I can't believe there are still people saying inflation isn't transitory, so instead of expressing the concepts like last time, I'll anchor them in my actual experience of owning a business through all of this to show you how inflation causes deflation, then we'll explore a time frame, and see if the market is confirming this view (spoiler: it is).
Let's start with the customer. Whether people are aware of it or not, everyone is running a business by being alive. At the end of every month you can subtract your expenses from your income and calculate your month's profit. Pick a number, but for the bottom X% of the population that disposable income is very limited, and it gets squeezed by rising costs if their wages don't keep up. I assume we can agree on that.
My small business used to have seven employees; now it has five. My number 1 & number 2 have been with me from the beginning. My number 3 replaced two part-time family members who graduated and moved on. At the end of each year I give everyone a raise and a bonus. I already paid above market rates because I value loyalty over squeezing out a little extra profit, and I think of them like family. This year I overheard them grumbling about rising living costs, so I gave them an additional raise in the summer. I plan on another at the end of the year. Thus far I've been able to grow revenues to compensate for this, so the bottom line has increased. In fact, in four years, I've grown the top and bottom line 3x while paying my employees nearly twice what the previous owner paid hers. Some of this was due to skill in selecting the right business and executing on it, some was luck, and some was divine intervention.
My suppliers have all been complaining about their input costs rising, so they've been raising their prices to maintain their margins and free cash flow because obviously they too are a business.
With the disposable income of my customers getting squeezed by higher expenses, last quarter (Q3) (ending August 31st) is the first time my revenue and net profit is significantly down (the net profit is 50% of Q3 2020 and 25% of Q3 of 2021). I also had to run a 20% and 10% discount this Q3 to move "inventory," so the net profit is down due to higher employee costs, higher supplier costs, and less demand. If I was a publicly traded company I would have to pre-announce to soften the blow and give vague guidance because I don't know for sure that some of the cause isn't people spending way more on vacations this summer, but I do know there is a significant drop in customer spending.
One thing I did was consolidate hours. I had 2 employees who only worked one day a week (for depth of staff), but they didn't take it seriously because they kept calling in, and since my number 2 wanted more hours, I gave their shifts to him. Even though it's the same amount of hours, in theory, 2 people lost their part-time job.
I've also negotiated with my suppliers for better prices, hinting that I may have to look elsewhere (meaning, I'm the customer not wanting to pay full price, so give me a discount). Business is a game of who needs who more? Do I need the employees more than they need the job? Do the suppliers need me more than I need them? Do I need this customer wanting a discount more than they need me? It's a balancing act of negotiation that requires constantly reading people. Fortunately, I'm good at that. So the suppliers came down a bit to share the burden, which means it eats into their margins and free cash flow too, but if this continues we are both going to get squeezed even more.
With demand down I will be careful not to order too much, in fact, I'm ordering less, so the supplier gets the feedback to produce less, which translates into less economic activity. When customer demand softens, particularly if it's because their discretionary income is shrinking because their expenses are rising faster than their wages, then I have to lower my prices to clear "inventory," but most of my expenses are fixed, so it leads to less earnings as seen in Q3. Since I'm in year four of a six year lease, rent hasn't gone up - yet. Utilities are up, which, of course, is tied to commodities as the baseline input to everyone's business on every level.
Do you see how inflation causes deflation? It's all about the free cash flow of the customer, which is limited. If it gets squeezed by expenses being higher than wage increases they will spend less and it spirals downward back onto businesses and their supply chains, squeezing margins, and causing less production and economic activity. If it keeps going it leads to layoffs and spending cuts that perpetuates the cycle, but debts remain, so inevitably people start using credit cards to pay bills, but eventually they run out of credit, so they stop paying credit cards, then mortgages, then cars. If it keeps going, centralized credit institutions get impaired, which causes either significant write-downs, or systemic risk if it's bad enough, which forces the central bank to socialize losses by buying up toxic debt, so the downward spiral must be stopped and reversed at some point. This is why there will always be a Fed put. It's not a choice. The only bright spot is the shortage of labor could help keep wages up while we go through this, but it doesn't seem sufficient to me.
