Inflation Inevitable as Fed Since Volcker Has Become Increasingly Dovish

By the Curmudgeon with Victor Sperandeo

Introduction:

Inflation is a quantitative measure of how quickly the price of goods in an economy is increasing. Inflation is caused when goods and services are in high demand, thus creating a drop in availability and upward pressure on prices. Higher levels of inflation can be dangerous for an economy as it causes prices of goods to rise to quickly, sometime in excess of wage increases. Conversely, inflation is good for debtors, like the U.S. government or student loan holders, because the debt is repaid with cheaper dollars.

For many years, inflation has come in below the Fed and other central bank targets of about 2%. Will that continue indefinitely as many believe?

In this post we assess the outlook for inflation as perceived by financial markets, gold, the Fed’s “no worry” approach, China’s role in keeping inflation low (which might be changing), and if the Fed will control inflation if it starts to increase rapidly.

Victor provides several points of order on U.S. government published inflation statistics and comments on why Gold prices have been weak. He sums it all up with a book excerpt which shows how a nation can create wealth, which is the opposite of the Fed’s monetary policies over the last 12+ years.

The Case for Continued Low Inflation:

Financial markets certainly do not foresee an inflation comeback. A Fed index of 5 year forward inflation-sensitive notes suggests investors expect inflation of 1.91% in 2026, below the Fed’s 2% inflation target. That expectation is up considerably from 0.86% on March 18, 2020 at the onset of the coronavirus pandemic, but it’s still below (by ~ 30 to 35 bps) where it was three years ago.

Meanwhile, gold futures (GCJ1) closed Friday at $1733 per ounce, DOWN -$ 42.4 (-2.39%) on the day. According to the Gold Price website, Gold’s recent peak was on January 5^th at $1951.34. It’s down $218 or 11.7% in the seven weeks since then. Gold is viewed as an inflation hedge, as it has historically risen in advance of accelerating inflation. The yellow metal should not be in its current downtrend if inflation were to appear anytime soon. More on why Gold prices are weak in Victor’s comments below.

Also, major industrial economies remain burdened by idle capacity and high unemployment, which are usually deflationary signs. Slack in the economy must disappear before inflation can take hold.

Acting as an outlier, global bond market yields have been rising sharply, perhaps anticipating inflation or at least more credit demand which might overwhelm bond buying binges by global central banks that might be reduced earlier than previously anticipated.

JP Morgan Asset Management estimates that the combined central bank and government stimulus measures already totaled $20 trillion last year, or more than a fifth of global economic output. Several economists now fret that the additional $1.9 trillion spending package prepared by the Biden administration may overheat the U.S. economy and reignite inflation.

Yet most analysts and investors stress that even with inflation likely to accelerate in 2021, it will prove a fleeting phenomenon, and not something that will pose a serious, longer-term challenge to fixed income markets.

While the recent rise in yields has been notable for its speed and power, bond yields remain astonishingly low by historical standard. Indeed, most REAL global bond yields are negative across the maturity spectrum. Nonetheless, some investors now believe yields have moved too far, too fast and are now stabilizing. That would agree with the topping out in U.S. inflation indexed notes and bonds, e.g., TIPs.

What Me Worry?

The U.S. Federal Reserve is surely not worried about inflation. Fed Chair Jerome Powell told the House Financial Services Committee on Wednesday that the central bank will maintain ultra-low interest rates and continue hefty asset purchases $120B per month) until “substantial further progress has been made” toward its employment and inflation goals. He said those goals are “likely to take some time” to achieve.

Powell said the Fed doesn’t foresee raising its benchmark fed-funds rate from near zero until three conditions are met: a broad range of statistics indicate that the labor market is at maximum strength, inflation has hit its 2% target, and forecasters expect inflation to remain at that level or higher.

“We’ve shown that we can, over the course of a long expansion, we can get to low levels of unemployment, and that the benefits to society—including particularly to lower and moderate-income people--are very substantial,” Mr. Powell said Wednesday.

The Fed reflected that new focus last August when it made a major shift on how it sets interest rates by dropping its longstanding practice of preemptively raising them to stave off higher inflation as the economy strengthens. The Fed said that under the new approach it wouldn’t raise interest rates until inflation had reached 2% and was on track to moderately exceed that target for some time, to make up for previous shortfalls. Victor and I provided our assessment of that new Fed policy in Sperandeo/Curmudgeon: Will the Fed’s New Monetary Policy Stimulate the Economy and Inflation?

While the Fed expects inflation to rise this year, Mr. Powell said Wednesday that he wouldn’t expect inflation to reach “troubling levels” and wouldn’t expect any increase in inflation to be large or persistent. But what if Powell and the financial markets are wrong about future inflation?

