Are Rising Prices “Transitory” As the Fed Insists?
The inflation debate continues. Of course, no one knows what the future holds. If they did they could quickly accumulate all the wealth in the world. While many people have an opinion about what is to come, it is just that, an opinion. The great frustration is that very cogent arguments can be made for both temporary and long-term higher prices. John Mauldin recently concluded his annual Strategic Investment Conference. He presented many heavy-hitters in the world of economics, finance and investment. Most of them addressed the inflation debate.
Arguments for long-term inflation
Jim Bianco of Bianco Research made a compelling argument that higher inflation is baked into the cake and will not be “transitory” as Fed Chairman Jerome Powell keeps insisting. He points to the massive US budget deficit ($4T over the last twelve months), the ever greater percentage of personal income that is coming as transfers from the government, “stimmie” checks, the highest level of money supply ever, soaring transportation costs, rising wages, demand for goods exceeding supply, spiking commodity prices, “shrinkflation” (12 oz. chocolate bars now packaged as 10 oz. but selling for the same price), rising 10 year bond yields and what looks like “forever” government stimulus and repressed interest rates. He argues that these point to rising costs to produce goods and therefore long-term rising prices.
Peter Bookvar of Bleakley Advisory Group agrees that rising prices will not be transitory. He calculates that “services inflation” will continue to grow at 2.8% a year or more for a decade and that “goods inflation” - that had been contained by globalization – will rise due to efforts at reshoring production. He notes that transportation costs continue to rise dramatically with trucking expenses up 5x over the last 10 years due to shippers’ bankruptcies and difficulty employing drivers.
He adds that the CRB (commodity) index is up sharply and opines that the price of copper must rise 50% to induce miners to open new projects. US oil rig numbers are down with shale production having peaked in 2019. Used car prices are soaring as the lack of semiconductors has limited the production of new cars and may do so for two years. Home prices are rising, with fewer new and existing homes available due to people fleeing cities looking to work from home in the suburbs. Lumber prices have skyrocketed driving up construction costs. Many manufacturers are passing on the price increases they are paying for raw materials and labor. Warren Buffett recently noted, “We are seeing very substantial inflation. It’s very interesting. We are raising prices. People are raising prices to us and it’s being accepted.”
Rising raw material and labor costs and Biden’s increased corporate taxes will all be passed on to the consumer. While politicians glibly argue that corporations need to pay more in taxes, the simple fact is that those increased taxes will ultimately be paid by you. Rising prices for goods and services is a tax on consumers but is never recognized as such. If prices continue to rise, there will be a predictable public outcry. Politicians will falsely blame “price-gouging” businesses for the increasing prices. They do so in order to divert blame from themselves for having caused those increased costs. The financially ignorant public will buy that story, to the politicians’ great relief.
Arguments for “transitory” inflation
“Not so fast,” says legendary economist Lacy Hunt of Hoisington Investment Management Co. He argues that these factors will indeed produce rising prices for a brief period but other factors will prevent them from becoming a problem. He admits that the huge drop in GDP over the last twelve months will lead to a major rebound in the economy as it plays catch up with demand, and the return of service businesses will result in soaring sales, but that will be tempered by massive debt loads that will keep the economy from overheating.
He asserts that rising prices are a lagging indicator of a GDP recovery. If interest rates go up that will slow the growth of the economy and lead to falling, rather than rising prices. Further, he says that productivity typically increases following a recession as companies strive to become more efficient to meet the new challenges, and the resurgence of imports as US ports open to full capacity will deliver goods with lower prices. He stresses that gargantuan personal, corporate and government debt loads will cause the rapid recovery to be short lived and act as a drag on the economy. Thus, he concludes, rising prices will indeed be transitory as Chairman Powell says.
In response to arguments that stimulus payments will ignite inflation, he observes that Japan has been trying to “stimulate” its economy for thirty years by printing money but that has not resulted in wildly inflated prices. The EU has been trying to stimulate its economies for twenty years without causing damaging price inflation. He says that history demonstrates that most efforts to “stimulate” economies result in just one or two quarters of GDP growth, followed by falling growth that will retard price increases.
He also points out that history demonstrates that as governments increase their efforts to “command and control” their economies, the result is always weaker economies because bureaucrats know nothing about managing businesses much less entire economies.