With what I just described in mind, how is it possible to have a permanent condition of inflation? The term transitory is not to predict the length of time, it's to describe the mechanism of markets limiting the effects of inflation because it causes its own demise by consuming disposable income, which starts a deflationary spiral that destroys earnings, spending, and jobs. This has nothing to do with the Fed. It's simply markets at work. Wages lag rising costs. The Fed can't print creditworthy borrowers, wage increases, or money into my customer's bank accounts. They can cause the stock and bond markets to inflate, which has some degree of wealth and psychological effect, but it doesn't put money into the hands of my customers to spend. I don't care what the economic textbooks say - I'm living it. And I should note just because my Q3 was down so much doesn't mean the greatest businesses in the world will see the same result, but it sure is a potential warning sign for the next 6-12 months. Deflation is at work, as seen with Fedex and Walmart.
Let's do a reality check to see if the market is confirming this view:
Treasury curve: inverted, doesn't care about CPI
Eurodollar curve: inverted, no fucks given.
5y 5y Forward Inflation Expectation: 2.27%
5-year breakeven: 2.49%
Oil, lumber, copper, silver, wheat, corn, gold, and nearly every commodity: currently downtrending.
Housing: coming down, but kinda sticky. With mortgage rates very high relative to recent years, and disposable income getting squeezed, this should continue to slow down. This lags the most because it's not driven by speculators pricing in the future like the other markets, so it's not surprising it will be last to be dragged down by a contracting economy as people tighten their spending or lose their jobs. Meaning, derivative markets look ahead and price in the future while housing and OER reflects the sentiment of the present and policies of the past.
CPI - Reverberations of the Past
The inflationists are strutting around like proud peacocks again, but they aren't making sense. And I do give the ones who aren't perma-inflationists all the credit for the correct call when inflation was happening two years ago. The CPI data we see now is the reverberations of the inflationary policies from 2020, which have long ago ended. Why is the concept of time so disregarded? I don't get it. It's like someone drank a bottle of whiskey and started acting intoxicated buying up everything on the internet, then the booze starts wearing off as fatigue and confusion sets in, and he's still flailing at the button for that last available foot massager, but as the pain of the impending hangover starts kicking in, the inflationists are saying he's gonna stay drunk forever, in fact, next year he'll be double digit drunk! How? The alcohol ran out. It's just working through his system. If your thesis is inflation will happen again when the Fed pivots, which will cause the dollar to descend (especially if the war ends and Europe's acute woes subside), so commodities will rally and increase input costs, that makes sense, which means you agree inflation is transitory, and so is the deflation happening now that will cause the Fed pivot. It's all cycles. And the next wave of inflation is going to depend on how low commodities like oil go during the deflation because don't forget the Fed doesn't put money into people's hands, so demand will be a concern. (Let me note as well, if commodity prices were to relentlessly rally despite collapsing consumer disposable income, then I would agree CPI would resume an uptrend, or stay elevated until equilibrium occurred. I've noted before my concern about oil supply, but based on what I'm seeing in my business and what the leading indicators are pricing, it doesn't seem possible because the demand will come down just as fast as supply during a deflationary period, but should that occur, then what I'm writing would be wrong. I don't really care about my opinion. I let the markets tell me what to think and adjust when necessary. Is there any other way?)
Unfortunately, it seems like we will have to listen to the inflationists for a few more months due to base effects. Here's the actual CPI data of the last year. Note the big MoM% changes in yellow that will drop off as we get to them. We also have to keep in mind that housing is slooow moving, so OER could be what I would argue as falsely elevated for awhile (in relation to what is actually happening in the surrounding economic data reflecting actual customer spending affected by squeezing disposable income).
Also, residential rents renew yearly, so that's a rolling issue going forward, but as housing slows it will slow too. Certainly, food was a bigger problem than it has been, both recently, and this year, and gasoline last month was down 10%, so if gas stops going down at this rate of change, other items have to go down to makeup the difference. Probably the biggest short-term concerns are housing and food from the fertilizer disruption. Also note over the last 3 months the level of CPI (in the 296's) has stopped going up.
