Intro
I might be losing my motivation for this blog because I keep choosing to look for my golf ball on the wrong fairway than write this article. Here's my argument for why structural inflation is impossible.
The Two Faces of CPI
Traditionally, inflation is defined as a monetary phenomenon, which is when CPI rises due to an increase in the money supply, so technically a supply shock that causes CPI to rise is not inflation, it's just CPI rising. The reason this is an important distinction is because supply shocks are anchored in the law of supply and demand and the incentives of free market participants, so they always return to equilibrium; whereas an increase in the money supply could be the result of a structural economic boom in a fractional reserve system, or the structural recklessness of excessive fiscal money. In other words, the bond market doesn't care about supply shocks because the companies involved are restrained by free market competition, so the prices can't spiral out of control permanently. If the profit becomes too large it will attract competitors to bring it back to the cost of production plus the market allowed profit, or if the price rises too high it will kill its own demand. There's no escaping this restraint, except for temporary dislocations, so the treasury market will look past it. The reason CPI was over 9 with the 10-year yield under 3 is because trillions of dollars in the treasury market is saying the bulk is CPI is not inflation; it's other temporary reasons like the labor gap, supply chain issues, and a temporary disruption in oil.
The Fed Rides Caboose
The Fed has almost nothing to do with the current increase in CPI, and they're not even capable of causing it to rise. It's not a power they have. Here are the three biggest false assumptions many on Wall Street believe: QE is inflationary; the Fed controls interest rates; and banks loan out deposits. All three have profound downstream effects in how the economy and markets behave, so let's explore them.
The Fed couldn't make CPI rise if they tried (and they did for 10 years), mostly because their transmission mechanism into the real economy is weak and diluted. If the money they create doesn't enter the economy it can't drive up consumer prices, so let's follow the money because there's some nuance here.
When the Fed buys treasuries it indirectly funds the government beyond their tax receipts, which is the definition of inflation, but all government spending programs (until Covid) were narrowly focused on specific Acts that created winners and losers in certain sectors, so it was never broad enough to cause CPI to rise as a whole.
When the Fed buys MBS it frees up room on the balance sheet of banks, which allows them to make loans they wouldn't otherwise be able to make, which creates money into circulation and is also the definition of inflation. While banks create the bulk of the money supply through loan issuance, they are not restrained by deposits or reserves - they're restrained by the creditworthiness of borrowers and the viability of the loan, which is why the Fed was unable to cause CPI to rise for a decade. They needed creditworthy borrowers with down payments in order to have a broad based effect on consumer prices.
Light My Fire
Along comes Covid, and the MMT crowd gets to see their foolish ideas play out as a real-time experiment. Combine several rounds of stimulus checks, additional unemployment money, the PPP loans, the extra child tax credits...and all of a sudden the country was full of creditworthy borrowers with down payments, which created a housing and car boom. Clearly, there is nothing better for the economy than a strong housing market since there's abundant ancillary spending that surrounds it. What resulted is the typical "pig through a python" inflation of CPI as this free fiscal money worked through the system, but without a continual source of funding it can't be anything more than a transitory, albeit exaggerated, effect. That money will be spent and end up in the bank accounts of businesses and once again get stuck in the banking system, restrained by the need for creditworthy borrowers with down payments or collateral to keep it circulating in the economy bidding up consumer prices.
In contrast, the 1970s inflation was driven by a relentless, persistent demand for money by a freak demographic boom all moving through peak borrowing years at the same time for a long stretch of time (amplified by the oil supply shock, of course). Since CPI is a measurement of change, in order to maintain a high and rising CPI, the borrowing and spending must persist over years, which it did in the '70s because it wasn't driven by an artificial and temporary source of funds like government stimulus.
