Inflation I: Post-Pandemic Worry. I was an early believer in “disinflation.” I first used that word, which means falling inflation, in my June 1981 commentary titled “Well on the Road to Disinflation.” The Consumer Price Index (CPI) inflation rate was 9.6% that month. I predicted that Federal Reserve Chair Paul Volcker would succeed in breaking the inflationary uptrend of the 1960s and 1970s, which he did. Nevertheless, throughout my career, I’ve often fielded questions about the likelihood of a rebound in inflation from accounts who were worried that it just might make a comeback. After all, the Fed chairs who followed Volcker tended to favor stimulative monetary policies. This year, as a result of the unprecedented monetary and fiscal policy stimulus provided by governments around the
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Nevertheless, throughout my career, I’ve often fielded questions about the likelihood of a rebound in inflation from accounts who were worried that it just might make a comeback. After all, the Fed chairs who followed Volcker tended to favor stimulative monetary policies. This year, as a result of the unprecedented monetary and fiscal policy stimulus provided by governments around the world to offset the adverse financial and economic consequences of the Great Virus Crisis (GVC), I’m hearing more concern that inflation could come roaring back once the pandemic is over.
In this widely feared scenario, interest rates might soar. That would create all sorts of trouble. The mountains of debt accumulated by the public and private sectors would compound at a faster pace. The credit markets could seize up, causing a credit crunch and a recession, possibly worse than those of the Great Financial Crisis (GFC). Stock markets would fall into bear markets as earnings declined and valuation multiples tumbled. If inflation were to come roaring back, my upbeat Roaring 2020s outlook would be its biggest casualty.
Given the consequences of getting their expectations for inflation wrong, it’s no wonder investors are worried about this bad-case scenario even if they aren’t ready to do anything in response to it, other than talk about it more often. In any event, while I’m still a disinflationist, our YRI team is focused on watching out for signs of trouble on the inflation front. Before I review what we are seeing, let’s briefly recount what happened during the Great Inflation of the 1970s.
Inflation II: A Brief History of Inflation in the 1970s. Almost everything that could go wrong did so back then. I reviewed what happened in my 2020 book titled Fed Watching for Fun and Profit. For starters, on August 15, 1971, President Richard Nixon suspended the convertibility of the dollar into gold, which ended the Bretton Woods system that had kept the dollar’s value at a constant $35 per ounce of gold since the system was established in 1944. The value of the dollar in foreign exchange markets suddenly plummeted, causing spikes in import prices as well as the prices of most commodities priced in dollars.
During the summer of 1971, Nixon imposed wage and price controls. They didn’t work, and the controls were lifted in 1973. During 1972 and 1973, for the first time since the Korean War, farm and food prices began to contribute substantially to inflationary pressures in the economy. Also, there was a major oil price shock during 1973 and again in 1979 (Fig. 1).
Together, the two oil price shocks of the 1970s caused the price of a barrel of West Texas crude oil to soar 11-fold from $3.56 during July 1973 to a peak of $39.50 during mid-1980, using available monthly data (Fig. 2). As a result, the CPI inflation rate soared from 2.7% during June 1972 to a record high of 14.8% during March 1980. Even the core inflation rate (i.e., the rate excluding food and energy) jumped from 3.0% to 13.0% over this period as higher energy costs led to faster wage gains, which were passed through into prices economy-wide. During the 1970s, strong labor unions in the private sector succeeded in quickly boosting wages through cost-of-living clauses in their contracts. The result was an inflationary wage-price spiral (Fig. 3).
It’s my view that the 1970s were uniquely inflation prone. Paul Volcker stopped the inflationary wage-price spiral by tightening monetary policy significantly during the late 1970s and early 1980s, causing a severe recession. However, inflation continued to trend lower since then through today, mostly because of the four deflationary forces (i.e., the “4Ds”), which we have discussed many times along the way. (For a summary, see the excerpt from my 2020 book titled Four Deflationary Forces Keeping a Lid on Inflation.)
Inflation III: Will the 4Ds Drown in M1’s Tsunami? The question for us today is whether the 4Ds are still relevant or whether they’ve met their inflationary match in the extraordinary monetary and fiscal policy responses to the pandemic. The 12-month federal deficit rose to a record high of $3.3 trillion through October, while the Fed’s purchases of Treasury securities totaled a record $2.4 trillion over the same period (Fig. 4). Most of those expansions occurred since the week of March 23, when the Fed and the Treasury essentially embraced Modern Monetary Theory and morphed into “T-Fed” in response to the GVC.
Contrary to Milton Friedman’s claim that inflation is essentially a monetary phenomenon, it has remained subdued ever since the GFC notwithstanding the ultra-easy monetary policies of the major central banks. We soon should find out if money matters to the inflation outlook given that the GVC has resulted in ultra-easy monetary policies on steroids and speed combined! In the US, M1 has increased by $2.3 trillion since the last week of February to a record $6.2 trillion during the week of November 23 (Fig. 5). It is up an astonishing and unprecedented $498 billion during the latest week and 57% y/y! MZM and M2 are up 28% and 25% y/y (Fig. 6).
Our money is on the 4Ds. They should continue to keep a lid on inflation. Here is our current bottom lines on each of the 4Ds:
(1) Détente. In the grand sweep of economic history, inflation tends to occur during relatively short and infrequent episodes, i.e., during war times. The more common experience has been either very low inflation or outright deflation during peacetimes.