On Friday, the Commerce Department reported that household income—the amount Americans received from wages, investments, and government programs—rose 10% in January from the previous month, said Friday. The increase was the second largest on record, eclipsed only by last April’s gain, when the federal government sent an initial round of pandemic-relief payments. Household income has risen 13% since February 2020, the month before the pandemic shut down large segments of the economy. And there’s another $1.9 trillion pandemic aid package, passed by the House of Representatives and sent to the Senate for its approval.

Up till now, most of the pandemic aid received by consumers has gone to paying down debt or savings. Household savings totaled $3.9 trillion last month, up from $1.4 trillion last February. A fair amount of stimulus aid was used to speculate in financially weak stocks touted on Reddit, Twitter, and other social media. However, that may change as there is a lot of pent-up spending demand waiting for the U.S. economy to open when lock downs end. Consumer spending is the biggest factor behind growth in the U.S.

Joseph Brusuelas, chief economist at RSM US LLP, said, “You’re going to see the fuel for a pretty big consumer-led boom this year, which will spill into next.” He expects the economy to grow 6.5% or more this year.

“People are going to travel more,” Lydia Boussour, senior economist at Oxford Economics, says. “They’re going to go back to restaurants and bars, they’ll go back to the gym—all the things they basically were not able to do before the pandemic. This is where you will really see a burst in spending,” she added.

Seth Carpenter, chief U.S. economist at UBS, envisages only a short-lived inflation burst. He thinks spending on services will surge as lock downs end. However, spending on goods will probably fall as people choose to visit restaurants and do less shopping online. Furthermore, much of the additional stimulus cash coming into households will go to repaying overdue debts, Carpenter told the Financial Times.

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China’s Role in Global Inflation:

There may be another factor at work to stimulate inflation. A provocative new book by British economists Charles Goodhart and Manoj Pradhan, “The Great Demographic Reversal: Aging Societies, Waning Inequality, and an Inflation Revival,” suggests that structural trends may push the global economy back toward an inflationary environment. The authors contend that the fundamental cause of low inflation for the past several decades was the rise of China, with its vast population of low-wage workers, and that country’s integration into global commerce.

Everyone knows that Apple has been making iPhones in China (via Foxconn) for years, but few people realize the HUGE amount of other electronics and computers that have been imported from China. In 2018, the total U.S. trade deficit with China was $419.5 billion—$168.2 billion of which was in computer and electronic parts. The Curmudgeon was surprised to learn that the control board of his Whirlpool oven was made in China and there were no other suppliers!

China’s working-age population is rapidly shrinking, which portends relative labor scarcity, rising wages, and a corresponding increase in worker bargaining power. While higher wages may mean less inequality, Goodhart and Pradhan argue, they also threaten to rekindle the wage-price spiral that was prevalent from the late 1960s to 1980. Equally alarming is that the British authors believe that the Fed’s tools to combat inflation may be ineffective or too little too late.

Will the Fed Raise Rates to Control Inflation?

The Congressional Budget Office (CBO) estimates the federal budget deficit will be $2.4 trillion this year under current spending law, and the Biden Administration’s $1.9 trillion stimulus bill would push it past $4 trillion. Courtesy of Modern Monetary Theory (MMT), many now believe that the amount of U.S. government spending and debt doesn’t matter when interest rates are at historic lows and the Fed is buying government debt for “as long as the eye can see.” But the risk is that rising rates or inflation will blow up this Pollyanna scenario.

Who cares if the Fed’s balance sheet is approaching $8 trillion? Powell essentially told Congress that the Fed bill buy U.S. Treasuries and Mortgage-Backed Securities (MBS’s) indefinitely to keep interest rates low in order to stimulate the economy. That despite numerous rounds of QE that have failed to increase GDP to above 3.1% trend growth.

This means the main justification for the Fed’s bond purchases isn’t to help households or the economy. The purpose is, in reality, to finance the debt required by record U.S. federal government spending and prop up/backstop financial markets. Otherwise, interest rates might spike if demand for Treasury debt falls around the world. But Chairman Powell can’t say this candidly without embarrassing Congress and calling into question the Fed’s independence.

The bottom line here is that the Fed has apparently given up on its first mandate, which is to control inflation to achieve price stability. If for any number of reasons inflation starts to accelerate, don’t expect the Powell led Fed to slam on the brakes with higher rates or tapered bond purchases. Each Fed Chair since Greenspan seems to be more dovish than his or her predecessor!

As we’ve stated many times, money velocity must increase (it’s now at an all-time record low as per Victor’s comments below and many previous Curmudgeon posts) before there are any price pressures in the economy. When an economy grows above trend, which hasn’t happened in the U.S. since the “great recession” ended in June 2009, consumer spending and money velocity both increase, which causes prices for goods and services to rise soon thereafter.

