Will a recession kill inflation?

There is plenty of evidence to suggest that recessions cause a sharp fall in the consumer price index. Alfonso Peccatiello recently analyzed US recessions over the past century and concluded that they caused an average drop in CPI of 6.8%.

MacroAlf: CPI & Recessions

A recession no doubt reduces inflation but it does not necessarily kill underlying inflationary pressures. It took massive pain inflicted by the Volcker Fed in the early ’80s to reverse the long-term up-trend in inflation. Average hourly earnings (gray) is a better gauge of underlying inflation as can be seen on the graph below.

CPI, Average Hourly Earnings & Recessions

Recessions cause a fall in earnings growth but do not interrupt the underlying trend unless the economy is administered a severe shock. In the early 1980s, it took four recessions in just over a decade, a Fed funds rate (gray below) peaking at 22% in December 1980, and unemployment (blue) spiking to 10.8%.

Fed Funds Rate & Unemployment

In the current scenario, we have had one recession, but cushioned by massive fiscal stimulus and Fed QE. Another recession would be unlikely to break the up-trend in underlying inflation unless there is a sharp rise in unemployment.

A study by Larry Summers and Olivier Blanchard maintains that unemployment will have to rise above 5% in order to tame inflation. The chart below suggests that unemployment may need to rise closer to 10% — as in 1982 and 2009 — in order to kill underlying inflationary pressures.

Unemployment(U3) & Average Hourly Earnings Growth

Conclusion

We are not suggesting that the Fed hike rates sufficiently for unemployment to reach 10%. That would cause widespread destruction of productive capacity in the economy and take years, even decades, to recover. Instead, we believe that the Fed should tolerate higher levels of inflation while Treasury focuses expenditure on building infrastructure and key supply chains, to create a more robust economy. Largely in line with Zoltan Pozsar’s four R’s:

(1) re-arm (to defend the world order);
(2) re-shore (to get around blockades);
(3) re-stock and invest (commodities); and
(4) re-wire the grid (to speed up energy transition).

An early Fed pause, before inflation is contained, would drive up long-term yields and weaken the Dollar. The former would cause a crash in stocks and bonds and the latter would increase demand for Gold and other inflation hedges.

A weaker Dollar would make US manufacturing more competitive in global markets and reduce the harm being caused to emerging markets. Unfortunately, one of the consequences would be higher prices for imported goods, including crude oil, and increased inflationary pressures.

The US Fed and Treasury are faced with an array of poor choices and in the end will have to settle for a strategy that minimizes long-term damage. In an economic war as at present, higher inflation will have to be tolerated until the war is won. An added benefit is that rapid growth in nominal GDP, through high inflation, would reduce the government’s precarious debt burden.

Federal Debt/GDP

Acknowledgements

Alfonso Peccatiello for his analysis of CPI and recessions.

CPI shock upsets markets

The consumer price index (CPI) dipped to 8.25% (seasonally adjusted) for the 12 months to August but disappointed stock and bond markets who were anticipating a sharp fall.

CPI

The S&P 500 fell 4.3% to test support at 3900. Follow-through below 3650 would confirm earlier bear market signals.

S&P 500

Services CPI — which has minimal exposure to producer prices and supply chains — climbed to 6.08%. Rising services costs indicate that inflation is growing embedded in the economy.

CPI Services

Fueled by strong growth in average hourly earnings.

CPI & Wage Rates

But it is not only services that present a problem.

Food prices are growing above 10% p.a. — signaling hardship for low income-earners.

CPI Food

The heavily-weighted shelter component — almost one-third of total CPI — climbed to 6.25%. We expect further increases as CPI shelter lags actual home prices — represented by the Case-Shiller 20-City Composite Home Price Index (pink) on the chart below — by 6 to 12 months.

CPI Shelter

CPI energy is still high, at 23.91% for the 12 months to August, but the index has fallen steeply over the past two months (July-August).

CPI Energy

The decline is likely to continue until the mid-term elections in November, as the US government releases crude from its strategic reserves (SPR) in order to suppress fuel prices.

SPR Levels

The reduction in strategic reserves is unsustainable in the longer-term and reversal could deliver a nasty surprise for consumers in the new year.

SPR Lowest since 1984

Conclusion

Strong CPI growth for the 12-months to August warns that inflation will be difficult to contain. Services CPI at 6.08% also confirms that inflation is growing embedded in the economy.

Energy costs are falling but this may be unsustainable. Releases from the strategic petroleum reserve (SPR) are likely to end after the mid-term elections in November.

The Fed is way behind the curve, with the real Fed funds rate (FFR-CPI) at -5.92%, below the previous record low of -4.97% from 1975.