Spiral Squeeze
You might argue there's a psychological effect that takes over and creates a wage/price spiral that pressures CPI higher continually unless it's stopped, but this too has natural restraints because it doesn't happen broadly all at once, so it tends to be haphazard, staggered, and narrow. In an inflationary environment businesses are faced with higher input costs and the simultaneous shrinking of a customer's discretionary income, so they can try to raise their prices to maintain their margins, but some businesses have more pricing power than others, and some customers receive quicker and better wage increases than others, so the haphazard and staggered distribution of these increases acts like a built-in mechanism that prevents a runaway upward spiral in wages and prices as both customers and businesses get squeezed, which results in spending cuts and layoffs to counteract it.
Technically, we've been in a wage/price spiral for a century. The average salary in 1913 was $575 per year, and it's now $54,000, so while wages often lag, they do rise because that's how markets adjust. An environment of 9% CPI doesn't mean you're losing that much purchasing power if your wages went up or you own assets that countered it. It also depends on what you're spending it on. If it's sitting in a brokerage account and what you want to buy went down 30%, then not only did your purchasing power go up by that amount, but also by the 30% to get back to where it started (assuming it does). It's not a simple calculation.
Fed Bread
When the Fed buys treasuries, most of the money printed out of thin air ends up sitting in the bank reserves of primary dealers. Fed apologists claim this is an asset swap, but it's not because the Fed doesn't have any assets. To illustrate the difference, if the Fed ran an underground bakery and they produced the best bread you can imagine and they stole market share from other bread companies by selling their bread to consumers who paid for it with the money they earned by owning, or working for, profitable businesses, the Fed would end up accumulating savings, and if they used those savings to buy treasuries in a QE program that would be as asset swap. The Fed doesn't have any assets. It's accounting gimmickry.
Purchasing Power Pilferage
The people who get hurt the most by inflation are the ones who need to not get hurt the most by inflation because they don't own assets or have enough cash to buy stocks that went down, or they are living on fixed income that understates their loss of purchasing power, so their fixed income doesn't keep up with their rising expenses. Inflating away the debt means stealing purchasing power from savers, the poor, and those living on fixed income, so a better alternative might be knocking on the door of poor people and punching them in face. Runaway inflation is impossible because the market forces of competition and the need for creditworthy borrowers will restrain prices even without the help of the Fed, which does not even control interest rates.
The Inversion Rebellion
If the entire Treasury curve bear-steepened in proportion as the Fed raised overnight rates, then I would agree the Fed controls interest rates. If mortgage rates followed Fed Funds in lockstep, then I would agree the Fed controls interest rates, but they don't. Interest rates are controlled by the market. This is the whole idea of why a yield curve inversion is such a powerful signal. It's the vast, diverse participants in the market disagreeing with the Fed as it responds to the same evolving economic data. Banks are going to charge as much interest as the customer will pay in the context of the bank's competitors. Mortgage rates skyrocketed as the housing market boomed, which created high prices in both housing and interest rates, and caused their own demise by cooling off demand. And if you eliminated the fiscal stimulus it wouldn't have mattered how many MBS or treasuries the Fed purchased, there would be no rise in CPI - just like the post-GFC decade - because there wouldn't be creditworthy borrowers with down payments. The Fed does not have the power to cause CPI to rise. They need the Treasury as an accomplice to send people money.
Fed critics like to say "the Fed is causing financial repression by artificially holding down interest rates," but ZIRP and QE happen during weak economies, so interest rates are already low from a widespread willingness to buy treasuries at lower and lower yields. I'm not saying the Fed buying treasuries has zero effect, but it's not nearly as much as the "financial repressionists" proclaim. Evidence for this would be the Taper Tantrum of 2013. Yields initially raced higher, then stopped at the appropriate yield for the time, and resumed their downtrend because globalization has stripped the engine out of our economy, which is the real cause of financial repression.
Poppycock Talk
Offshoring our manufacturing base not only removed tens of millions of the most secure high paying blue collar jobs, but it also resulted in exporting trillions of dollars. This is the disinflationary black hole in our economy that forces the Fed and Treasury to continually reinflate asset bubbles. This is the reason interest rates are structurally low. This is the cause of financial repression. And the people who think we're entering an era of deglobalization are full of poppycock.