Points of Order (Victor):

The U.S. government reported statistics are often misleading to make the economy look better than it actually is. A great example is the CPI “core inflation” numbers which exclude food and energy prices. Does that imply you don’t have to eat, pay for gas or electricity? Aren’t those CORE expenses?

For reasons never articulated, the U.S. debt is reported as “debt in the hands of the public” rather than “TOTAL stated debt.” Also never discussed in typical reporting is “off balance sheet debt and unfunded liabilities.” As of 2/17/21 inter-governmental debt was $ 6.1 trillion and public debt was $21.8 trillion, with total debt $27.9 trillion! But the $ 6.1 trillion debt for social security is dropped off.

This begs the question of how does the U.S. Bureau of Labor Statistics (BLS) define inflation? In the August 2008 BLS Monthly Labor Review, an article titled: “Common Misconceptions About the CPI” reveals how the BLS calculates the CPI: “The CPI’s objective is to calculate the change in the amount consumers need to spend to maintain a constant level of satisfaction.”

The key words here are “need” and “satisfaction.” I guarantee my needs and satisfaction are different than Lady Gaga or John Kerry’s and are different than yours! There is a no one size fits all definition for this type of inflation index!

The implication here is that the BLS makes up how consumers SHOULD spend their money, in order to calculate a “cost of living index” (e.g. the CPI). So, there’s a lot of guesswork by the BLS bureaucrats in the reported CPI numbers which don’t measure a constant and continuous cost of a fixed basket of goods and services.

→ In other words, the CPI is a sham and worthless today on what inflation is in terms of price increases.

The Fed uses the Personal Consumption Expenditures (PCE) for inflation targeting. To no one’s surprise, it is always lower than the CPI. As per research from the Cleveland Fed, prices have increased by 39% as per CPI and 31% as per PCE since 2000.

What is Inflation? (Victor):

In the purest sense, inflation is an increase in the money supply (M2), as defined by the Austrian School of Economics. Any increase in prices is dependent on the velocity of money, i.e., the turnover of M2 per year. The velocity of money has crashed in the last 23 years -- from 2.2 to 1.1 (see graph of FRED Velocity of M2).

With the collapse in money velocity, government stated inflation has declined. It is still very low at 1.71% per year for the last 10 years (seasonally adjusted) using the CPI HEADLINE RATE. The projected CPI is still acceptable to the “money printers” before the Fed raises short term rates.

As the Fed stated, it will allow inflation to rise without increasing short term interest rates to balance the low years and average the price increases. That then begs the question of why the Fed’s inflation target is 2% when their mandate is “price stability?”

Victor on Gold:

To the surprise of many, Gold prices have been declining recently. The yellow metal has been weak, along with the Yen, Bonds and Notes. Those are all “Risk Off” assets. It’s been “Risk On” since the November U.S. elections with expectations for trillion-dollar stimulus packages, economy opening up, and continued Fed bond buying. That makes defensive assets like gold decline, as investments instead go into Bitcoin, equities, risky bonds, collectibles, and commodities – all of which are in demand as the economy strengthens. Goldman Sachs is in the “Risk On” camp. The investment bank is now forecasting 7% nominal GDP for the year. They don’t mention inflation. Why not?

Also, the risk of defaults by renters and mortgage borrowers, especially in Commercial Real Estate is a huge deflationary risk and may come sooner rather than later. That deflationary risk might also be contributing to gold’s price weakness.

Victor’s Conclusions:

The Fed’s 2% inflation target is a sham. Inflation kills the lower and middle class and is the reverse of creating wealth. The inflation created by the Fed is in financial assets which have further enriched the wealthy at the expense of everyone else.

Here’s a relevant excerpt from “The Wealth of Nations"—first published on March 9, 1776 by Adam Smith, a Scottish moral philosopher:

"That state is opulent where the necessaries and conveniences of life are easily come at. ...To talk of the wealth of nations is to talk of the abundance of its people. Therefore, whatever policy tends to raise the market price (of the necessaries and conveniences) diminishes public opulence and the wealth of the state, and hence it diminishes the necessaries and happiness of people."

Written 245 years ago, it clearly states why “Nations” become wealthy. It is the “exact opposite” policy formula of the Fed’s seemingly never-ending rounds of QE and the income inequality it created.

End Quotes:

“The more dovish central banks are, the more money they pump into the system, the more dependent markets become on that money to maintain high valuations.” Matt King, Citi Group investment strategist.

“At some point — and it may be now — there will be a capitulation, yields will have gotten too high, and the relentless weight of the bond purchases from the central banks will stabilize the market,” he says. “The asset purchases are relentless. You can’t fight that.” Robert Michele, chief investment officer at JPMorgan Asset Management

“The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation.” Vladimir Lenin.

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Stay calm, be well, persevere, and till next time……………………………………...

The Curmudgeon
ajwdct@gmail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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