Real Fed Funds Rate (FFR-CPI)

We expect interest rates to rise “higher for longer.” A 75 basis-point hike is almost certain at next weeks’ FOMC meeting (September 20-21).

Long-term Treasury yields are rising, with the 10-year at 3.42%. Breakout above resistance at 3.50% is likely, signaling the end of a four decade-long secular bull trend in bonds.

10-Year Treasury Yields

Stocks and bonds are both falling, with the S&P 500 down 18.0% year-to-date compared to -25.4% for TLT.

S&P 500 and iShares 20+ Year Treasury ETF (TLT)

The best short-term haven is cash.

Larry Summers: Fed needs same disinflation as under Volcker

Larry Summers highlights a paper from the NBER regarding measurement of CPI since the 1980s. Changes in how cost of housing is measured have lowered core CPI relative to the methodology used prior to the early 1980s (blue line below). Applying the current methodology (red line) retrospectively suggests that comparable core CPI is closer to the Volcker era.

Larry Summers

Summers continues:

“New paper shows past and present CPI inflation are more similar than official data suggests. When correcting for change in how housing inflation is measured, we find a return to target core inflation will require the same disinflation as achieved under Volcker.”

Services inflation

A friend asked a question: “Our advanced economies are 70 – 80 % Services based these days; so will this make CPI inflation difficult to sustain if wages growth is not sustained.”

The answer is YES. Inflation is unlikely to be sustained if wages growth declines.

BUT wages growth is accelerating, not declining, both in the services sector and in the broader economy.

Average Hourly Wages Growth: Total Private & Services Sector

Wages growth is also not likely to decline while we have record job openings; 5.4 million in the services sector alone.

Job Openings: Services Sector

Employers are having to offer higher wages and sign-on bonuses to attract workers — the result of record high savings levels fueled by government stimulus.

M2/GDP

David Woo: Prelude to volatility

The bond market had a heart attack last week. Rising inflation caused a massive back up in bond yields in the short end of the market. The market is now pricing in two rate hikes in 2022. The Fed will have to raise real interest rates in order to tame inflation.

Real interest rates are falling. The stock market is taking its cue from the bond market and is rising. Stock prices represent discounted future cash flows, so negative real interest rates make a big difference to earnings multiples.

The Democrats are determined to spend their way to a mid-term election victory, with a $1T infrastructure bill and $1.75T social spending, both light on tax revenue. The GOP will try to stop them when the debt ceiling issue returns in December but they don’t have much leverage.

Financial conditions will have to tighten a lot more in 2022. The Fed is way behind the curve and is going to have to play catch-up.

Conclusion

Inflationary pressures in the US economy are growing, while the Democrats plan a further $2.75T in fiscal stimulus which is light on tax revenues.

Long-term yields lag far behind inflation, with real interest rates growing increasingly negative. The assumption is that the Fed will tighten sharply in 2022 to curb inflation. We expect that the Fed will taper but is not going to rush to hike interest rates for three reasons:

  1. The Fed would be tightening into a slowing economy, with growth fading as stimulus winds down;
  2. High energy prices will also help to cool demand; and
  3. US federal debt levels — already > 120% of GDP and likely to grow further with proposed new stimulus measures — are a greater long-term threat than inflation. The Fed and Treasury are expected to work together to boost GDP and tax revenues through inflation, keeping real interest rates negative to alleviate the cost to Treasury of servicing the excessive debt burden.

Labor market turmoil

Pundits are wringing their hands about the poor jobs report, with +266K of new jobs in April compared to 1M estimated. Non-farm jobs recovered to 144.3 million in April, compared to 152.5m in Feb 2020, a shortfall of 5.4%.

Non-farm Payroll

Hours worked has done slightly better, at 5.05 billion in April, compared to 5.25bn in Feb 2020, a shortfall of 3.8%.

Real GDP and Hours Worked

The rate of increase (in hours worked) slowed significantly from March 2021, but that is to be expected. It will be difficult to match the recovery rates achieved at the re-opening and we suspect that the +1m new jobs estimate for April was over-optimistic.

Increase in Hours Worked

Manufacturing

Manufacturing jobs are not fully recovered either, at 12.3m in April, a 4.0% shortfall from the 12.8m in Feb 2020. But manufacturing production in March 2021 (104.3) was only 1.7% below its Feb 2020 reading and is expected to close the gap even further in April. A sign that productivity is improving.

Manufacturing Jobs & Industrial Production

Average hourly wage rates continue to grow between 2.5% and 3.5% (YoY). A sign that employers are able to fill job openings.

Manufacturing Hourly Wage Rates

Job Openings

Outside of manufacturing, job openings are growing. A sign that wage rates are likely to follow.

