My thoughts on US inflation
This ended up being way longer than I thought it would be
Should we worry about US inflation? Arguably not. Can we do better with US inflation? Arguably not.
If inflation transitory? Maybe. Is inflation persistent? …Maybe. (this is why economics is called the dismal science!)
What is going on in Jay Powell’s head today?
The ideal equilibrium to strike in terms of game theory is one of risk tradeoff - and the Fed’s current trajectory with respect to monetary policy observes that view.
If I were in Jay Powell’s shoes, I’d probably be doing the same thing.
A lot has been said about US inflation in the past 6 months or so. Today, I shall be adding my own insignificant views to the veritable sea of opinions out there.
The point of this post is to add value to the chorus of observations out there, not to regurgitate them. Hence for the uninitiated, I’ll just be giving a brief overview of the context behind the current state of US inflation before moving on to my own actual views. If you really need more detail on the context of the topic, Google is your BFF.
US inflation so far
Keep in mind this is the super-short version, so it’s going to leave a lot out.
As the world recovered from the covid pandemic in late-2020, US e-commerce transactions grew by leaps and bounds, as offline retail stores around the world were forced to stay closed due to government-imposed lockdowns. This surge in demand was handsomely embraced by increased supply from China, whose economy specializes in pumping out low-tech widgets from factories. And most of those exports had to be delivered to the USA by ships.
Unfortunately, a series of unfortunate events led to the global shipping sector experiencing gridlock. Many empty shipping containers sat idle in US ports at the time, owing to the drop in aggregate demand caused by covid throughout 2020 - and the unexpected roaring back of aggregate demand due to generous monetary policy by the Federal Reserve caught everyone off-guard. This meant that in order for those exports to reach the doors of US consumers, those empty shipping containers had to be shipped back empty to China, before they could be filled with widgets, and then shipped back to the USA. Theoretically, this meant that shipping prices had to at least double in order to breakeven on old rates. Add in the Suez Canal fiasco, immense backlogs at global ports and logistics employees falling sick throughout the supply chain, and you get crazy high shipping rates.
To add to that hot mess of a melted ice cream sundae, semiconductors also started becoming short in supply. The main reason for this was because when the entire global economy shut down in 2020, the tech sector which was booming instead started booking chip supply way ahead in advance. Non-tech businesses were happy to allow them to do this - as based on historical trends, demand from those sectors wasn’t anticipated to rebound anytime soon. However, when loose monetary policy enabled a rapid V-shaped economic recovery in the USA, demand roared back with a vengeance and led to a mad scramble for chips by the entire world at the same time. This significantly impacted sectors that depended on chips for their production (e.g. the auto sector and high-tech manufacturing) leading to a “buy at any cost” mentality that has pervaded semiconductor supply chains today and higher prices for the end-consumer.
On top of that, there is also the labour issue in the USA. Plump with state and federal unemployment benefits amounting to $800-$1,400 per month and $3,000 per child in annual childcare tax benefit, many lower-income families have opted to stay home instead of working for the same take-home pay at 12-hour-per-day part-time jobs under slave-like conditions. The immense retrenchment that took place amongst the service sector in 2020 has almost seemingly reflected the living embodiment of resentment, with many service sector workers refusing to come back to work despite offers of $15 per hour pay. Some of the reasons given were that parents had grown accustomed to at-home childcare during the pandemic, and didn’t want to give that up. The widespread embracement of work-from-home (WFH) norms by the wider society at large also meant that people were switching out of entire industries into jobs that allowed WFH arrangements - which the service sector was understandably unable to provide. To make matters worse, the lack of staff at service establishments meant that those who did accept service sector jobs were left doing the work of what was previously for 2-3 people. This drove wage inflation in the part-time sector to sky-high rates. (even the high-income sector wasn’t spared by wage inflation, but that’s less relevant in this context).
The last piece of the inflation puzzle is surging commodity prices. A confluence of factors led to hard commodities experiencing a simultaneous rise in prices around the world - including 1) the Texas cold spell affecting gas prices; 2) Hurricane Ida’s impact on resin prices; 3) energy prices being affected by the recent rationalization of the US fracking industry; 4) lumber and building materials prices skyrocketing due to the booming US housing market, etc - as well as the general reflation trade from the economic rebound. Notably missing from the excitement however was the gold price, which only rose about 20% since the pre-covid period - despite the near doubling of the Fed’s balance sheet and the M2 monetary base rising by some 30% since then.