The entire reason our CEO's moved those jobs offshore is to lower their expenses by evading our taxes, regulations, and unions. None of that has changed. There's no way any CEO is going to reshore those jobs back to the same exact conditions that prompted the exodus in the first place, voluntarily increasing payroll expenses many times over. Pointing to a few semiconductor plants as evidence of deglobalization is disingenuous because they are being heavily subsidized as a geopolitical strategy to protect our semiconductor production. There is nothing better that can happen to this country than reshoring our manufacturing base, but it is not a choice a CEO can make. If they don't like China anymore they can move to Vietnam or Africa or Mexico, but not the US. And I'm sure every single one of them want to reshore, but I want to flap my arms and take flight, which is equally as likely, so go ahead and scratch that off your structural inflation bingo card. Deglobalization would be career suicide for whoever attempts it. No one is going to buy a $10,000 iphone. The math doesn't work.
Thug Life Currencies
And this idea that somehow Russia and China are making a power play to create a new currency that's going to displace the dollar is not appreciating the fact that no one is going to denominate their international business in the currency of lawless communist dictators who don't respect the rule of law or free markets. The US might be flawed but we're not communist-dictator flawed. It's our rule of law, individual rights, democracy, and free markets that stand behind our dollar and override its flaws. There is no alternative. At the end of this, Putin will be dead, and Russia will be devastated for a generation as the whole world accelerates their flight away from Russian energy.
The Great Conflation
One reason everyone thinks the Fed has more power than they do is because the stock market is so dependent on the shortest end of the yield curve, which the Fed does influence, so people conflate the stock market effects with the real economy. Any institution, corporation, or fund that is able to borrow at practically zero can leverage up risk assets, which unquestionably forces more and more people out the risk curve, and amplifies an expansionary period. Money flows into tech as a proxy for duration because the cash flows of the present are dwarfed by returns from growth stocks pricing in the cash flows of the future, so multiples expand. This has almost no effect on CPI in the real economy at all besides a very weak wealth effect that comes from people seeing their retirement accounts, or the value of their house, increasing. Additionally, if the Fed buys bonds from non-banks the cash can bid up stock prices.
When the Fed keeps overnight rates below where the market would set them, zombie companies are kept alive that shouldn't be, but those jobs and that economic activity is not nearly enough to nudge the broad prices of CPI higher. When corporations can borrow cheap to fund buyback programs, reduce their share count, and drive up both their EPS and the stock price, the effect is also not broad enough to nudge CPI higher. QE and ZIRP only inflate asset prices, so the Fed's bubble blowing machine is constrained to financial markets.
Financial bubbles don't need higher interest rates to pop - simple human psychology is enough. People have an intuitive sense of what the price should be, and while that gets muted by greed and irrational thinking during bubbles, eventually the buyers hesitate, and the whole thing implodes. That's literally the restraint on every speculative market in history. The Fed just quickens the end.
Dodo Bird Death
The lack of oil capex is certainly a compelling narrative, not so much as a source of runaway CPI, but as a catalyst for recession. The way to gauge the burden of oil is to determine what percentage of discretionary income oil consumes and compare it to other eras, as opposed to thinking $80 oil is twice as bad as $40 in the 90s because wages have gone up to compensate, and debt levels are higher too. As the slow transition to EV's unfolds over the decade and oil companies are disincentivized to keep drilling, oil could find an equilibrium at a higher price, but that doesn't have to be any more disruptive than when it's moved up in the past. Until the '70s oil was well under $10 a barrel. Since then everything has moved up in price permanently, including the wages to pay for it. And why is everyone so sure that the current capex spending isn't the right amount given EV adoption will be moving from the lower left to the upper right? That seems like an assumption which is hard to calculate and may or may not be true.
