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The Fed’s Nemesis Returns

The one economic factor that western countries have been able to comfortably ignore for years is inflation.  Since the early 1990s, when globalization began to spread, secular downward pressure has been imposed on prices of goods, commodities, and wages.  Low inflation has become a benign factor for investors and policymakers alike.

It wasn’t always this way, of course.  U.S. inflation reached it most recent peak over 40 years ago.  1979 and 1980 saw consumer inflation rates of 13.3% and 12.5% respectively, as the effects of Viet Nam war spending, OPEC’s oil price hikes, and labor’s increasing wage demands combined to create a price spiral from both the demand and supply side.  It took the forceful, but unpopular, actions of Fed chairman Paul Volcker to break the embedded psychology of inflationary expectations by raising the Fed funds rate to 20% and allowing 30-year T-Bond yields to rise to over 15%.

From those grim days for borrowers we have come full circle to the point of overcapacity and glut in many industries, which had pushed inflation down to less than 1% in 2014-15.  Not coincidentally, that period saw major lows in bond market yields which were not exceeded until the pandemic rush for safe harbor assets just a year ago.

We have long asserted that inflation in recent years was most obviously occurring in paper assets, such as stocks or bonds, while makers of consumer goods struggled to retain any pricing power.  But in recent months the costs of industrial goods, packaging, food, and transportation have made an undeniable leap higher.  Recent surveys of manufacturers almost universally cite rising costs, and less availability, of raw materials as current problems, confirming the surge in demand as the economy recovers from the pandemic.  Moreover, producers are imposing price hikes, which are sticking, in contrast to recent decades when ruinous price wars were the norm.  Suddenly, consumer inflation is back on the radar screen, and inflation expectations are awakening.

Why is this happening now?  After all, the Federal Reserve has been trying to spur inflation since 2009 through various iterations of “quantitative easing” (QE) policies.  In the wake of the 2007-08 mortgage market debacle, they cranked up the money printing presses, yet consumer prices remained quiescent.

One answer may be in the sheer scale of the Fed’s pandemic response, which dwarfed all previous QE efforts in size and time.  As the economy shut down a year ago, the Fed created over $1.6 trillion in bank reserves just from February to May.  This money finds its way into the system with a lag time of a few quarters.  That typical lag, combined with widening vaccination, and the fact that we had little to spend on in the early days of the pandemic, mean that high savings and pent-up demand are colliding right now to create a demand-inspired rise in prices.

The other catalyst for resurgent inflation is the way QE is distributed.  From the time the Pandora’s box of QE was opened by Fed chair Bernanke in 2009, dollars that were electronically “printed” went into the banking system.  It was thought that banks, flush with the Fed’s cash and needing to earn a return, would lend the funds widely and thus spur demand by feeding consumer borrowing.  That only partly worked, as banks, burned by their experience with sub-prime borrowers, were content to let marginal quality consumer borrowers go wanting, and focused on their gilt-edged clients instead (including Wall Street).  With this lending restraint, much QE money ended up stuck in the banking system, unable to create the Fed’s hoped-for inflation.

The key difference in the last year is that the government has discovered “helicopter money.”  Coined by economist Milton Friedman when he wrote a parable of dropping money from a helicopter to illustrate the effects of monetary expansion, helicopter money has always remained theoretical until the pandemic struck.  It became a reality with the first round of $1200 checks sent to every household in April 2020, followed by a second round in January 2021, and a third payment this March.

Thus, the fuel for inflation was sent directly to consumers who wasted no time in spending it.  No loan applications, no strings attached, just a cash injection to do with what we liked.  By using direct deposit and bypassing the banks, the Fed dramatically increased the efficiency of QE, and got the inflationary surge it has long sought.

The Fed continues to assert that current inflationary pressures are “transitory,” and that there is no need to fret about raising the short-term rates they control.  In public comments, Chairman Powell and others have pledged to keep rates low until 2023, much to stock buyers’ delight.

But bond investors see things differently, and their reaction implies a more persistent period of inflation is ahead.  Bond yields rose (bond prices fell) markedly in the first quarter as the economic tone improved and the government stimulus spigot was opened wide.  Accelerating inflation has become less anecdotal and far more widespread, leading investors to bid up yields to compensate for holding fixed income investments.

