Inflation – the first stage of grief is denial
- At the sound of barking during a film, a dog looks up quizzically from its basket, head half-cocked as it recognises the type of noise but knows somehow that it’s different. It turns towards the TV and starts growling. Its owner pats it on the head and reassures it that it’s “just a TV dog” and that there is nothing to worry about. Right now, the Fed might be hoping that it is the owner, the dog is the bond market, and inflation is the barking on the TV. What happens if the film is ‘101 Dalmatians’?
- There is a school of thought that you can’t have inflation without the velocity of money (the turnover or number of times it’s spent) increasing. This is true even with a huge increase in the amount of money in the system. The graph below (St Louis Federal Reserve Data) shows the M2 money supply (cash, sight deposits and ‘near money’ like time deposits and some mutual fund balances) in blue and M2 velocity in red. Clearly, in 2020 M2 has rocketed while the velocity has collapsed. No velocity, no inflation. Why is this so?
Source: Board of Governors; St Louis Fed, 31st December 2020.
- The answer lies in the quantity theory of money. The equation MV = PQ has M (the amount of money) multiplied by V (its velocity – the two components shown in the graph above) balanced against P (price levels) multiplied by Q (the economy’s output, often stylised as GDP). At a given level of output or GDP (Q), inflation (a rise in P) only comes if the quantity of money (M) and its velocity (V) are both rising. With US GDP having fallen in 2020 along with the velocity of money, you can’t have inflation moving much higher. In theory.
- Part of the fall in velocity is because of the sheer amount of money created by the Fed in 2020 coupled with lockdowns preventing people from spending it. The ‘real’ unemployment rate in the US is still over 10% per Fed calculations, and this also means a lot of folk don’t have as much money to spend despite lockdowns. While median US household income has risen in 2020, averages are misleading here. That said, as America opens up and gets back to work post-pandemic, the velocity should naturally rise.
- The other reason for the falling velocity is that a huge amount of the newly created money has been invested in the financial economy. The personal savings rate peaked at a staggering 34% in April 2020 during lockdown 1.0, but the most recent reading as at December 2020 still shows an elevated savings rate of 13.7% versus an average of around 7% in previous years. Clearly, a lot of money has been parked in banks, money-market mutual funds (and the stock market…), and this doesn’t appear in M2 velocity calculations. It does arguably create asset price inflation though.
- If M2 velocity is telling you there is no inflation, then the commodity market is revealing a bit of a different story. The graph below shows the Bloomberg Agricultural subindex (BCOMAG) which comprises of a basket of soft commodities including soybean, corn, sugar and wheat, and is often used as a leading indicator within the commodity suite for inflation. Commodity prices are always subject to supply and demand issues – for example China is importing more soybeans to build up its pig herd and more wheat due to a rain affected harvest in 2020. But as the graph below shows, the price of the basket is rocketing higher.
Source: Bloomberg, 10 February 2021. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.
- Swiftly-rising prices are not just to be observed in the soft commodities. From a $216 low in March 2020, the March 2021 front-month copper future is currently at a multi-year high of $377 (vs. a peak of $463 in 2011). Lumber is at an all-time high of $947 (the prior peak was $624 per tonne in 2018). The West-Texas Intermediate oil future is at $58.5 – this is the same as pre-pandemic levels even with no one travelling. Commodity prices are surging everywhere.
- Rising input prices from higher commodity prices are already making themselves felt in corporate earnings. We are currently in the middle of Q4/full year earnings season. Below is a selection of comments from corporates reporting in the last few weeks:
- Eaton (EV.US): “with respect to supply chain, yes, we’re absolutely seeing it (input cost pressures). We’re seeing inflationary pressures in copper. We’re seeing it in some steel. We’re seeing some availability and some pressures also on microprocessors and the like around the company.”
- Coloplast (COLOB.DC): “cost pressure from wage inflation and labour shortages”.
- Atkore (ATKR.US): “working to quickly absorb and pass-through our higher input costs.”
- NXP Semiconductors (NXPI.US): “we are seeing price increases, hopefully pass them on (to customers) pretty quickly”.
- Microchip (MCHP.US): “We are seeing broad-based cost increases and some aggressive commercial terms from our supplier base, and we must pass these cost increases to our customers through a broad-based price increase.”