He observes that while money supply (e.g., M-2) has been soaring, the loan to deposit ratio at banks has been falling and the Velocity of Money has dropped. [When the Fed prints money and gives it to the banking sector which in turn stores it as “excess reserves,” that money sits at the Fed and is not out competing for goods and services. Similarly, corporations that raised money through stock sales or near zero interest loans are sitting on that money to the consternation of their bankers.] Both of these factors retard rising prices. He concludes that we are in a classic Debt Trap that will result in a shrinking economy not an over-heating one. He argues that history proves there is no “Keynesian Multiplier.” That is to say, Fed “pump-priming” is a failed long-term strategy that should by now be obvious to everyone.
David Rosenberg agrees that rising prices will be transitory. He thinks that as the supply of goods and services increases, demand will subside leading to falling prices. He argues that the “consensus view” is growing inflation and he takes the contrarian side of that bet noting the majority is often wrong. Higher productivity typically follows a recession and that is an “inflation killer.” As stimulus checks end and unemployment benefits return to former levels, more people will return to work reducing wage pressures and there will be less money in their pockets to drive up the price of goods. Thus, the economy will cool.
He asks, “with 80% of the economy now open, where will rapid growth come from?” While Q3 earnings are expected to be high, he thinks that Q4 earnings will not be 5% as predicted but more likely in the 0%-2% range. Demographics are also working against inflation. Shrinking populations are deflationary as fewer people need fewer goods and services, as do aging populations. He agrees with Lacy that soaring debt to GDP ratios (US 130%) will act as a constraint on demand and the higher prices for goods and equities will revert to the mean (causing lower corporate earnings and falling stock prices that will shrink the money supply).
Developing an investment strategy
If the “experts” cannot agree on what is going to happen, we are left to develop a hedged investment strategy that can hopefully protect our savings and investments from either rampant inflation or deflation. Of course, we could go “all in” on one or the other but that means betting the ranch on an uncertain future.
However, another possible outcome is that we will confront a 1970’s style “stagflation” that couples the agonies of rising inflation with slowing economic growth. Those were not good times and will not be if they come again. You may remember that stock prices essentially moved sideways during that period. However, if you adjusted those stock prices for inflation, there was in fact a recession with falling real asset prices. Jim Dines refers to this as the “Invisible Crash.”
One thing we can count on is that if the economy, employment or the markets begin to head south again, there will be enormous political pressure on the Fed and Congress to “go big” in order to keep the incumbents in office. We worry that could be what finally brings down the house of cards leading to massive market losses, soaring unemployment, shortages of goods and services, rising prices and social unrest.
Whatever the Fed and Congress choose to do at that point will have unforeseen, negative consequences. Your elected representatives are only focused on the short-term goal of getting re-elected so they look to create short-term benefits and damn the long-term consequences.
In 1971 unemployment was 6.1% and price inflation 5.8%. President Nixon’s answer was to impose wage and price controls. It seemed like a good idea at the time but we now know what resulted. Those controls created shortages of nearly everything because businesses refused to produce goods and services at a loss. That policy failure was long enough ago to be forgotten by most.
Recently, the Fed grew its balance sheet by $7T during the Covid crisis. Imagine the consequences of adding another $10-15T to the economy at the next crisis. The value of the dollar would likely tank meaning the cash and bond component of your retirement nest egg would be devastated. But remaining in equities would wager that corporate profits would not be affected by a market crash – an improbable scenario.
Below is a chart reporting the US government’s stupendous growth of “current expenditures.”
How is it paying for this spend-a-thon? The Fed represses interest rates so the “cost of carry” of this debt remains manageable. The Fed drives down interest rates by bidding a low rate for government bonds. The Treasury happily accepts the low bid rate to reduce its interest obligation. In the past, the so-called “bond vigilantes” would ride in and drive up the interest rate. They are now an historic footnote.
The red line below is the rapidly growing federal debt and the blue line is interest paid on that debt. The scheme is even more twisted. The Fed pays much of the interest it receives from the Treasury back to the Treasury, so the bonds really come with no real cost. How long can this fiction go on? No one knows but we must assume that at some point in time bond investors will have a “The emperor has no clothes!” moment and bond holders will suffer.
The next chart shows the “real” (net of inflation) interest rate paid by the Treasury on 10-year bonds. Jim Grant refers to these bonds as certificates of guaranteed confiscation. No sane person would buy them. That leaves the Fed to monetize them.
From 2000 to 2020, publicly-held debt soared by 535% while the Treasury’s interest expense rose by only 41%. How is that possible? Through the magic of zero interest rates. It is through this gimmick of repressed rates that the US government has managed to stumble forward under its staggering and ever-growing debt load. While this can go on for a long time, it cannot go on forever.
