output cuts and outright embargoes, the dissolution of the post-WWII international monetary system and aggressive monetary policy (which included more than 900bps of rate cuts in two quarters, leading the dollar lower in the late 1970s), a large increase in military spending associated with the Vietnam War, strong legislation supporting the bargaining rights of unions and workers, robust antitrust enforcement, and other factors. Most of these dynamics are largely absent in today’s US economy which likely preclude a sustained pick up in inflation. Despite this, some economists and market participants have expressed concerns that massive budget deficits and money creation, reopenings, vaccinations and a widely anticipated growth surge will lead to a post-Covid jump in inflation. While we expect a modest cyclical increase in the months ahead, current inflation fears are overblown. The Federal Reserve has consistently undershot its inflation target for more than a decade. This experience is not unique to the United States. In the case of Japan, the BOJ has also missed its target for decades. Provided that inflation-expectations remain anchored, which appears to be the case, any increase in pricing power is likely to be temporary.

Structural factors

Broadly, inflation can result from several different phenomena which are not mutually exclusive: cost-push, demand-pull, and excess money supply. Cost-push inflation is traditionally associated with supply chain disruptions or commodities (mainly oil) related shocks,while demand-pull inflation is usually associated with quickly rising incomes, potentially through workers collectively exercising bargaining power in pursuit of higher wages, thus unlocking greater spending and higher prices. Meanwhile, the quantity theory of money states that prices will rise if the money supply grows faster than nominal GDP. This is the Friedmanite view of “too much money chasing too few goods.”

The risk of demand-pull inflation is relatively low because US workers still have little bargaining power. First, the United States’ labor market has seen a substantial increase in industry concentration. This is the monopsony view. It has materialized for a variety of factors including but not limited to: lax antitrust enforcement, a deluge of merger activity beginningin the 1990s, mass bankruptcies following the 2008 financial crisis, rising geospatial inequality (the buyers of labor are not aligned with where available workers live), and others. A lack of labor market competition has placed undue, downward pressure  on wages. Second, the decline of American manufacturing (a trend which started in the 1970s and greatly accelerated in the 1980s) has led to the secular decline in workforce unionization which, as of 2020, sat at a meager 10.8%. Unionization may be critical for counteracting power imbalances that arise between buyers and sellers of labor. At the same time, the use of legal instruments such as noncompete and no-poaching agreements has been increasing. Firms have used these tools to restrict the growth of labor costs. These factors equate to a low ceiling on aggregate wage gains. It is difficult to see how the US can generate sustained core inflation without strong, continued wage gains.

A continued, steady march in inflation-expectations could also percolate through in to realized price gains. But with inflation expectations charting a steady downward path over a multi-decade period, a self-fulfilling dynamic is at play—where, because inflation has been low, economic agents react in such a way that furthers the low inflation problem. In the event inflation-expectations do not pickup, it is unlikely that realized rates of inflation match the Fed’s goals. In the 1970s, monetary policymakers overestimated the economy’s underlying potential growth rate, thereby adding too much money relative to productive capacity. Initially, investors were slow to catch on to excessive credit and money creation. Inflation expectations were adaptively formed. Over time, this changed. Investors became forward-looking. This is central to the current backdrop, because without a commensurate increase in inflation-expectations, the current increase in the money supply will lead to an increase in financial assets, real assets, and collectibles and not be reflected in goods and services inflation measures.

On the supply side, the establishment of global supply  chains and the proliferation of low-barrier, international trade has increased the global production possibilities frontier, thus unlocking efficiency gains through the offshoring of heavy industry with comparatively costly labor, into emerging markets. This dynamic dramatically expanded the pool of cost-controlled labor, increasing the number of “sellers” of labor.

Additionally,the United States has become the world’s largest energy producer due to shale fracking technologies with daily crude production above 11 million barrels per day. These advancements have allowed for exploration and production companies to tap resource deposits that used to be either outright in accessible or economically infeasible. In turn, the US energy intensity per unit of GDP has collapsed. Furthermore, the US is a net exporter of oil. OPEC-induced oil shocks are much less likely in today’s environment.