Periods of globalization follow wartimes. During peacetimes, national markets become increasingly integrated through trade and capital flows. The result is more global competition, which is inherently deflationary. The worsening Cold War between the US and China is a threat to globalization, but probably won’t heat up to the point of causing inflation now that a regime change is coming to Washington. In any event, China’s exports during November edged back up to the record high hit during July notwithstanding Trump’s trade war with that country (Fig. 7).
(2) Technological Disruption. Nevertheless, recent global trade tensions and the pandemic are likely to cause businesses to diversify their offshore supply chains away from China and to onshore more of them. That could be costly and inflationary. It could also be cost effective now that labor shortages attributable to global demographic trends are stimulating technological innovations in automation, robotics, artificial intelligence, and 3D manufacturing. These all enable onshoring and boost productivity to boot.
Nonfarm productivity jumped 4.0% y/y during Q3, the fastest pace since Q1-2010. We are expecting a secular rebound in productivity growth during the Roaring 2020s. So far, so good: The 20-quarter growth rate of productivity (at an annual rate) is up from a recent low of 0.6% during Q4-2015 to 1.7% during Q3 (Fig. 8). I believe that the pandemic accelerated the pace of applying new technologies to boost efficiency and profit margins, as we will discuss more fully tomorrow.
(3) Demographics. Fertility rates have plunged below population replacement in recent decades around the world as urbanization has changed the economics of having children. Instead of being an important source of labor and elder care, as they were in agrarian communities, children are all cost in urban settings. Nursing homes have few vacancies, while maternity wards have plenty. Increasingly geriatric demographic profiles are inherently deflationary.
4) Debt. During the 1960s through the 1980s, debt was stimulative; more of it stimulated more demand and added to inflationary pressures. Now, easy credit conditions aren’t as stimulative to demand as in the past because so many consumers have so much debt already. However, easy monetary conditions are a lifeline to zombie companies, enabling them to raise funds to stay in business and add to global supplies of goods and services, which is deflationary.
Inflation IV: By the Numbers. Now let’s review the latest inflation data around the world. Inflation remains remarkably subdued, as it has been since the mid-1990s. Consider the following:
(1) G7. The core CPI inflation rate among the seven major industrial economies has fluctuated in a flat range between a high of 2.2% and a low of 0.7% since 1997 (Fig. 9). The core rate was only 1.1% during October. Here are the latest core CPI inflation rates for the US (1.6%), Eurozone (0.2), and Japan (-0.4) (Fig. 10).
(2) China. While China’s economy has staged a significant recovery from its lockdown recession at the start of the year, the CPI inflation rate dropped from a recent peak of 5.8% during February to only 0.5% during October. The Producer Price Index was down 2.1% y/y during October.
(3) US. The pandemic has had a dramatic inflationary impact on only one component of the CPI: Used car and truck prices are up 11.5% y/y through October (Fig. 11). (They are up 14.4% in the PCED, or personal consumption expenditure deflator, measure.) This is a category with little weight in the CPI.
Rent of shelter has a much bigger weight, and its inflation rate has been falling sharply as a result of the pandemic because of two phenomena: people unable to pay their rent and renters becoming homeowners. This CPI item’s inflation rate is down from 3.4% at the start of the year to 2.1% during October (Fig. 12). It does include hotel and motel fees, which should reflate once a vaccine is widely distributed.
Inflation V: Bonds, the Dollar & Commodity Prices. Notwithstanding all the above, the financial markets seem to be signaling that inflationary pressures are making a comeback of sorts. More likely, in our opinion, is that they’re simply signaling that the deflationary pressures initially unleashed by the pandemic are abating as the global economy continues to recover. Consider the following:
(1) Expected inflation rebounds. The 10-year US Treasury bond yield has been relatively flat just below 1.00% recently, while the comparable TIPS yield has been edging lower again following a smallish and shortish rebound from its fall earlier this year (Fig. 13). As a result, the yield spread between the two, which is widely used as a proxy for the average annual 10-year expected inflation rate, has rebounded from this year’s low of 0.5% on March 19 to 1.9% on Monday (Fig. 14).
(2) Copper is red hot. The price of copper has rebounded dramatically along with China’s economy as auto sales in China rose for a fourth straight month in October. The price of the red metal is up 65.5% since the year’s low on March 23 from $2.12 per pound to $3.51 on Monday (Fig. 15). The two previous rebounds that exceeded the current one since 2004 were not associated with rising CPI inflation.
Meanwhile, the ratio of the nearby futures prices of copper to gold continues to signal that the bond yield should be closer to 2.00% than to 1.00% (Fig. 16). There’s been a tight fit between the ratio (multiplied by 10) and the yield since 2004. Without the Fed’s open market purchases of Treasury notes and bonds, the yield would probably be higher, boosting the expected inflation proxy over 2.00%.
By the way, the reason why the copper/gold ratio tracks the nominal yield so closely is that the price of copper is highly correlated with the yield spread inflation proxy, while the price of gold is highly correlated with the inverse of the 10-year TIPS yield (Fig. 17 and Fig. 18).
(3) The dollar’s descent. Yet another interesting set of correlations is the ones between the inverse of the dollar versus the price of copper and versus expected inflation (Fig. 19 and Fig. 20). All three variables are consistent with rising inflation pressures. However, similar past episodes in recent years signaled that deflationary pressures were abating rather than inflation rebounding.