- Arrow Electronics (ARW.LN): “the price increases are coming now.”
- Kimball (KE.US): “Margin pressure experienced due to spiking freight costs and the inflation impact on raw materials”.
- Powell Industries (POWL.US): “we will see some inflation in commodities going forward”.
- Century Communities (CCS.US): “material and labour cost increases.”
- Peloton (PTON.US): “shipping costs were about 3x of what we would normally pay”.
- Valvoline (VVV.US): “passing through cost increases”.
- Assa Abloy (ASSAB.SS): “starting to hike prices due to raw materials”.
- Clearly tracking the velocity of M2 money is not a luxury that actual businesses can afford. Inflation is here, and the question is whether it is here to stay. Market measures of inflation are moving sharply higher. The graph below shows the implied inflation breakeven on 5yr US Treasury TIPS (inflation-adjusted bonds). At 2.34%, not only is this through the Fed’s medium-term target of 2%, but it is way higher than it was pre-pandemic and is in touching distance of the pre-global financial crisis level.
Source: Bloomberg 10 February 2021.
- This graph also offers a hint a why inflation is on the march. If one compares the ‘V’ in the graph above from 2008-9 and 2020, one can see that the market never priced in outright deflation the second time around. This is because the Fed was already doing quantitative easing (QE) before the pandemic struck, and merely turned it up to 11 during lockdown. First time around, the Fed only started QE in December 2008. The volume of QE in 2020 also dwarfed not only QE 1 but also QE 2 and 3 combined. The big difference between then and now is the US deficit – the austerity of 2009 has been replaced by fiscal largesse. When the government is expanding credit and the Fed is monetising the debt to do it, it looks like you get inflation. This isn’t theory – this is just an observation of market prices as they stand early in 2021.
- The Fed has already set out its stall. The new ‘average’ inflation policy means the Fed will tolerate inflation above 2% in order to play catch up for the time when inflation was below 2%. The Fed is already expecting higher inflation in 2021 in part from base effects – this is the year-to-year comparison of prices which will, in 2021, involve comparing prices to those in 2020 which were considerably lower due to the lockdown which started in March 2020. In a speech on February 9th, President of the Dallas Fed, Robert Kaplan, reiterated the stance – he won’t be surprised by a temporary rise in inflation, although cyclical elements of inflation may grow over time. Importantly, he said neither rate hikes nor the tapering of QE is imminent. It’s just a TV dog.
- When you add up the possibility of a splurge of spending with the end of the pandemic, the reshoring of supply chains due to the trade war, rising transport, shipping and commodity costs, an economic recovery juiced by massive US infrastructure spending, a new $15 minimum wage, and new child-support payments, there is a confluence of inflationary pressures which one might expect in a recovery but also a genuine political shift to demand-side economics by the new Biden administration. The output gap is large in the US, as is the rate of unemployment. The huge stock of debt mitigates against inflation too (debt servicing diminishes consumption and is deflationary, all else equal). But when you talk about government deficit spending getting to 25% of GDP over a year or so, it is a sort of now or never moment for inflation.
- No fear though. Secretary of the Treasury Janet Yellen has been quoted on the weekend of February 6th as saying, “I’ve spent many years studying inflation and worrying about inflation. And I can tell you we have the tools to deal with that risk if it materialises”.
- Not only do they not expect inflation to be anything but a transitory phenomenon, they can also deal with it. The last time they had to do this was in the early 1980s when Paul Volker at one point in 1981 took rates to 20%. Back then, the stock of debt (public and private) was a fraction of what it is now. We know from Jay Powell’s auto-pilot rate hiking in Q4 2018 and the subsequent collapse of the equity market and the closing of the credit market that aggressive monetary tightening with a large stock of debt is fatal to markets. The stock of debt in 2021 is a lot higher even than in 2018, largely due to the pandemic.
- While some question whether anyone has the guts to do what Volker did, the real question should be whether the tools even exist to control inflation with such a large stock of debt outstanding. The Fed is in a trap – you hike rates and crash markets through deflation and default, or you continue with the expansionary monetary policy and inflation eats away at capital. It’s like choosing to be electrocuted by AC or DC. The best thing for now is to say you expect some inflation but add that it’ll be transitory. The question is for how long the denial can continue.
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