It is certainly an interesting dynamic, and while there might be crazy spikes from temporary geopolitical dislocations, and a mismatched timing of wages catching up, the price of oil can only rise so much in such an indebted economy before it causes its own demise by killing the demand.
(I do agree the most self-evident solution to our energy problem is to power the grid with nuclear, and power vehicles with batteries - and if you're concerned about lithium, research sodium-ion batteries and perovskite solar cells - both are not ready for primetime, but they are steadily improving their charge capacity and efficiency. Innovation will lead the way.)
Great Temptations
The only cause of structural inflation would be a permanent Universal Basic Income program that artificially overrides the natural restraints of the banking system by sending money directly to the people without the need for collateral, down payments, or adequate income since it's not a loan. The MMT crowd refuses to acknowledge the money they want the Treasury to spend comes from someone else. There's no free lunch. If you imagine a dollar bill made up of 100 little squares of purchasing power, inflation is taking handfuls of those squares from those who hold cash (or cash equivalents), or those who earn cash but don't own assets, and distributing them to those who own assets that adjust higher in price as the currency is diluted.
The increase in house prices is a transfer of purchasing power from existing debt instruments like cash and bonds, and it disproportionately hurts the poor because they don't own assets, so their lagging wages squeezes their spending. If the Treasury determined the magic number was $10,000 to send to everyone making less than $30,000 a year, it would offset the pain on the poor, but it still comes from someone else. UBI would be a persistent, structural inflation the treasury market would have to account for, so purchasing power would be transferred from bondholders to UBI recipients to the stockholders of the businesses with the products and services they spend it on. Any inflationary impulse short of this lacks the persistent source of funds to maintain it, so it will be restrained by the natural forces of the markets, even if it takes longer for the money to work through the system than anyone believes. Underlying economic principles don't change just because things take time.
Summary
Without creditworthy borrowers with down payments or collateral there is a natural restraint on the inflation created by banks, and the only other source of inflation is the Treasury since the Fed by itself has a weak and dilutive transmission mechanism, and they don't really control interest rates, except the shortest of durations, which is contained to financial markets. Treasury spending programs are not broad enough to create lasting inflation with the exception of UBI, and since rising oil kills its own demand, especially in an environment of heavy debt, any and all CPI spikes have built-in natural restraints that will make them transitory. And since Congress is likely to become even more divided this November, the conditions for structural inflation do not currently exist, and don't appear to be on the horizon.
If this view is correct, what you would expect to see is the YoY% change in M2 go straight up and straight back down, commodity prices go straight up and straight back down, earnings go straight up in the Covid beneficiary businesses then revert to normal, inversions of the Treasury and Eurodollar curves, the rising price of oil hurting spending at businesses like Walmart, and if recession happens from here just about all businesses and their stocks will suffer.
Possible CPI Delays
Since nothing goes in a straight line, here's two main concerns:
1. I don't see why Putin wouldn't use his power over natural gas flows to accomplish what he wants this winter when Europe is the most vulnerable. If he does (and to his credit he did allow wheat exports, which is somewhat surprising for a sociopath), it will likely cause another temporary geopolitical spike in the front months of oil that could cause CPI to stick even longer, but all geopolitical dislocations of price eventually revert to the cost of production plus the market allowed profit. Personally, I'm not into trading the irrational behavior of sociopaths, so I'll stick to my long-term investing allocations. If this does occur, it will be recessionary. Maybe this is what the inverted curves are anticipating, unless it's just a growth slowdown from a Fed overshoot.
2. Another concern is the 2-for-1 job openings-to-unemployed ratio of the labor gap. Covid caused upwards of a million domestic deaths, baby boomers scrambled into retirement, and the flow of immigrants slowed to a halt, putting upward pressure on wages, so if this labor gap doesn't close it could continue to squeeze employers and profit margins. There seems to be an enormous discrepancy between the Establishment and Household methodologies, so I don't know what data to believe anymore, but the people making a stagflation argument have a valid point if oil becomes a problem again at the same time labor keeps putting upward pressure on wages.