History teaches that the result of massive debt is slower growth. We do not have to rely on anecdotal evidence. Visual proof can be seen here: huge growth of US debt (green bars) is compared to the pathetic growth of US GDP (blue bars).
While the Fed is printing money like crazy and the Treasury is frantically mailing it out to voters, no one seems to be paying any attention to who is getting it.
David Stockman reports:
“There is no doubt that Washington has descended into sheer fiscal incontinence. There is no other way to explain the fact that since the pre-Covid peak, nominal GDP has declined by about $735 billion, while our unhinged legislators have ponied up $6 trillion of Everything Bailouts to purportedly stimulate a recovery. These drunken sailors overshot the mark by about 8.2X, yet now they wonder why there are economic anomalies, dislocations, shortages, soaring prices and crazy-ass speculations everywhere. Consider that the three rounds of stimmy checks cost $292 billion, $164 billion and $411 billion, respectively, for a total outlay of $867 billion to upwards of 160 million recipients. Yet 20 million of these were social security recipients and other non-employed persons who didn’t lose a dime of income owing to the pandemic and another 100+ million were workers and their families who suffered no job losses or layoffs at all.
Whenever the government prints vast sums of money, it typically results in a shortage of goods and rising prices because they can print money effortlessly but businesses cannot produce goods and services effortlessly. Eight million people are still sitting at home cashing unemployment checks. This is a tax. It’s an inflation tax, a Biden tax, whatever you want to call it. But when Joe Biden says ‘don’t worry! Only people that make over $400,000 a year are going to have to pay higher taxes to fund all these programs,’ he’s lying. Because every American is going to pay the inflation tax. And it’s going to hit the middle class and the poor the hardest.”
Where is this sea of printed money going? Durable goods (refrigerators and Peloton bikes) and the stock markets are obvious destinations as evidenced by record sales and higher equity prices, but they are not the only place. Housing prices have exploded well past their 2008 bubble levels in many major cities, making housing unaffordable to all but higher earners.
There is a growing divide between home prices and employee compensation. The green slope below shows the rapid growth in housing prices and the purple slope shows the slow growth in employee compensation. The result is that middle and lower classes are being shut out of the housing market.
The Fed’s trillions are also fueling surges in basic commodity prices. Over the last weeks the following price increases were reported:
Buffett complains that, “We’ve got nine home builders in addition to our manufactured housing and operation, which is the largest in the country. So we really do a lot of housing. The costs are just up, up, up. Steel costs, you know, just every day they’re going up.” Who pays these increased costs? You the consumer do but those on the bottom of the wage scale pay disproportionately far more of their incomes.
Lest we fail to remember who is responsible for this growing inequality crisis, Stanley Druckenmiller, former chairman and president of hedge fund Duquesne Capital, pins the tail on the donkey:
“I don’t think there has been a greater engine of inequality than the Federal Reserve Bank of the United States…so hearing the Chairman [Powell] talking about visiting homeless shelters is very rich indeed…”“Everyone wealthy that I know is making fortunes” because “this guy [Powell] is printing money like there’s no tomorrow” adding that the kids in Harlem are not benefitting from money-printing but...for the life of me I can’t understand why the left is so excited about money-printing when all the data shows that the people who benefit from money-printing are rich people.”“The odds-on bet is we’re going to have inflation, and inflation is going to hurt poor people, again, a lot more than rich people.”
This chart shows that over the last forty years, while the top 10% in the US got richer, the working men and women have seen no real wage growth whatsoever. This has exacerbated the split between “haves” and “have-not,” with the latter group growing ever more dissatisfied with their lot in life.
History teaches us that this does not lead to happy times. Should the ever-shrinking middle class ever figure out who is to blame for their suffering, it will be Powell’s head on a pike in front of the Eccles Building.
Other brewing crises
While the Fed and Congress print and spend money with abandon, they ignore other pressing issues that will rear their ugly heads in the near future. We are talking about entitlements that have been promised but not adequately funded, such as social security, social security disability, hospital insurance and the highway trust fund. They are all in dire straits with no sign of receiving attention from Congress or the White House. At some point we will have an awakening only to discover that the cost to address them is high.
