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Things Just Got Real

By Jesse FelderMarket OverviewMay 16, 2021 12:31AM ET
Things Just Got Real
By Jesse Felder   |  May 16, 2021 12:31AM ET
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The big news last week was that the inflation reading from the CPI report not only surpassed all expectations, it was the largest positive surprise on record. The headline number rose 4.2% in April from a year ago and the core number (less food and energy costs) rose 3%. Most notable about all of this, perhaps, is the fact that inflation has already made up for its shortfalls last year and is now running faster than its pre-pandemic trend. Thus the recent surge is clearly more than just a result of the low base numbers from a year ago.

This would seem to validate the comments from many corporate executives lately like those from Kellogg (NYSE:K) CEO, Steve Cahillane: “We haven’t seen this type of inflation in many, many years.” More than just a statistical quirk resulting from, “base effects,” inflation has returned in way not seen in a long time. Representative of this fact is core inflation’s gain of 0.9% in April from March, the fastest monthly increase since 1982.

The Fed would like us to believe these trends are, “transitory,” and will not last more than a few months. However, as my friend Peter Atwater tweeted last week, “At the end of the day, it is far less important whether the Fed thinks inflation is transitory than whether the crowd thinks inflation is transitory.” In other words, what will actually determine whether inflation is transitory is not fedspeak but inflation expectations.

The reaction of consumers to the shutdown of the Colonial Pipeline last week due to cyberattack is emblematic of how this works. Fearing gas would not be available, many individuals rushed to fill up their tanks, resulting in long lines and mass outages reminiscent of those from the 1970’s. When tanks were full, some started filling gas cans and even buckets and plastic bags. This led to a much more serious shortage than if consumers had simply bought only what they needed.

Should this sort of mindset spread to a variety of other goods and services you can bet that inflation will prove more than just a “transitory” phenomenon. In this vein, it was rather interesting to see Google (NASDAQ:GOOGL) searches for the term “inflation” recently soar to a record high (in data going back to 2004). Similarly, the University of Michigan survey showed consumer expectations also rising at the fastest rate on record. This would seem to suggest that consumers are indeed becoming more worried about rising prices in a more general sense.

Beyond cyclical inflationary forces, it is also notable to see the wider acceptance of the secular inflation narrative. James Mackintosh, in a piece for the Wall Street Journal titled “Everything Screams Inflation” that ran well before last week’s CPI report was released, wrote, “We could be at a generational turning point for finance. Politics, economics, international relations, demography and labor are all shifting to supporting inflation.”

Then last week, Greg Ip, senior economics commentator for the Wall Street Journal, took up the secular inflation mantle framing the current labor shortage in just such a light. “Some of the forces that have long kept inflation in check are starting to turn. Most important: demographics,” he writes citing the work of Charles Goodhart and Manoj Pradhan in their book “The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival.”

In short, a rising dependency ratio, simply the young and old divided by the working age population, is inflationary and that is exactly what we are seeing today after a prolonged period of decline. The Baby Boom generation is retiring resulting in a shrinking of the working age population relative to the dependent population. And there are signs that suggest the pandemic may have accelerated this trend.

Certainly, this dynamic is not entirely responsible for the shortage of workers we see today. Some people are just reluctant to return to jobs they feel may still present a higher degree of risk to their health while others have left the labor force in order to care for their children after schools were closed. Together, however, these trends have resulted in the number of job vacancies exceeding hires by more than 2 million, “the largest gap on record,” according to Bloomberg.

Thus it would seem that, just as these demographic forces were beginning to assert themselves in the economy, along came the pandemic and exacerbated their inflationary impact and to a significant degree. As a result, companies of all sorts, from Amazon (NASDAQ:AMZN) and WalMart (NYSE:WMT) to McDonald’s (NYSE:MCD) and Chipotle (NYSE:CMG), are having to raise wages significantly in order to try to attract applicants.

It’s important to recognize, however, that this is more than just a labor shortage. The rapidly changing demographic picture is also resulting in what the Washington Post describes as a, “reallocation friction, the idea that the types of jobs in the economy are changing and workers are taking awhile to figure out what new jobs they want — or what skills they need for different roles.”

Obviously, the vast majority of baby boomers are not retiring from fast food and retail jobs. Their vacancy, largely from white collar jobs or at least higher ranking positions in blue collar jobs, creates opportunities for younger employees to climb the ladder into better paying positions. And so this upward economic mobility, in addition to the other forces noted earlier, also contributes to those pressures on companies that are typically staffed by relatively low-skilled labor.