The Fed’s Inflation Reaction Function

The standard neoclassical view is that as the unemployment rate decreases, wage inflation should increase, thus flowing into an overall increase in inflation thereafter. This relationship is tenuous. To illustrate, prior the pandemic, US unemployment steadily marched lower before hitting its lowest rate in 50years which, all else constant, should portend an acceleration in inflation. Instead, core PCE inflation undershot the Fed’s 2.0% target for 39 of 42 quarters. In this cycle, not only was corePCE inflation considerably below the Fed’s 2.0% target, it had been steadily decelerating since Q12018. The economy was weak en ough that the Federal Reserve had to cut rates three times in the fall of 2019, from an already low level of 2.38%. Then in reaction, following a 2020 policy review, the Federal Reserve adopted a new strategy where the rate of (corePCE) inflation will be allowed to overshoot 2% target by some undetermined magnitude, for some unspecified time, before using active tools to tighten. There are many reasons to doubt whether the US will reach this in an expeditious manner.

The upshot is that the Federal Reserve is prepared to allow inflation to grow above the 2% mark in exchange for more widespread employment gains. What is also new in the Fed’s updated framework is that the FOMC will not preemptively raise the fed funds rates (based on forecasts) to stem increases in inflation. The Fed will need core inflation to concretely print figures justifying a tighter path of policy. We see 2.3% as being sufficient to galvanize the Fed to action, if experienced over a long enough period combined with substantive labor gains.

Fiscal Policy

While fiscal policy has the ability to generate a cyclical lift in inflation through Keynesian stimulus effects and/or pushing available resources up against their capacity constraints to support price growth, the recent stimulus efforts do little to reverse the structural maladies (mentioned earlier) condemning the US to a setting of stubbornly low inflation. Currently, the US federal government is running budget deficits unseen since WWII. This level of stimulus was critical for staving off potentially cataclysmic economic conditions. With these levels of  spending continuing for 2021—which is anticipated to be a boom year—and in 2022 which also will bring multiple multi-trillion-dollar infrastructure spending bills, has led many prognosticators to worry about inflation. These fears are unjustified as most  spending is coming in the form of one-time direct transfers (one-off checks), and temporarily enhanced unemployment insurance. This government spending is unlikely to spark sustained increases in inflation.

What has been realized at this point is a level shift in commodities (specifically oil) leading to an ephemeral spurt in headline inflation, while core inflation has lagged. In addition to commodities, the wave of money creation has also flowed in to real assets and housing, which can be best illustrated in the more than 10%i increase in home prices.Rising mortgage rates and new housing supply coming online will likely be  sufficient to stem price gains in 2022.

Risks to Inflation Outlook

For Q2 2021, inflationary risks are tilted to the upside due to uncertainty stemming from widespread economic reopenings, lingering virus-related bottlenecks, and massive money creation suddenly having an outlet. However, H22021 and onward, risks are in the direction of disinflation. The US economy will likely reach peak growth in Q22021 before charting a steady path of deceleration. Historically, the economy tends to slow sharply after pent-up demand has been met. Int he past, whenever the US grew 6% or more, real GDP growth was cut in half in the following year. The fact that most of this year’s projected 6%(o or more) increase is narrowly concentrated in the consumer spending, increases the probability that output could slow even more next year.

Despite the likely (and possibly large) slowdown in GDP growth in 2022, the rhetoric from the Federal Reserve seems to hint at moving toward a tighter posture. This will likely lead to a sharp pullback in financial markets. In addition, waning fiscal impulses will heavily weigh on growth next year. Small business sentiment remains subdued and those planning to make capital outlays continues to decline. Additionally, services spending remains approximately $500billion lower than pre-pandemic levels. Mid year 2021 reopenings will need to fill big gaps. These dynamics are not emblematic of a durable economic renaissance, as a result, we see medium term inflation risks to the downside.What else could go wrong?

Given the fact that economists were slow to recognize the disinflationary forces of globalization and the loss of union power among other factors, it is possible that monetary policymakers are repeating the same mistakes of the 1970s. In providing excess policy accommodation relative to perceived underlying slack, inflation expectations eventually become unanchored. At that point, there may be a desire to remove accommodation and tighten policy, but underlying politics could prove difficult. After all, the Federal Reserve is the largest purchaser of Treasury debt and the decision to increase interest rates will have  a direct effect on the government’s cost of borrowing. There is no economic roadmap for the current monetary and fiscal backdrop.

Houses and Holes

Comments are hidden for Membership Subscribers only.