Inflation at 40-Year High: Contributors and Causes
Today’s work attempts to address the issue facing the world’s financial system – an upward push in domestic and global inflation – the cause and the cost, and finally a solution to the building problem of the highest inflation rates our country has seen in four decades.
People are people and aren’t perfect and actions have consequences. The drivers and causes of our current inflation problem are many. An over-reliance on China as a source of many manufactured goods, the COVID problem and a lack of investment in the world’s capacity to bring “stuff” out of the ground all added to the problem. But in the end, I suggest much of the inflation problem radiated from the world’s governmental decisions, which have occurred over the last few years. Actions that have spurred growth in final demand without consideration of increasing aggregate supply at the same time.
A surge in deficit spending, the accomplice of this spending and central bank policies all helped drive the world’s economy into the position we now find ourselves, that is the highest inflation rate our economy has seen in 40 years. While some will say government actions weren’t the “cause” of our current inflation problem, all must agree that at the least, government policies aided and abetted the current pricing problems. As noted above, actions have consequences, and the consequences of the Federal Reserve and many government spending programs have intensified today’s inflation problem.
Enter the Fed and Government’s Fiscal Policy
The members of the Federal Reserve Board of Governors decided throughout last year to maintain the presence of not just their 0% interest rate policy, but to continue the $120 billion-per-month bond purchase program. These decisions were consistently made in the name of defeating the recession and helping the labor market recover from the pandemic-driven recession, a recession that had officially ended the year before, according to the National Bureau of Economic Research.
The Fed was focusing on one of its mandates, that of attempting to ensure the labor market was reaching “full” employment, by recovering from the pandemic-induced recession. The Fed’s focus was on spurring economic activity with an end goal of creating enough jobs, so the labor market had the same number of workers as before the onset of the COVID-based recession.
Achieving that goal turned out to be elusive, due to two major factors, neither of which the Fed could control. First, the number of people taking retirement following the COVID downturn accelerated rather dramatically. Second, the government’s increased unemployment benefits contributed to keeping many workers at home versus returning to the workplace well after the end of the recession. Some say this was driven by fear of the COVID virus. Perhaps this added to the issue. But in the end, many workers decided to stay home, irrespective of the reason, and irrespective of the Fed’s monetary policy.
So, the Fed didn’t, and I argue couldn’t, have succeeded in its goal to bring the labor market into an even keel with the pre-pandemic environment, as fundamentals in the labor market had changed. These changes were largely beyond the Fed’s control and reach. But the Fed persisted in its 0% interest rate and bond purchase policies, fueling excessive money growth in an environment of rapid economic expansion. It should be no surprise that inflation intensified as a result.
We shouldn’t blame Fed Chair Chairman Powell as the sole inflation villain – he had the backing of a new, untested (and frankly highly flawed) monetary policy theory, which was gaining acceptance by many, labeled Modern Monetary Theory. This is a theory politicians love, as it holds the view that it doesn’t matter how much money the government borrows or spends, so long as the currency of the country was a global “reserve” currency. This theory gives politicians a blank check to spend borrowed money on anything they desire at any level they think appropriate. I have consistently written in the past that this theory is deeply flawed.
Milton Friedman, the modern-day proponent of monetarist economic theory.
So, returning to our view on the Fed – of its two mandates (full employment and stable prices), why did the Fed decide to focus on the full-employment mandate and let the stable-price mandate go to seed? I suggest the Fed was fighting the previous war. After all, inflation had remained below the Fed’s 2% target for quite some time, no matter what the Fed did prior to the onset of the COVID-based recession. They apparently thought that inflation was dead, and in the Fed’s defense, may have thought that inflation was truly “transitory” as previous actions attempting to spur pricing flexibility had mostly been foiled. So, like many military generals, the Fed was, in the end, fighting yesterday’s war and as it turned out, the wrong war. Additionally, the Fed was aided and abetted by Modern Monetary Theory (MMT) and political pressure.
Government Fiscal and Monetary Expansion
Over the recent two years, the Fed increased M2 (a calculation of money supply) by 40% above the normal M2 growth rate. Did the productive capacity of the nation’s economy expand by 40% over the last two years as money supply increased at this rate? Of course not. As opposed to the MMT proponents, monetarist economists believe that more money chasing the same amount of goods leads to inflation. The modern-day proponent of monetarist economic theory is, of course, Milton Friedman, pictured above, who followed those economists of the Austrian school, such as Mises, Menger and Hayek, all proponents of free markets and free enterprise.