Job Openings

We suspect that job openings are concentrated in low paid jobs where the pandemic and higher unemployment benefits are likely to have the most impact on participation rates.

Low Participation

Low Participation

Unemployment Benefits

Bond Market

After momentary panic, the bond market seems to have decided that the weak jobs report is a non-event and unlikely to reduce inflation or require increased Fed intervention. The 10-year Treasury yield dropped to 1.525% in the morning but recovered to 1.572% by the close.

10-Year Treasury Yields

Conclusion

The labor participation rate has been declining for 20 years and the COVID-19 pandemic may have accelerated the decline. Participation rates may never fully recover to pre-pandemic levels.

Declining Labor Participation

But as long as the difference is made up by rising productivity (output/jobs), boosted by increased automation, then the economy is expected to make a full recovery.

Manufacturing Production/Jobs

Higher unemployment benefits and a lower participation rate are likely to drive up wages for unskilled jobs, while de-coupling from China and on-shoring of critical supply chains is expected to lead to skills shortages, driving up wages for higher-paid employees. The Fed will be reluctant to increase interest rates to cool the economic recovery, allowing inflation to rise.

When the (inflation) train starts to roll, it is difficult to stop. Sharp pressure on the (interest rate) brake is then required, but would cause havoc in bond and equity markets.

Inflation is baked into the cake

Inflation is a hot topic at the moment. For good reason: higher inflation would drive up interest rates, affecting both bond and equity prices, as well as commodities and precious metals.

March CPI jumped to 2.64% but the increase is partly attributable to the low base from March 2020. Core CPI (excluding food and energy) came in at a more modest 1.65%. The main difference between CPI and core CPI is rising energy and food costs.

CPI & Core CPI

The annual inflation rate in the US ……is the highest reading since August of 2018 with main upward pressure coming from energy (13.2% vs 3.7% in February), namely gasoline (22.5% vs 1.6%), electricity (2.5% vs 2.3%) and utility gas service (9.8% vs 6.7%). Prices also accelerated for used cars and trucks (9.4% vs 9.3%), shelter (1.7% vs 1.5%) and new vehicles (1.5% vs 1.2%) while inflation slowed for medical care services (2.7% vs 3%) and food (3.5% vs 3.6%). Cost of apparel continued to fall (-2.5% vs -3.6%)……..a jump in commodities and material costs, coupled with supply constraints, are pushing producer prices up and some companies are passing those costs to clients. (Reuters)

10-year Treasury yields eased to 1.62% with the breakeven inflation rate at 2.33% — weakening the real 10-year yield to -0.71%.

10-Year Treasury Yield & Breakeven Inflation Rate

Inflation and the Money Supply

Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

CPI & M2 Money Supply

But experience since the 1980s shows several surges in money supply growth without a corresponding rise in inflation. While an increase in money supply may be a prerequisite for a spike in inflation, it is not the cause.

More direct causes of inflation are increases in input costs for suppliers of goods and services. The two largest input costs are commodities and wages. Rises in commodity prices will mostly affect the manufacturing sector, while increases in wage rates impacts on all employers. Also, commodity prices tend to be cyclical, so price fluctuations will be more readily absorbed, while wage increases tend to be permanent and more likely to be passed on to customers.

The chart below shows a much closer correlation between hourly wage rates and CPI since the 1970s, with surges in hourly earnings accompanied by a rise in inflation.

CPI & Hourly Manufacturing Wages

Conclusion

Rising commodity prices are driving higher inflation at present. While some of the pressures may be transitory, due to supply interruptions, underinvestment in new production over the last decade is likely to act as a supply constraint for both energy and base metals. Rising demand fueled by short-term stimulus and longer-term infrastructure investment would act as an accelerant.

Wage rate increases are so far restrained, but that is likely to change as the economy recovers, boosted by decoupling from China and on-shoring of critical supply chains. Shortages of skilled labor are expected to drive up wage rates, maintaining upward pressure on inflation in the longer-term. Training and education of suitable staff will take time.

We have all the ingredients for an inflation spike. A massive boost in the money supply, accompanied by record stimulus payments, much of which has been channeled into savings. This will help to fuel increased demand in the longer term, while restricted supply will drive up commodity prices and wage rates for skilled labor.

Modern Monetary Theory (MMT)

A reader asked me to explain MMT. I am not an economist and will try to avoid any jargon.

The basic tenet of MMT is that government has the power to reduce unemployment by increasing stimulus spending. Government spending in excess of tax revenues (a deficit) is funded by an increase in public debt. Deficits are likely to cause inflation but MMT holds that inflation can be reduced by raising tax revenues.