Combine all these factors together with the low base effect of YoY CPI/PCE inflation accounting metrics, and you get the eye-popping 5% average inflation rates that we are seeing permeate across the broader US economy today.
Where are we today?
Ever since then, inflation hawks have been squawking from the rooftops of the Eccles Building while channelling the energy of the Austrian economist Fredrich Hayek - if he had been hooked up to a dynamo while rolling in his grave. The indignant “I told you so’s” from high society has been almost palpably happy to have finally made itself heard - especially after the decade-long experiment of hooking up the US economy to the unlimited heroin vending machine of loose monetary policy. Meanwhile, Jay Powell is for the first time in a long time in Fed history facing potential mutineers amongst the typically docile Fed board, paving the way for a potentially rocky renomination when his current term as Fed Chair ends in Feb 2022.
The official stance of US policymakers is that this stretch of inflation is simply a “transitory” one - or mean-reverting in nature - as a result of temporary supply shocks. Those in this transitory camp argue that much of the recent inflation we’ve been seeing can be explained by cost-push inflation, which tends to be much more controllable compared to the more endemic demand-pull inflation - as the former is caused by higher input prices which can be tampered down by force, while the latter tends to be a result of animal spirits which the data nerds find harder to tame.
Regardless of which camp you belong to, the inflation milk has already been spilled - and what matters now is what can be done about it. So if hyperinflation is the devil, how do we unbreak the seal that summoned it? There are a few possible outcomes that I think can happen from here on:
Nothing happens. US inflation continues to tread water until the next cyclical downturn, and the hawks keep squawking for a few more years until things die down. Just like the last time post-2008 when approximately the same thing happened.
US inflation rises to uncomfortable levels, as predicted by the hawks.
US inflation exceeds everyone’s expectations and transmogrifies into hyperinflation.
For obvious reasons, we won’t be discussing the prospect of deflation in an article exploring hyperinflation. But I just wanted to point out there that a Japanese-style Lost Decade is not completely out of the question for the US of A.
So, let’s explore the other 3 scenarios.
Scenario 1: Transitory Inflation
In Scenario 1, inflation indeed turns out to be transitory and nothing happens. The strongest argument for this view is our experience with inflation post-2008. Similar to today, the Fed doubled its balance sheet in the wake of the GFC and the M2 monetary base surged. Also similar to today, the inflation hawks came out shrilling from the trees and prophesied the death of the dollar, hyperinflation and skyrocketing gold prices (now it’s Bitcoin).
All of which has failed to materialize. In the immediate pre-covid period of late-2019, US inflation had stagnated around its 2% target for nearly a decade, and in fact efforts to taper quantitative easing triggered deflationary concerns - the opposite of what the gold bugs were fearing.
There are several hypotheses about why US inflation has failed to excite since the GFC, despite the massive money printing that had taken place. One of them is that at the same time when most of the monetary stimulus took place in the immediate post-GFC period, the Basel Accords that dictated US banking regulatory regime introduced huge capital buffers for US Banks which absorbed most of this newly created money. As this newly printed money remained stuck as excess reserves held at the Fed and did not enter the real economy, banks remained as gatekeepers for inflation by not actually engaging in the hyper excessive amounts of lending required to spur inflation.
The other hypothesis is that just as the Western economic bloc was experiencing a slowdown of growth in the post-GFC period, the rest of the developing world was actually growing faster than the developed world. As the USD is the reserve currency of the world, this dichotomy resulted in increased demand for dollars outside of the USA in excess of incremental money supply created by the Fed - resulting in an exporting of inflation to the developing world (as ceteris paribus, other countries would need to print more of their own currencies to buy more dollars, e.g. for oil).
Obviously there are many layers to this phenomenon given the sheer scale of the topic - but regardless of the underlying reasons, the fact remains that US inflation did not overexcite post-2008 despite fears to the contrary. The argument for today is that once all these transitory factors in the global supply chain gridlock resolve themselves over time, US inflation will wear down naturally and Fed action may prove to be unnecessary (or even detrimental, considering how there’s usually a time lag between implementation of monetary policy and actual impact to the real economy).