These dynamics have created a situation in which labor, as a group, is largely beginning to understand that, for the first time in at least a generation, it has increased its bargaining power. After retaliating, “in the voting booth,” as Goodhard and Pradhan put it, by electing a labor-friendly, populist administration, workers are now retaliating in the workplace, demanding significantly higher pay and increased benefits. And they’re clearly getting them.

Rapidly rising costs at the corporate level will, no doubt, lead to rapidly rising consumer prices as businesses are forced to raise prices. At the same time, rapidly rising wages will also lead to increased consumption, putting additional pressure on prices. All of this points to a positive feedback loop in inflationary dynamics that is anything but “transitory,” as the Fed would have us believe.

And that brings up the most important development in all of this: The Fed’s dedication to its new policy prescription of keeping the gas pedal to the floor even as inflationary pressures build. As former president of the New York Fed, Bill Dudley, wrote last week prior to the release of the CPI report, should inflation rise to 3%, in order to keep inflation under wraps the Fed may need to raise rates as high as 4.5%. With inflation printing 4.2% last month does that mean the Fed should be at 5.7% to prevent inflation taking hold in the economy?

In fact, the Fed Funds Rate stands currently at 0%, or a negative 4.1% real rate. This is the most deeply negative real rate since 1980. 1975 was the only other year in modern history in which the real Fed Funds Rate was more deeply negative than it is today. In other words, only during the greatest inflationary period in our country’s history has monetary policy ever been as loose as it is today. And this is happening today, not in the midst of a deflationary episode, but as the greatest month-on-month inflation readings since that infamous period are printing.

Speaking of printing, of course, the central bank is also printing money to purchase government debt and mortgage-backed securities at an annualized rate of nearly $1.5 trillion, or 6.5% of GDP. As Stan Druckenmiller told CNBC, “I can’t find any period in history where monetary and fiscal policy were this out of step with the economic circumstances, not one.” And it is the potential for an extreme policy mistake, or even just the widespread perception of one, that potentially compounds the problem.

It is telling that the architect of the Fed’s new policy regime, Ben Bernanke, warned of this very risk a couple of years ago. “If people don’t understand or believe the Fed’s strategy—if the Fed is imperfectly credible—and their expectations of inflation become un-anchored as inflation rises above target, then inflation could be more persistent and the costs of the policy could be much higher than anticipated,” he wrote.

Ironically, as Bernanke envisioned, the Fed’s insistence on coloring the current surge in inflation as “transitory” could damage their credibility in such a way as to ensure it will be anything but. Inflation readings will only get hotter going forward, possibly as high as 8% over the next few months. In that case, should monetary policy continue to fail to respond it would seem almost a certainty that investors and consumers alike would lose faith in the Fed’s commitment to its inflation mandate.

More than anything else, that loss of faith could serve as a catalyst for even higher inflation expectations and, more importantly, inflationary behavior on the part of consumers, only exacerbating positive feedback loops. At least equally important would be the fallout resulting from of a loss in faith on the part of treasury investors, both domestic and foreign. Who in their right mind would buy a 10-year treasury when the real yield is more negative than any other point in history?

And if investors were to broadly abandon treasuries, it would only force the Fed to more aggressively intervene in the market to prevent interest rates from rising to levels that would be economically catastrophic, further eroding faith in the central bank’s inflation mandate. As Druckenmiller revealed, “That’s why I’m worried now for the first time that within 15 years we lose reserve currency status and of course all the unbelievable benefits that have accrued with it.”

On the other hand, should the Fed decide to try to head off these problems by address rising inflationary pressures over the next few months via tapering its purchases or raising interest rates it would represent a dramatic departure from the policy forecasts they have provided for many months now. Markets have come to expect zero interest rates and continued asset purchases to persist for at least another year. Any hint from the Fed that this timetable for normalization of monetary policy has been stepped up risks a market tantrum that would make 2013’s look like a blip.

In other words, the Fed is now damned if they do (fight inflation and precipitate a crash in risk assets) and damned if they don’t (fight inflation and allow it to spiral out of control). It is the very scenario, of a choice between the devil and the deep blue sea, I have been expecting for the past few years and it appears to have finally arrived. By all indications, the Fed has already made its choice.

However, as I have written before, they may, in fact, precipitate both outcomes, an inflationary spiral and resulting bust in asset prices. As Druckenmiller said on CNBC last week, “If they want to do all this and risk our reserve currency status, risk an asset bubble blowing up, so be it.”

You may remember that Stan stated several years ago, “80% of the big, big money we made was in bear markets and equities because crazy things were going on in response to what I would call central bank mistakes during that 30-year period.” Reading between the lines, it would appear that one of the greatest hedge fund managers of all time is looking to dust off the old playbook in order to take advantage of what may prove to be the greatest mistake in the history of the central bank.

Things Just Got Real

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Things Just Got Real

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