Inflation is hitting very high numbers – CPI, for example, is at its highest level since 1982. But what is driving it? Some blame too much money in the system. Others say it’s consumer demand. Yet others say that the scarcity of goods and labor is pushing up the cost of everything. Or all three.
Identifying the reasons behind rising prices is important in order to craft a proper response. If money supply is the problem, then the Fed must take liquidity off the system and raise interest rates. Overheated demand requires making consumers spend less. And ending the supply crunch, frankly, will depend on luck.
The liquidity argument may be overstated
It is true that the Fed has injected mountains of money, but much of it ended back at the Fed in the form of excess bank reserves. More importantly, the velocity of money (which measures how fast money circulates through the economy) is now at an all-time low – that is, the money did not make it that far into the economy.
It doesn’t matter how much money the Fed injects if it goes nowhere. Private domestic investment, for example, was a far smaller percentage of GDP in the last 12 years than in the previous 12, regardless of the money dumped onto the economy since 2009. Many, including us, have argued that much of the excess money found its way into financial assets, contributing to the bull market in stocks but not much else.
Demand strength is mostly about consumers catching up
At first glance, consumer demand may seem very strong. Personal consumption is at a peak both in dollar terms and as a percentage of GDP.
On the other hand, its annualized 7-quarter growth rate (since pre-pandemic levels) is just at 2%, unremarkable by historical standards, lower than the average of 2011-2019 and well below pre-financial crisis levels. On top of that, just-released figures show that December 2021 retail sales contracted by 2.3%.
The real issue is the supply chain
Even assuming that excess liquidity and consumer behavior could be factors influencing inflation, it is evident that prices are climbing because of sharp disruptions to production, supply channels and labor patterns. The ten-fold increase in container fees or the five-fold increase in the price of fertilizer, for example, cannot be attributed to too much money or to overactive shopping.
Stubborn transportation bottlenecks are well-known, such as the record times for ships waiting at anchor at key ports around the world. The sight of empty lots at car dealerships has become commonplace; dealerships, meanwhile, are getting away with astronomical margins to compensate for cratering sales volumes, shifting the burden of scarcity to car buyers. U.S. car inventories were last counted at just 40,000, a record low and just a fraction of the 560,000 just before the pandemic.
The Fed responds, but maybe it shouldn’t
Fed chairman Jay Powell declared that because inflation is no longer considered “temporary” the Fed’s long-standing accommodation policy will end. But this can only address the issues of liquidity and consumer demand. Withdrawing liquidity or hiking rates has no impact on preventing a Covid-19 outbreak that shuts down a major Chinese port, nor it can reverse the ban imposed by China on synthetic nutrients exports, part of the reason why fertilizer prices are so high, nor entice people to come back and fill in the 2.6M private jobs vacated since February 2020 which left employers scrambling for workers.
It follows that hiking rates a few times or letting billions of dollars’ worth of bonds roll off the Fed’s balance sheet will have no effect on inflation if the supply crunch does not ease. If this happens, inflation will come down; if it doesn’t, it won’t.
If it does, then the Fed may refrain from doing too much. At least that is what chairman Powell and other Fed officials keep saying – that their policy will be “flexible.”
If it doesn’t – and the experts’ consensus is that supply issues will last well into 2023 – then the Fed will either not respond, if it judges their policies to be mostly useless to address supply-driven inflation, or redouble efforts to bring it down.
It is unlikely that the fed will be reticent if inflation persists. Inaction would cause an uproar from politicians who distrust the Fed’s independence and like to blame the Fed for anything anyway. But in the absence of better supply conditions, a forceful response risks depressing demand too much. This, perversely, could bring inflation down, but only by sinking consumption so much that shortages will no longer matter.
The Fed, therefore, faces an unenviable task. It waited as long as it could for supply conditions to improve, but that is taking so long that it can no longer afford the optics of doing nothing. It will need a lot of skill to do just enough and keep the confidence of the public. The risk of slowing down the economy too much, then, is real. It would not be the first time the Fed overshoots.
On the other hand, the Fed may indeed be thinking that too much demand is the main cause of inflation. If so, the only way to cool it is to make people spend less. Which they will, if they feel less wealthy because the value of their savings falls or their income goes down. That means that real estate and stock prices must fall, or that there are fewer jobs or that real wages decline.
Therefore, the outlook for stocks is bleak unless supply opens up soon. This means hoping that Covid-19 will not mutate into dangerous variants and that it will vanish in the next few months, that geopolitical tensions will ease and that logistics channels will unclog.
This is, indeed, the apparent consensus of the day. The Omicron spread is thought to be “mild” and possibly the virus’ last gasp. Few are discussing how Russia’s intimidation campaign towards Ukraine, let alone an invasion, can affect oil and natural gas prices. The market is shrugging off the persistently-high number of ships waiting to dock at Port of Los Angeles or the vessel congestion in Shanghai (the world’s largest port) caused by the lockdowns at Ningbo (the world’s third largest).
All the elements for a stock market decline are therefore in place, including, precisely, the fact that market participants seem complacent, which can change quickly. If they are right that everything will turn out fine, we will be lucky. Otherwise, the long bull market will finally die at the hands of the Fed.