Scenario 2: Persistent Inflation
This is the scenario that most inflation hawks are worried about. As evidenced by US CPI printing 5% YoY rates over the past few months - and the race to the stratosphere of US home prices, part-time wages and global shipping rates - there is palpable on-the-ground feedback of worryingly rising prices occurring in the real economy. It would be one thing if Jay Powell at least put on a show of grave concern about it while delivering his speeches - but his cavalier attitude towards it and switching of the Fed’s employment mandate to one of maximum employment gives room for the interpretation that the Fed might be missing the forest for the trees, in pursuit of its progressive policy with its new best friend the US Treasury (which it’s supposed to be independent from).
Naturally if you’re either a conservative, Austrian economist or just a someone who watches too much Fox News, it’s easy to get sucked into the drama llama of infinite money printing resulting in - guess what - the death of the dollar, hyperinflation and skyrocketing Bitcoin prices. And this time there are actually legitimate reasons for it too.
For one, there are no undercapitalized banks this time around to absorb all that excess newly created money. This is ensured by the Fed and the Treasury acting in concert to divvy up actual money (not reserves) created, and launch it out of a helicopter. Yes, that’s right; that once taboo line-in-the-sand of helicopter money has been crossed even right here in the USA, at the altar of free-market capitalism; and that’s a precedent that can never be taken back now that we’ve given future politicians a new toy to play with. Hayek isn’t just rolling in his grave anymore; he’s somehow found room in his coffin to do backflips (meanwhile Keynes is losing count of all the chickens that have just hatched in his).
When money is delivered straight to your doorstep in the form of stimulus checks, that’s going to have a profound impact on aggregate demand in the real economy - the current impact of which is clear as day for all to see. But it’s also had some unexpected consequences - such as spurring some families to opt for staying out of the workforce for childcare reasons, or at least look for new jobs that allows them to WFH. While skyrocketing home prices could have been expected from the rampant abuse of mortgage-backed securities (MBS) purchases by the Fed, few would have predicted in advance that the restaurant industry which was under lockdown for most of 2020 would see sector wages climb an ivory tower of missed expectations.
The fear is that if the Fed could have missed this, what else could it be missing now which could have profound impact on future inflation? Could mountain gear prices suddenly climb a wall of worry? Could oil prices spiral out of control in the face of US shale rationalization and an OPEC with diminishing influence? Could pigs start flying, hence justifying the creation of a new industry for flying pork chops and boosting aggregate demand?
The answer is we don’t know - and it is this uncertainty which is prompting the inflation hawks to worry.
Scenario 3: Hyperinflation
If you’ve been bitten by the Bitcoin bug, then this narrative of USD hyperinflation should be no stranger to you. It’s basically just an extension of the aforementioned concerns, except this time everyone starts losing faith in the dollar and makes a proverbial rush to spend - leading to higher prices which leads to even higher prices. Hyperinflation is the one exception to the saying, “the cure for high prices is high prices”.
In my own view, I think USD hyperinflation is an extremely fringe possibility. The main ingredient for runaway hyperinflation to take place is the loss of faith in the fiat currency itself, rather than simply an increase in the money supply. If faith in the currency is maintained, excessively high inflation will simply be met by falling demand, which will naturally lead to falling prices.
Perhaps an illustration about how this works might be helpful to the uninitiated. The words “In God We Trust” are emblazoned on every physical dollar printed in paper. If God holds the power of creation - and the dollar is created out of thin air by the Fed - then the Fed can be seen as the God of the fiat dollar. As fiat currency is not backed by any tangible asset, its perceived value (expressed in terms of real value) depends on whether people trust it to hold its current value. If that faith is broken, there is technically nothing stopping it from being worth nothing - resulting in runaway hyperinflation.
Hence the answer to how likely the USD might experience hyperinflation can be boiled down to this: will people lose faith in the dollar? And the answer to that is a resounding no. For one, the USD is the reserve currency of the world - and if not the dollar, what else are companies and governments going to put their faith into (in terms of holding value)? Euro? Yen? Gold? Bitcoin? There Is No Alternative. And because of TINA, it will take a lot more than a belligerent Fed for the world to lose faith in the USD.
Another counterpoint to the USD hyperinflation narrative can be made by looking at an actual instance of USD hyperinflation in the past. This happened in the late 70’s, when then-Fed Chair Paul Volcker broke the back of inflation by raising interest rates to unimaginable rates. Some might correctly make the argument that even if hyperinflation could ultimately be contained, the cost of allowing it to happen in the first place would be too high (as seen immediately after the Volcker tightening era) - hence preemptive measures to mute inflation are necessary.