Problem with Lags

There is normally a lag between an increase in debt and the resulting increase in inflation. If you wait for inflation to rise before raising taxes, underlying inflationary pressures have already built and will be hard to contain.

There is also likely to be a lag between raising taxes and a resulting fall in inflation. This means that authorities will keep raising taxes for longer, causing an eventual contraction in employment.

The second problem is that it is far easier to increase government spending than it is to raise taxes. Voters seldom object to an increase in public spending but are likely to punish any government that increases taxes. This is likely to make the lag between identifying inflation and raising taxes even bigger.

Third, regular increases in government spending followed by tax increases (to subdue inflation) are likely to ratchet up government spending relative to GDP. Rising levels of public spending followed by rising taxes is simply creeping socialism and is likely to slow long-term economic growth.

Finally, sharp increases in public debt no longer deliver bang for buck.

Real GDP & Public Debt

Has inflation been tamed?

The consumer price index (CPI) is nowadays a lot less volatile than producer prices (PPI) which it tracked quite closely in the 1960s and 70s. Some of this can be attributed to better management at the Fed but the primary reason is the offshoring of manufacturing jobs to Asia.

CPI, PPI & Hourly Earnings

The service sector is largely immune from producer prices and fluctuations in offshore manufacturing costs are partially absorbed through a floating exchange rate.

We have witnessed a decline in global trade over the past two years and this is likely to develop into a long-term trend towards on-shoring key supply chains in both Europe and North America. On-shoring is likely to drive up prices.

Conclusion

Inflation is not dead. On-shoring of supply chains is likely to drive up prices. Rapid expansion of public debt is expected to weaken the Dollar, slow growth and fuel inflation. Long-term costs of bringing inflation under control are likely to outweigh the shorter-term benefits of MMT-level stimulus.

Notes

Hat tip to Neils Jensen at Absolute Return Partners and Luke Gromen at FFTT.

Can the Fed keep a lid on inflation?

Jeremy Siegel, Wharton finance professor, says the Fed has poured a tremendous amount of money into the economy in response to the pandemic, which will eventually cause higher inflation. David Rosenberg of Rosenberg Research argues that velocity of money is declining and the US economy has a large output gap so inflation is unlikely to materialize.

CNBC VideoClick to play

Both are right, just in different time frames.

Putting the cart before the horse

The velocity of money is simply the ratio of GDP to the money supply. Fluctuations in the velocity of money have more to do with fluctuations in GDP than in the money supply. If GDP recovers, so will the velocity of money. Equating velocity of money with inflation is putting the cart before the horse. Contractions in GDP coincide with low/negative inflation while rapid expansions in GDP are normally accompanied, after a lag, by rising inflation.

CPI & GDP

Money supply and interest rates

Inflation is likely to rise when consumption grows at a faster rate than output. Prices rise when supply is scarce — when we consume more than we produce. Interest rates play a key role in this.

Low interest rates mean cheap credit, making it easy for people to borrow and consume more than they earn. Low rates also boost the stock market, raising corporate earnings because of lower interest costs, but most importantly, raising earnings multiples as the cost of capital falls. Speculators also take advantage of low interest rates to leverage their investments, driving up prices.

S&P 500

In the housing market, prices rise as cheap mortgage finance attracts buyers, pushing up demand and facilitating greater leverage.

Housing: Building Starts & Permits

Wealth effect

Higher stock and house prices create a wealth effect. Consumers are more ready to borrow and spend when they feel wealthier.

High interest rates, on the other hand, have the exact opposite effect. Credit is expensive and consumption falls. Speculation fades as stock earnings multiples fall and housing buyers are scarce.

Money supply is only a factor in inflation to the extent that it affects interest rates. There is also a lag between lower interest rates and rising consumption. It takes time for consumers and investors to rebuild confidence after an economic contraction.

The role of the Fed

Fed Chairman, William McChesney Martin, described the role of the Federal Reserve as:

“…..to take away the punch bowl just as the party gets going.”

In other words, to raise interest rates just as the economic recovery starts to build up steam — to avoid a build up of inflationary pressures.

The Fed’s mandate is to maintain stable prices but there are times, like the present, when their hands are tied.

Federal government debt is currently above 120% of GDP.

Federal Debt/GDP

GDP is likely to rise as the economy recovers but so is federal debt as the government injects more stimulus and embarks on an infrastructure program to lift the economy.

With federal debt at record levels of GDP, raising interest rates could blow the federal deficit wide open as the cost of servicing Treasury debt threatens to overtake tax revenues.

Conclusion

Inflation is likely to remain low until GDP recovers. But the need to maintain low interest rates — to support Treasury markets and keep a lid on the federal deficit — will then hamper the Fed’s ability to contain a buildup of inflationary pressure.