Currently, we are burdened with annual federal, state, and local spending totaling $10.064 trillion. US nominal GDP is $22.049 trillion. Thus, government spending is consuming 45.7% of US GDP and President Biden and Congress are proposing trillions more in spending. No problem, we are told. We will just have the Fed print whatever money is needed and repress interest rates to make our massive debt load bearable. As explained by Lacy Hunt above, the result of this ongoing folly is that real GDP has been on a steady downward trajectory for decades. This chart of “Real GDP” (net of inflation) shows that our rising debt loads have inexorably led to falling growth levels.
David Stockman addresses the Fed’s repression of real interest rates:
The chart shows the real Fed funds rate, calculated by subtracting the YoY trimmed mean CPI increase from the Fed’s target rate. During the last 169 months (since March 2008) the rate has been deeply negative most of the time…. And now, after last year’s money-printing orgy—the real Fed funds rate stands at -2.37%, nearly the deepest level ever.
Of course, never in a million years would participants in voluntary exchange on the free market lend money—even overnight—at a negative real rate 96% of the time over a 13 year period. It defies economic logic and sanity itself. Needless to say, these new mechanisms of socialist control, just like in the old Soviet Union, were not remotely up to the task. Among the manifold failings and ills in the latter was the fact that central planning tended to produce enormous unintended and malign effects owing to erroneous incentives and price signals. Besides useless and unfair financial windfalls to the top of the economic ladder, the Fed’s massive interest rate repression has destroyed fiscal rectitude entirely, thereby unleashing the Leviathan on the Potomac like never before.
We were reminded of that today by the fiscal year-to-day budget numbers. After 7 months, the Federal deficit has clocked in at $1.9 trillion, 28% higher than last year’s out-of-this world $1.48 trillion.
More specifically, outlays totaled $4.07 trillion during the period, while revenues posted at just $2.14 trillion. That is to say, the Banana Republic-worthy politicians on the Potomac borrowed fully 48% of what they spent.
We presume the next crisis will lead to massive amounts of new debt issuance that must be monetized by the Fed coupled with the likely implementation of negative nominal interest rates (even deeper than the current real negative rates). Here is a chart of real 10 year Treasury yields.
This will threaten all segments of the economy. Pensions, life insurance companies, investors, retirees, corporate money managers, and banks all rely on interest income to meet their financial goals. Negative rates have the effect of bleeding the economy dry - the more negative, the more rapid the exsanguination. Most economists now concede that the EU’s negative rates following the 2008 crisis seriously damaged their economies. Despite this, Chairman Powell will try to convince us that “this time is different” when he is forced to employ negative rates.
One needs to remember that GDP growth requires either a larger work force or a more productive one and that printing money does not create any goods or services. A growing problem facing all western nations’ economies is shrinking work-forces.
The only way to overcome this hurdle, short of mass immigration, is for our economies to become more productive. Unfortunately, corporate capital expenditures for plants and equipment have not kept pace. Borrowed money was instead spent on stock buybacks and executive compensation. The result will be shrinking growth.
Fewer goods produced coupled with more printed money suggests that we may first see rapidly rising prices, as predicted by Lacy, but then followed by falling standards of living as more people are priced out of the market – not predicted by him. It is unlikely that those suffering a serious decline in living standards will take it gracefully. This will tempt politicians to implement some form of universal basic income to keep a lid on social unrest. Like every government benefit, once instituted, there is no way it will ever be ended. The unforeseen result will be massive numbers of people on the dole with nothing but time on their hands. We will come to understand the wisdom of the old saying that, “Idle hands are the devil’s workshop.”
The Continuing Bitcoin Debate
If cryptocurrencies are ever going to act as currency substitutes, they must take on the utility of a currency. To do so they must be readily exchangeable for goods and services and a reliable store of value. Current versions of cryptocurrencies fail on both counts. They are not widely accepted in the market place for the purchase of goods and services and they are not a reliable store of value.
The chart below shows Bitcoin’s highly erratic valuations. This is why Tesla stopped accepting them for the purchase of its vehicles. Musk’s explanation that Bitcoins consume too much electricity was a fact known to him from the beginning and a convenient “green” excuse to abandon their use. He stopped selling cars for Bitcoins because the latter have been falling rapidly in value.
Extreme price volatility and lack of acceptance for payments are not the only problems. China recently announced a crackdown on cryptocurrency mining and trading and banned banks and financial institutions from accepting them. It needs to control its currency in order to prevent its citizens from sending money out of the country (currency controls). It is slowing implementing its own cryptocurrency that will allow it to surveil its entire population. State-run cryptos are ideal vehicles for police states like China. Not only can the state keep track of every purchase and sale but political agitators can be tracked and frozen out of the economy.