This may soon put the Fed in a quandary.  They are loath to raise rates for fear of short-circuiting the pandemic recovery.  Having access to extremely cheap and plentiful financing has been a hallmark of the U.S. recovery since 2009.  But the suppression of interest rates the Fed has engineered has become addictive for businesses, consumers and Wall Street, and there are fears about how the economy and financial markets would react to a return to a (mostly) market-based yield structure.

It is no secret that the recovery since 2008 has been built on a debt binge, with government, businesses, and Wall Street borrowed up to the hilt.  Rising interest rates will make managing this debt more difficult, but it is hard to see how overleveraged institutions will be able to avoid it.  Recent months have witnessed the collapse of three hedge funds directly due to their high leverage.  Greensill (UK), Melvin Capital, and Archegos all made highly leveraged bets on companies, and when just a few of those went sour, the entire edifice caved in due to margin calls that could not be met.  Wall Street’s “cockroach theory” states that when one firm runs into trouble, it is usually not isolated.  Like cockroaches, more problems are hidden in the cupboards.  Inflation and rising interest rates may soon reveal who those problematic firms are.

Perhaps the Fed wants inflation, for a more cynical reason.  Inflation has been a time-honored way for governments to manage their debt burdens by paying back debt in cheaper dollars.  During inflationary times, the “real” (i.e. inflation-adjusted) value of a currency falls, as it costs more “dollars” to buy the same goods as previously.  Consumers are losers under inflation as their purchasing power falls.  But debtors gain under inflation, because they are able to pay back debts in cheaper “real” dollars.  Repayments (interest and redemptions) are made in fixed “nominal” dollar amounts, but the “real” value of those payments is falling.  Thus, it is in the federal government’s interest to have high inflation, as it eases the “real” debt burden.  Total U.S. federal debt now stands at 129% of GDP ($27.7 trillion), and looks to go higher under Biden’s ambitious spending plans.  There is no way this gargantuan level of debt can be paid off in the conventional sense.  The only practical way to bring this debt to more manageable levels is through inflation. We should expect to see policymakers to embrace inflation, even though they will publicly denounce it.

Finally, we should not forget the social implications of higher inflation.  Over history, periods of high inflation have also been periods of social unrest.  This is not surprising, as the reduced ability to make ends meet and feed one’s family can lead to desperate reactions.

While Wall Street’s one-percenters can conveniently sweep these concerns under the rug, the mayors of most American cities cannot.  For the bottom half of the population, perhaps living paycheck to paycheck with little savings in the bank, inflation looms as a large threat.  “Real” wages have been under pressure for over thirty years, and labor’s only saving grace over that time has been low or falling inflation.  If we have an inflationary period lasting several years, this could push people who are just barely getting by over the edge.  We got a taste of this last summer, when, catalyzed by demands for racial justice, America’s cities were wracked by violent protests.  Similarly, if people feel they have nothing left to lose, and inflation is robbing them of their purchasing power, social unrest may follow.

Housing may provide the flashpoint for social discord.  It is no secret that home prices are rising at the fastest pace ever seen, with consistent low teens percentage increases.  The current US median home price is $346,800, with wide regional variations, of course.  The chart below indexes median home prices and the consumer price index to 100 at 6/30/2008 for comparability.  Home prices have far exceeded the CPI over the last 13 years, by about 24%.

Homeowners are rejoicing, of course, but young homebuyers are increasingly being shut out of the market unless they’re willing to take on an enormous mortgage.  Apartment rents are also high, and have been rising significantly over the last decade.  Now imagine the day when the eviction moratoriums are lifted, and landlords get to work booting out the tenants that have been unable to pay rent during the pandemic.  Where will the evictees go?  Finding another apartment will be difficult (especially with an eviction on their credit report), and buying even a simple house is out of reach.  Will we see a surge in homelessness?  Will we see a rise in protests?  This scenario paints a plausible way for housing inflation to lead to social unrest.

The Fed is at risk of losing their hard-won reputation as inflation fighters by committing to their current low interest rate policy.  Ironically, the Fed, whose primary mandate is to promote price stability, is a key catalyst for making inflation accelerate, and their reluctance to even consider raising rates in respect of the changing environment smacks of hubris.  Their QE policies have encouraged the layering of debt upon debt, and now they are faced with the dilemma of how to control inflation without toppling the debt-based house of cards they helped build.

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