But let’s also take another look at what enabled the hyperinflation of the 70’s in the first place. There were two main ingredients - the oil embargo imposed by OPEC, and the presence of strong corporate unions. The oil embargo was obviously the catalyst that sparked hyperinflation, with the resulting price controls imposed by Nixon doing nothing to stop excess demand leaking into the rest of the economy. But it was also the presence of strong corporate unions in America at the time that enabled wages - the stickiest form of inflation - to rise in lockstep with wider inflation, and contribute further to the upward spiral. In the absence of both of these ingredients (no foreign economic threat, and corporate unions having been declawed by Reagan’s crushing of the air controller’s strike in 1981), the title of ‘stickiest form of inflation’ has been relegated to rent prices; which for a multitude of reasons haven’t really budged over the past decade despite a surging House Price Index (HPI).
In summary, USD hyperinflation isn’t really something we have to really worry about. At least, not according to little ol’ me.'
What is the Fed thinking about US inflation?
I’m not trying to suggest that an economic phenomenon on the scale of US inflation can be reduced to a clickbait headline (e.g. 15,826 Reasons Why US Inflation Will Exceed 10%!). There is a good reason why there is still no consensus agreement on which way inflation will go - it’s way too big of a topic to wrap your head around. But despite this, I shall try.
Putting myself in the shoes of Jerome, here’s what I think might have been going through the Fed Chair’s head over the past half-year. The ideal equilibrium to strike in terms of game theory - when infinite unacceptable risks exist no matter which path you take - is one of risk tradeoff. That is, rather than trying to determine which path will maximize your gain, the optimal path involves trying to determine which path will minimize your risks. It’s entirely possible that the risks you were trying to avoid do not actually end up materializing, resulting in lower returns in such a scenario - but since the future can’t be predicted, mitigating all life-threatening risks in all potential outcomes should at least ensure that you remain alive long enough to have the ability to write history. Better to be a live chicken than a dead duck; glory can come later.
Therefore, what are the options available to the Fed in this context? Everyone is preoccupied with the risk of persistent dovish policy now, because the risks are highly visible and unyieldingly pushing everyone’s buttons. But what of the risk of the alternative? If the Fed tapered now, couldn’t that possibly lead to a repeat of the taper tantrum in late-2018 when Powell tried to do the same?
Regardless of whether the “I told you so’s” of starting down this wretched path of quantitative easing in the first place are justified or not, the fact remains that markets today are not the markets of our grandfathers - and that a combination of excessive passive fund participation, gluttonous investor appetite for derivatives, high investor risk tolerance and late-cycle economic conditions have resulted in increasingly volatile market responses to central bank policy. Markets have become beholden to a telegraphic Fed - trying to fax a taper ahead of its time could result in a taper tantrum, that might result in even worse outcomes than uncomfortably high inflation.
We can also find clues in the Fed’s newly stated mandate of maximum employment. Why would the Fed need to construct a new narrative, if Keynesian monetary policy already allowed infinite stimulus under the old dual mandate? This might mean that the Fed’s priorities have since shifted away from monetary stability, towards one of enabling inflation. As we know, US GDP growth has been endemic for awhile; and in a laissez-faire business environment, the US economy could very well have a Japan-style Lost Decade in its windshield as the economic center of the world shifts East.
In light of the pandemic, competitive growth may not be making headlines now - but in a post-pandemic world, perhaps a Lost Decade is a greater evil than uncomfortable inflation, especially with the anticipated idealogical war on the horizon. As we know, governments think in terms of decades - and that narrative might be enough to justify embracing the lower risk from uncomfortable inflation; especially compared to the risk of losing global geopolitical hegemony to China.
To tie up my thoughts into a neat little bow, let’s say hyperinflation does happen. What then can the Fed do? Well, it could simply announce that it would begin tapering in size - without even coming within a ten-foot pole’s range of raising rates. I’d expect this to have a similar effect on markets as tightening, with markets collapsing a la late-2018 and the real economy following in lockstep, tampering down aggregate demand and hence inflation. There, hyperinflation solved.
In summary, I think that the balance of risks lies towards preferring avoiding deflation rather than avoiding inflation - which happens to be consistent with mainstream economic policy. If I were in Jay Powell’s shoes, I’d probably be doing the same thing.