However, stagflation is supposed to be driven by a weak dollar, which is how commodity prices keep input costs high regardless of weakening demand. Otherwise, the burden of existing debt leaves no room in discretionary income to weather a period of rising oil, so demand is quickly cooled. While the Fed has no power to cause CPI to rise, they can certainly cause it to fall by inverting the yield curve for as long as it takes to kill any remaining bank lending, which would hurt the consumer and cause the layoffs needed to induce a recession. Combine that with an oil supply shock and you get temporary stagflation, but because there isn't underlying growth caused by a high demand for money like the 70s, and the dollar isn't falling, it's more likely to be a disinflationary recession instead of stagflation. Meaning, in a period of weak economic demand the only thing that can maintain high prices is a supply shock or a weak dollar.
3. There's three things working against stocks: Putin tightening the screws; the labor gap squeezing margins; and, most importantly, QT. The Fed wants to wind down its balance sheet, which is impossible, but I don't see why they would stop unless a plunging stock market forces them like in 2018. That's my belief. If you disagree, it's on you to explain why QE excites stock prices up, but QT doesn't depress them down.
In fact, if you'd like to disagree with this article, here's ten questions to answer:
1. How does money sitting in bank reserves make broad consumer prices go up?
2. How can the consumer afford oil at $150 without devastating their other spending and then dragging down oil?
3. Without a strong demand for bank loans in ever increasing amounts for many years, where is the source of funds coming from to continually pressure consumer prices in ever increasing amounts since CPI is a measurement of change?
4. With CPI over 9, why did treasury yields stop between 3-3.50%?
5. If inflation was a concern why is the yield curve inverted? Shouldn't it be bear-steepening aggressively?
6. If the Fed controls interest rates, how is it possible for the yield curve to invert? Why don't mortgage rates track Fed Funds in lock step?
7. How is a CEO going to reshore any jobs that aren't subsidized if it increases input costs many times over? How will the consumer afford those prices?
8. Why would international businesses choose to transact in Thug Life currencies?
9. If growth slows and commodity prices drop to reflect it, what's the mechanism to drive consumer prices higher?
10. How can a wage/price spiral maintain upward pressure if it doesn't happen broadly all at once? And why would now be different than the last 100 years of rising prices and wages?
The bottom line is nothing has changed. There is a deflationary fire in the black hole of missing manufacturing at the heart of the developed world that is pulling interest rates and growth lower as central banks and governments attempt to fight it with hoses of liquidity.
One chart - SPX daily. Note it's between the 200-day EMA and 200-day SMA. A backtest of the 4168 area would be normal, then we'll see if it can assault the downtrend line. Also, note the positioning on the COT chart that follows. Dealers are extremely net long. They almost never lose. All they need to do is bid the market into Sept OPEX and they will make out like bandits as a huge percentage of those contracts expire and all that money transfers to their accounts. That's not a prediction, it's just a highly unusual situation, and with oil still languishing it's not likely CPI is going to be a huge upside miss. I suppose Powell or NFP could be downside catalysts, but if you ask yourself what is the nastiest thing that could happen it would be a breakout of this triangle into OPEX. The short yellow line is the 61.8% retracement. Look at all the shorts who are currently trapped. Don't you think they have to puke up their position before the market goes lower? Just food for thought. Personally, I don't think the bear market will be over until we revisit the lows or likely make new ones, but that doesn't mean we can't double top, or reverse off the 61.8 retracement. From a trading perspective, these are the key levels setting up for Sept. I'm mostly an investor now, so I don't really care. Apple's going to $350, so if it makes new lows first, isn't that a good thing?
COT chart
Bonus Song - if this doesn't blow your hair back, we can be cordial acquaintances, but we will never really know each other.