Hong Kong announced a proposed rule to limit crypto trading to accredited investors. That would kill its use as a currency substitute. The Bank of Canada cited crypto concerns in its annual financial system review, saying that “the rapid evolution in crypto asset markets is an emerging financial vulnerability.”
Gary Gensler, the chairman of the S.E.C., said that American regulators should be ready to bring cases involving wrongdoing in the crypto markets. The US Treasury Department noted in a recent report that a “cryptocurrency already poses a significant detection problem by facilitating illegal activity broadly including tax evasion.” The I.R.S. said it will require more extensive reporting of crypto transactions by US citizens and businesses.We believe the dagger-in-the-heart for cryptos is the recent disclosure that their transactions are neither confidential nor secure. The US Justice Department disclosed that it had traced and seized most of the ransom that Colonial Pipeline paid to Russian hackers last month. The ransomware attack had shut down the pipeline for a week, creating fuel shortages and price spikes, until the company paid hackers more than $4 million worth of Bitcoin. Federal officials said that the F.B.I. had seized most of those Bitcoins by “hacking the hackers.” The funds were traced to an account which a federal judge allowed the F.B.I. to breach. The feds obtained the account’s “private key” that is the crucial password giving the user control over the funds inside the account. How they got the private key was not disclosed.
We reported in our December issue that the US government seized nearly $1B of Bitcoins from the owner of the Silk Road dark website that trafficked in illegal goods. If the government can do that with Russian hackers and foreign internet criminals, it can do it to you and anyone else. The blockchain reports all transactions publicly and was designed to do so to insure transparency and accuracy. Thus, crypto transactions are neither confidential nor secure as advertised. If government agents can seize your Bitcoins, so too can other hackers. Caveat emptor.
The Continuing EU Drama
“The ECB cannot risk signaling the end of bond purchases because that will trigger a sell-off in the Italian debt market. They are trapped and I don’t see how this is going to end,” said Professor Thomas Meyer, Deutsche Bank’s ex-chief economist and author of Europe’s Unfinished Currency.
We believe that the “end” is not ambiguous at all. It will end badly. The ECB will either continue to support Italian government debt or there will be crisis leading to political upheaval, popular demand for an “Italexit” and a return to the lira. EP adds,
Jürgen Stark, the ECB’s former chief economist, complains that the institution has abandoned the Maastricht rule-book and become a monetary engine for deficit financing. The ECB cannot stop the process because it alone is holding up the debt edifice. “Nobody wants to go there,” he said. Prof Stark says that the EU Recovery Fund is a sham that has “absolutely nothing to do with the pandemic” and is essentially a fiscal power-grab by Brussels at the expense of German democracy. He fears that galloping debt creation without constitutional clarity on who stands behind the debt will lead to a repeat of the eurozone crisis but on a bigger scale, testing the system to destruction. “I can’t rule out a crash,” he said. Whether the German people accept this state of affairs may soon become the existential question hanging over the European project. Half of Germans rent their home and few of them own equities or wealth assets. They have no inflation hedges.
Many Germans keep their money in deposit accounts with the country’s regional savings and co-operative banks. They know they are being robbed by steeply negative real rates – Bild Zeitung publishes tirades telling them so – and they can see that prices are rising. Petrol was up 23pc in April, heating oil 21pc, financial services 5.6pc, and coffee 5.1pc. They are about to experience a textbook supermarket shock to drive home the point.
A bad bout of inflation will crush the majority of German families. That would trigger a political crisis that could easily blow up the EU’s Rube Goldberg project.
Conclusion
While we may be near the end of the Covid crisis, we appear to be near the beginning of the next financial crisis where massive amounts of unpayable personal, corporate, local, state and national debt will have to be addressed.
A Deutsche Bank report, led by chief economist David Folkerts-Landau, warns,
The most basic laws of economics, the ones that have stood the test of time over a millennium, have not been suspended. An explosive growth in debt financed largely by central banks is likely to lead to higher inflation. We worry that the painful lessons of an inflationary past are being ignored by central bankers, either because they really believe that this time is different, or they have bought into a new paradigm that low interest rates are here to stay, or they are protecting their institutions by not trying to hold back a political steam-roller.
Which is to say, that central banks have now been captured by the politicians. Giving politicians the keys to the printing press reminds us of P.J. O’Rourke’s famous observation that doing so is akin to giving whiskey and the car keys to a teenager. It will not end well.
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