The MMT’ers have been suggesting that the significant monetary and debt expansion which occurred following the Great Recession (2009-2012) didn’t fuel a new round of inflation, so Friedman and the monetarists have been wrong all along. Well, it appears that the MMT’ers were wrong and not the monetarists.
What the MMT’ers fail to highlight is the fact that the money expansion that occurred following the Great Recession (Quantitative Easing) occurred with the newly created money staying captured in the banking system, being held in bank reserves, and not getting released into the public’s hands as the velocity of money remained very low. That fundamental didn’t occur during the pandemic-driven round of money creation, as checks were sent out by the government to most people. This money distribution created an upward push in final demand for many goods and services, at a time when the expansion of supply was restrained.
The chart above (Longtermtrends.com) depicts the longer-term historical relationship between M2 growth (black line) and underlying inflation (red line). The chart dates to 1943. Perhaps Milton Friedman and the monetarists/Austrians weren’t doddering fools and have had a point all along. Money supply and velocity of money combined have had a major influence on inflationary pressure historically.
You and I Pay the Price
Who is paying the price for these missteps? All consumers in the U.S. are paying more for almost everything than was the case a year ago. According to Barron’s magazine, consumers are now paying double-digit price increases for everything from meat, eggs and bread, to gas, electricity and bank checking account fees.1 Moody’s calculated that the average American family is paying $276 per month for goods and services based on an inflation rate of 7.5% compared to a 2.1% average inflation rate in 2018 and 2019.2 If accurate, that equates to an increase in living costs of a little over $3,000 per year for the average family.
The median U.S. family income is around $67,500 per year3 so the $3,000 cost increase represents an increase of 4.4% in the cost of living, a tax, if you will, for many of us. Unless your net (after tax) income has risen by at least 4.4% over the last year you are worse off today than you were this time last year. Another unintended consequence of wrong-footed government policies.
What Kind of Mess Do We Have?
To understand how we fight the inflation dragon, we need to not only understand who to blame for the problem (primarily wrong-footed government policies) but also where our economy, and specifically the government now stands.
How great is the size of the Fed’s balance sheet, which was driven by the expansion of the nation’s money supply simply through computer entry? The answer gives us further evidence of the source of the inflation problem but also gives us a clue as to what needs to be done to unwind inflation’s fire.
Since the end of the Great Recession, QE (Quantitative Easing) activity by the Fed has ballooned the size of its balance sheet from roughly $5 trillion, to $8.4 trillion (See chart below.). The Fed now effectively owns about a third of both the Treasury and the home mortgage markets, according to Barron’s. This process was financed by a rapid rise in our money supply, as noted above. Effectively, the Fed purchased these bonds by printing money via computer entry. The Fed increased the nation’s money supply (M2) by $6.3 trillion, rising by 25.2% per year over the last two years, as compared to the historical average growth rate of 6.8% per year (1960-2019, according to the St. Louis Fed). So, our money supply has increased by almost 40% over the last two years in excess of normalized levels.
Now, the Fed has announced plans to end loose monetary policies. As the Fed winds down its bond purchase plans, what is going to happen to the valuation of the core bond markets, which have been the focus of the Fed’s purchase programs? Will the government stop spending more money?
Consider that government spending increased by 63% between 2019 and 2021 to about $7.2 trillion.4 Much of this spending increase was directly financed by the government itself, by the Fed’s monetary policies as noted above. Government borrowing will be about $1.83 trillion this year (2022) as compared to $3.66 trillion in 2021.2 That sounds hopeful.
But consider the $1.83 trillion in new debt this year, as compared to the $0.98 trillion of new debt, which was created in the pre-pandemic year of 2019. The annual deficit has almost doubled on a sustained basis in a mere three years. Now that the most prolific purchaser of government debt is going away (Federal Reserve) somebody, somewhere will need to step up and buy the government’s $1.8 trillion of new debt to be issued this year, followed by an apparent sustained $1.3 trillion in new debt to be issued annually as far as the eye can see.
Source: The Boston Federal Reserve
To be fair, the economy ground to a halt during the COVID shutdown, and a shock needed to occur in 2020. The government provided that shock through fiscal expenditure with the Fed’s actions acting as the financier of those actions. Per the NBER, our economy was out of recession by the end of the second quarter of 2020. Government’s economic medicine worked, and the economy started growing once again. But remember, 2020 was an election year. Politicians were on the grill regarding not only COVID, but overall economic growth. The unemployment rate was still high in the summer of 2020 but declining. We can justify a very loose monetary and fiscal policy stance for all of 2020. But for all of 2021? When the recession ended in 2020? I beg to differ. It appears the Fed made a policy error for which we are all now paying the price.
No Easy Solutions
What is the Fed to do? In the world of economics, there are few “solutions” to problems, only trade-offs. Now, if you find yourself standing in a hole deeper than desired, the first rule of hole management is to stop digging. That is what the Fed will now do. It is slowly ceasing its bond purchase program.
Now that the Fed is entering a new, “tighter” (note I didn’t say “tight”) monetary policy, what does history tell us of such events? History shows us that the Fed has entered a new “tighter” monetary policy 15 times since 1950.3
- In six of the last 13 rate increase cycle experiences, the yield curve has inverted (short-term rates higher than long-term rates) within one year of the initial rate increase.5
- The average, short-term rate increased by 430 basis points (4.3%).5
- On average, the 10-year Treasury yield increased by 119 basis points.5
- The Fed rate increase cycles have tended to last about 1.2 years in duration.5
- The Fed’s actions will arguably slow overall economic growth (lowering demand growth), which should bring supply/demand growth rates back in balance, leading to lower inflationary pressure.
- In the past, the economy has tended to fall into recession within a year or so following interest rate inversion (See chart above that depicts the shape of the yield curve (light blue line) and the Fed Funds rate (dark blue line). The vertical grey bars represent previous recessionary environments).6
Inflation is lighting your money on fire at a record pace.
What investments can help battle inflation?
I am on record in my view that inflation pressures will recede as 2022 moves forward. GDP growth (real) grew about 6% last year, the highest growth rate we have seen in decades. I am suggesting that GDP growth this year will probably be around 3%; about half that from last year. I have highlighted in previous writings why inflation pressure should recede this year but remain more intense than has been the case for quite some time.
But I don’t think the significant improvement in Consumer Price Index growth rates will occur until the second half of the year. In the meantime, the Fed will stop its bond purchase program and start to let bonds roll off upon maturity. Additionally, the Fed will start to raise interest rates—I am looking for 150 bps increase in Fed Funds this year. This will drive longer rates upward as well, cooling the housing market. The Fed may not stop there. We could be looking at another round of rate increase in 2022, until we start to see weakness in overall GDP growth.
In the end, I suggest the days of ever-lower inflation and interest rates (deflation and disinflation) are probably behind us. Inflation going forward should remain higher, longer than the Fed’s current 2% “target range” would dictate. As consumers, businesses and investors alike conclude that the days of deflation and disinflation are behind us, behavior will change. That is a process, not an event, and will probably have a longer tail than many currently expect.
What of economic growth? I suggest growth, like inflation, will slow, but remain positive for this year. We will be monitoring Fed monetary tightening policies closely, as history tells us the risk of seeing a growth recession occur sometime over the next two years will be heightened. I continue to look for 3% “real” GDP growth this year.
In my opinion, the Fed made a policy error and this isn’t really in question. Our country is seeing inflation pressure that we haven’t experienced in 40 years. I hope my arguments made above will help you understand my thoughts as to why this has happened. Without that knowledge, we don’t know how to fight the current problem.
Is the Fed making another error, resulting in more unintended consequences by raising interest rates and shrinking the size of its balance sheet? I think at times many will be asking that question, as I suspect the global capital markets will continue to show pricing volatility as the world’s investors become accustomed to higher interest and inflation rates. In the end, inflation acts as a regressive tax on our society that needs to be brought under control. I suspect the Fed will accomplish this task. I also suspect the process won’t be painless.
4University of California, Santa Barbara
5David Bianco of Deutsche Bank
6The Boston Federal Reserve
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